The right (and wrong) way to buy stocks

July 9, JDN 2457944

Most people don’t buy stocks at all. Stock equity is the quintessential form of financial wealth, and 42% of financial net wealth in the United States is held by the top 1%, while the bottom 80% owns essentially none.

Half of American households do not have any private retirement savings at all, and are depending either on employee pensions or Social Security for their retirement plans.

This is not necessarily irrational. In order to save for retirement, one must first have sufficient income to live on. Indeed, I got very annoyed at a “financial planning seminar” for grad students I attended recently, trying to scare us about the fact that almost none of us had any meaningful retirement savings. No, we shouldn’t have meaningful retirement savings, because our income is currently much lower than what we can expect to get once we graduate and enter our professions. It doesn’t make sense for someone scraping by on a $20,000 per year graduate student stipend to be saving up for retirement, when they can quite reasonably expect to be making $70,000-$100,000 per year once they finally get that PhD and become a professional economist (or sociologist, or psychologist or physicist or statistician or political scientist or material, mechanical, chemical, or aerospace engineer, or college professor in general, etc.). Even social workers, historians, and archaeologists make a lot more money than grad students. If you are already in the workforce and only expect to be getting small raises in the future, maybe you should start saving for retirement in your 20s. If you’re a grad student, don’t bother. It’ll be a lot easier to save once your income triples after graduation. (Personally, I keep about $700 in stocks mostly to get a feel for what it is like owning and trading stocks that I will apply later, not out of any serious expectation to support a retirement fund. Even at Warren Buffet-level returns I wouldn’t make more than $200 a year this way.)

Total US retirement savings are over $25 trillion, which… does actually sound low to me. In a country with a GDP now over $19 trillion, that means we’ve only saved a year and change of total income. If we had a rapidly growing population this might be fine, but we don’t; our population is fairly stable. People seem to be relying on economic growth to provide for their retirement, and since we are almost certainly at steady-state capital stock and fairly near full employment, that means waiting for technological advancement.

So basically people are hoping that we get to the Wall-E future where the robots will provide for us. And hey, maybe we will; but assuming that we haven’t abandoned capitalism by then (as they certainly haven’t in Wall-E), maybe you should try to make sure you own some assets to pay for robots with?

But okay, let’s set all that aside, and say you do actually want to save for retirement. How should you go about doing it?

Stocks are clearly the way to go. A certain proportion of government bonds also makes sense as a hedge against risk, and maybe you should even throw in the occasional commodity future. I wouldn’t recommend oil or coal at this point—either we do something about climate change and those prices plummet, or we don’t and we’ve got bigger problems—but it’s hard to go wrong with corn or steel, and for this one purpose it also can make sense to buy gold as well. Gold is not a magical panacea or the foundation of all wealth, but its price does tend to correlate negatively with stock returns, so it’s not a bad risk hedge.

Don’t buy exotic derivatives unless you really know what you’re doing—they can make a lot of money, but they can lose it just as fast—and never buy non-portfolio assets as a financial investment. If your goal is to buy something to make money, make it something you can trade at the click of a button. Buy a house because you want to live in that house. Buy wine because you like drinking wine. Don’t buy a house in the hopes of making a financial return—you’ll have leveraged your entire portfolio 10 to 1 while leaving it completely undiversified. And the problem with investing in wine, ironically, is its lack of liquidity.

The core of your investment portfolio should definitely be stocks. The biggest reason for this is the equity premium; equities—that is, stocks—get returns so much higher than other assets that it’s actually baffling to most economists. Bond returns are currently terrible, while stock returns are currently fantastic. The former is currently near 0% in inflation-adjusted terms, while the latter is closer to 16%. If this continues for the next 10 years, that means that $1000 put in bonds would be worth… $1000, while $1000 put in stocks would be worth $4400. So, do you want to keep the same amount of money, or quadruple your money? It’s up to you.

Higher risk is generally associated with higher return, because rational investors will only accept additional risk when they get some additional benefit from it; and stocks are indeed riskier than most other assets, but not that much riskier. For this to be rational, people would need to be extremely risk-averse, to the point where they should never drive a car or eat a cheeseburger. (Of course, human beings are terrible at assessing risk, so what I really think is going on is that people wildly underestimate the risk of driving a car and wildly overestimate the risk of buying stocks.)

Next, you may be asking: How does one buy stocks? This doesn’t seem to be something people teach in school.

You will need a brokerage of some sort. There are many such brokerages, but they are basically all equivalent except for the fees they charge. Some of them will try to offer you various bells and whistles to justify whatever additional cut they get of your trades, but they are almost never worth it. You should choose one that has a low a trade fee as possible, because even a few dollars here and there can add up surprisingly quickly.

Fortunately, there is now at least one well-established reliable stock brokerage available to almost anyone that has a standard trade fee of zero. They are called Robinhood, and I highly recommend them. If they have any downside, it is ironically that they make trading too easy, so you can be tempted to do it too often. Learn to resist that urge, and they will serve you well and cost you nothing.

Now, which stocks should you buy? There are a lot of them out there. The answer I’m going to give may sound strange: All of them. You should buy all the stocks.

All of them? How can you buy all of them? Wouldn’t that be ludicrously expensive?

No, it’s quite affordable in fact. In my little $700 portfolio, I own every single stock in the S&P 500 and the NASDAQ. If I get a little extra money to save, I may expand to own every stock in Europe and China as well.

How? A clever little arrangement called an exchange-traded fund, or ETF for short. An ETF is actually a form of mutual fund, where the fund purchases shares in a huge array of stocks, and adjusts what they own to precisely track the behavior of an entire stock market (such as the S&P 500). Then what you can buy is shares in that mutual fund, which are usually priced somewhere between $100 and $300 each. As the price of stocks in the market rises, the price of shares in the mutual fund rises to match, and you can reap the same capital gains they do.

A major advantage of this arrangement, especially for a typical person who isn’t well-versed in stock markets, is that it requires almost no attention at your end. You can buy into a few ETFs and then leave your money to sit there, knowing that it will grow as long as the overall stock market grows.

But there is an even more important advantage, which is that it maximizes your diversification. I said earlier that you shouldn’t buy a house as an investment, because it’s not at all diversified. What I mean by this is that the price of that house depends only on one thing—that house itself. If the price of that house changes, the full change is reflected immediately in the value of your asset. In fact, if you have 10% down on a mortgage, the full change is reflected ten times over in your net wealth, because you are leveraged 10 to 1.

An ETF is basically the opposite of that. Instead of its price depending on only one thing, it depends on a vast array of things, averaging over the prices of literally hundreds or thousands of different corporations. When some fall, others will rise. On average, as long as the economy continues to grow, they will rise.

The result is that you can get the same average return you would from owning stocks, while dramatically reducing the risk you bear.

To see how this works, consider the past year’s performance of Apple (AAPL), which has done very well, versus Fitbit (FIT), which has done very poorly, compared with the NASDAQ as a whole, of which they are both part.

AAPL has grown over 50% (40 log points) in the last year; so if you’d bought $1000 of their stock a year ago it would be worth $1500. FIT has fallen over 60% (84 log points) in the same time, so if you’d bought $1000 of their stock instead, it would be worth only $400. That’s the risk you’re taking by buying individual stocks.

Whereas, if you had simply bought a NASDAQ ETF a year ago, your return would be 35%, so that $1000 would be worth $1350.

Of course, that does mean you don’t get as high a return as you would if you had managed to choose the highest-performing stock on that index. But you’re unlikely to be able to do that, as even professional financial forecasters are worse than random chance. So, would you rather take a 50-50 shot between gaining $500 and losing $600, or would you prefer a guaranteed $350?

If higher return is not your only goal, and you want to be socially responsible in your investments, there are ETFs for that too. Instead of buying the whole stock market, these funds buy only a section of the market that is associated with some social benefit, such as lower carbon emissions or better representation of women in management. On average, you can expect a slightly lower return this way; but you are also helping to make a better world. And still your average return is generally going to be better than it would be if you tried to pick individual stocks yourself. In fact, certain classes of socially-responsible funds—particularly green tech and women’s representation—actually perform better than conventional ETFs, probably because most investors undervalue renewable energy and, well, also undervalue women. Women CEOs perform better at lower prices; why would you not want to buy their companies?

In fact ETFs are not literally guaranteed—the market as a whole does move up and down, so it is possible to lose money even by buying ETFs. But because the risk is so much lower, your odds of losing money are considerably reduced. And on average, an ETF will, by construction, perform exactly as well as the average performance of a randomly-chosen stock from that market.

Indeed, I am quite convinced that most people don’t take enough risk on their investment portfolios, because they confuse two very different types of risk.

The kind you should be worried about is idiosyncratic risk, which is risk tied to a particular investment—the risk of having chosen the Fitbit instead of Apple. But a lot of the time people seem to be avoiding market risk, which is the risk tied to changes in the market as a whole. Avoiding market risk does reduce your chances of losing money, but it does so at the cost of reducing your chances of making money even more.

Idiosyncratic risk is basically all downside. Yeah, you could get lucky; but you could just as well get unlucky. Far better if you could somehow average over that risk and get the average return. But with diversification, that is exactly what you can do. Then you are left only with market risk, which is the kind of risk that is directly tied to higher average returns.

Young people should especially be willing to take more risk in their portfolios. As you get closer to retirement, it becomes important to have more certainty about how much money will really be available to you once you retire. But if retirement is still 30 years away, the thing you should care most about is maximizing your average return. That means taking on a lot of market risk, which is then less risky overall if you diversify away the idiosyncratic risk.

I hope now that I have convinced you to avoid buying individual stocks. For most people most of the time, this is the advice you need to hear. Don’t try to forecast the market, don’t try to outperform the indexes; just buy and hold some ETFs and leave your money alone to grow.

But if you really must buy individual stocks, either because you think you are savvy enough to beat the forecasters or because you enjoy the gamble, here’s some additional advice I have for you.

My first piece of advice is that you should still buy ETFs. Even if you’re willing to risk some of your wealth on greater gambles, don’t risk all of it that way.

My second piece of advice is to buy primarily large, well-established companies (like Apple or Microsoft or Ford or General Electric). Their stocks certainly do rise and fall, but they are unlikely to completely crash and burn the way that young companies like Fitbit can.

My third piece of advice is to watch the price-earnings ratio (P/E for short). Roughly speaking, this is the number of years it would take for the profits of this corporation to pay off the value of its stock. If they pay most of their profits in dividends, it is approximately how many years you’d need to hold the stock in order to get as much in dividends as you paid for the shares.

Do you want P/E to be large or small? You want it to be small. This is called value investing, but it really should just be called “investing”. The alternatives to value investing are actually not investment but speculation and arbitrage. If you are actually investing, you are buying into companies that are currently undervalued; you want them to be cheap.

Of course, it is not always easy to tell whether a company is undervalued. A common rule-of-thumb is that you should aim for a P/E around 20 (20 years to pay off means about 5% return in dividends); if the P/E is below 10, it’s a fantastic deal, and if it is above 30, it might not be worth the price. But reality is of course more complicated than this. You don’t actually care about current earnings, you care about future earnings, and it could be that a company which is earning very little now will earn more later, or vice-versa. The more you can learn about a company, the better judgment you can make about their future profitability; this is another reason why it makes sense to buy large, well-known companies rather than tiny startups.

My final piece of advice is not to trade too frequently. Especially with something like Robinhood where trades are instant and free, it can be tempting to try to ride every little ripple in the market. Up 0.5%? Sell! Down 0.3%? Buy! And yes, in principle, if you could perfectly forecast every such fluctuation, this would be optimal—and make you an almost obscene amount of money. But you can’t. We know you can’t. You need to remember that you can’t. You should only trade if one of two things happens: Either your situation changes, or the company’s situation changes. If you need the money, sell, to get the money. If you have extra savings, buy, to give those savings a good return. If something bad happened to the company and their profits are going to fall, sell. If something good happened to the company and their profits are going to rise, buy. Otherwise, hold. In the long run, those who hold stocks longer are better off.

How not to do financial transaction tax

JDN 2457520

I strongly support the implementation of a financial transaction tax; like a basic income, it’s one of those economic policy ideas that are so brilliantly simple it’s honestly a little hard to believe how incredibly effective they are at making the world a better place. You mean we might be able to end stock market crashes just by implementing this little tax that most people will never even notice, and it will raise enough revenue to pay for food stamps? Yes, a financial transaction tax is that good.

So, keep that in mind when I say this:

TruthOut’s proposal for a financial transaction tax is somewhere between completely economically illiterate and outright insane.

They propose a 10% transaction tax on stocks and a 1% transaction tax on notional value of derivatives, then offer a “compromise” of 5% on stocks and 0.5% on derivatives. They make a bunch of revenue projections based on these that clearly amount to nothing but multiplying the current amount of transactions by the tax rate, which is so completely wrong we now officially have a left-wing counterpart to trickle-down voodoo economics.

Their argument is basically like this (I’m paraphrasing): “If we have to pay 5% sales tax on groceries, why shouldn’t you have to pay 5% on stocks?”

But that’s not how any of this works.

Demand for most groceries is very inelastic, especially in the aggregate. While you might change which groceries you’ll buy depending on their respective prices, and you may buy in bulk or wait for sales, over a reasonably long period (say a year) across a large population (say all of Michigan or all of the US), total amount of spending on groceries is extremely stable. People only need a certain amount of food, and they generally buy that amount and then stop.

So, if you implement a 5% sales tax that applies to groceries (actually sales tax in most states doesn’t apply to most groceries, but honestly it probably should—offset the regressiveness by providing more social services), people would just… spend about 5% more on groceries. Probably a bit less than that, actually, since suppliers would absorb some of the tax; but demand is much less elastic for groceries than supply, so buyers would bear most of the incidence of the tax. (It does not matter how the tax is collected; see my tax incidence series for further explanation of why.)

Other goods like clothing and electronics are a bit more elastic, so you’d get some deadweight loss from the sales tax; but at a typical 5% to 10% in the US this is pretty minimal, and even the hefty 20% or 30% VATs in some European countries only have a moderate effect. (Denmark’s 180% sales tax on cars seems a bit excessive to me, but it is Pigovian to disincentivize driving, so it also has very little deadweight loss.)

But what would happen if you implemented a 5% transaction tax on stocks? The entire stock market would immediately collapse.

A typical return on stocks is between 5% and 15% per year. As a rule of thumb, let’s say about 10%.

If you pay 5% sales tax and trade once per year, tax just cut your return in half.

If you pay 5% sales tax and trade twice per year, tax destroyed your return completely.

Even if you only trade once every five years, a 5% sales tax means that instead of your stocks being worth 61% more after those 5 years they are only worth 53% more. Your annual return has been reduced from 10% to 8.9%.

But in fact there are many perfectly legitimate reasons to trade as often as monthly, and a 5% tax would make monthly trading completely unviable.

Even if you could somehow stop everyone from pulling out all their money just before the tax takes effect, you would still completely dry up the stock market as a source of funding for all but the most long-term projects. Corporations would either need to finance their entire operations out of cash or bonds, or collapse and trigger a global depression.

Derivatives are even more extreme. The notional value of derivatives is often ludicrously huge; we currently have over a quadrillion dollars in notional value of outstanding derivatives. Assume that say 10% of those are traded every year, and we’re talking $100 trillion in notional value of transactions. At 0.5% you’re trying to take in a tax of $500 billion. That sounds fantastic—so much money!—but in fact what you should be thinking about is that’s a really strong avoidance incentive. You don’t think banks will find a way to restructure their trading practices—or stop trading altogether—to avoid this tax?

Honestly, maybe a total end to derivatives trading would be tolerable. I certainly think we need to dramatically reduce the amount of derivatives trading, and much of what is being traded—credit default swaps, collateralized debt obligations, synthetic collateralized debt obligations, etc.—really should not exist and serves no real function except to obscure fraud and speculation. (Credit default swaps are basically insurance you can buy on other people’s companies. There’s a reason you’re not allowed to buy insurance on other people’s stuff!) Interest rate swaps aren’t terrible (when they’re not being used to perpetrate the largest white-collar crime in history), but they also aren’t necessary. You might be able to convince me that commodity futures and stock options are genuinely useful, though even these are clearly overrated. (Fun fact: Futures markets have been causing financial crises since at least Classical Rome.) Exchange-traded funds are technically derivatives, and they’re just fine (actually ETFs are very low-risk, because they are inherently diversified—which is why you should probably be buying them); but actually their returns are more like stocks, so the 0.5% might not be insanely high in that case.

But stocks? We kind of need those. Equity financing has been the foundation of capitalism since the very beginning. Maybe we could conceivably go to a fully debt-financed system, but it would be a radical overhaul of our entire financial system and is certainly not something to be done lightly.

Indeed, TruthOut even seems to think we could apply the same sales tax rate to bonds, which means that debt financing would also collapse, and now we’re definitely talking about global depression. How exactly is anyone supposed to finance new investments, if they can’t sell stock or bonds? And a 5% tax on the face value of stock or bonds, for all practical purposes, is saying that you can’t sell stock or bonds. It would make no one want to buy them.

Wealthy investors buying of stocks and bonds is essentially no different than average folks buying food, clothing or other real “goods and services.”

Yes it is. It is fundamentally different.

People buy goods to use them. People buy stocks to make money selling them.

This seems perfectly obvious, but it is a vital distinction that seems to be lost on TruthOut.

When you buy an apple or a shoe or a phone or a car, you care how much it costs relative to how useful it is to you; if we make it a bit more expensive, that will make you a bit less likely to buy it—but probably not even one-to-one so that a 5% tax would reduce purchases by 5%; it would probably be more like a 2% reduction. Demand for goods is inelastic. Taxing them will raise a lot of revenue and not reduce the quantity purchased very much.

But when you buy a stock or a bond or an interest rate swap, you care how much it costs relative to what you will be able to sell it for—you care about not its utility but its return. So a 5% tax will reduce the amount of buying and selling by substantially more than 5%—it could well be 50% or even 100%. Demand for financial assets is elastic. Taxing them will not raise much revenue but will substantially reduce the quantity purchased.

Now, for some financial assets, we want to reduce the quantity purchased—the derivatives market is clearly too big, and high-frequency trading that trades thousands of times per second can do nothing but destabilize the financial system. Joseph Stiglitz supports a small financial transaction tax precisely because it would substantially reduce high-frequency trading, and he’s a Nobel Laureate as you may recall. Naturally, he was excluded from the SEC hearings on the subject, because reasons. But the figures Stiglitz is talking about (and I agree with) are on the order of 0.1% for stocks and 0.01% for derivatives—50 times smaller than what TruthOut is advocating.

At the end, they offer another “compromise”:

Okay, half it again, to a 2.5 percent tax on stocks and bonds and a 0.25 percent on derivative trades. That certainly won’t discourage stock and bond trading by the rich (not that that is an all bad idea either).

Yes it will. By a lot. That’s the whole point.

A financial transaction tax is a great idea whose time has come; let’s not ruin its reputation by setting it at a preposterous value. Just as a $15 minimum wage is probably a good idea but a $250 minimum wage is definitely a terrible idea, a 0.1% financial transaction tax could be very beneficial but a 5% financial transaction tax would clearly be disastrous.

Happy Capybara Day! Or the power of culture

JDN 2457131 EDT 14:33.

Did you celebrate Capybara Day yesterday? You didn’t? Why not? We weren’t able to find any actual capybaras this year, but maybe next year we’ll be able to plan better and find a capybara at a zoo; unfortunately the nearest zoo with a capybara appears to be in Maryland. But where would we be without a capybara to consult annually on the stock market?

Right now you are probably rather confused, perhaps wondering if I’ve gone completely insane. This is because Capybara Day is a holiday of my own invention, one which only a handful of people have even heard about.

But if you think we’d never have a holiday so bizarre, think again: For all I did was make some slight modifications to Groundhog Day. Instead of consulting a groundhog about the weather every February 2, I proposed that we consult a capybara about the stock market every April 17. And if you think you have some reason why groundhogs are better at predicting the weather (perhaps because they at least have some vague notion of what weather is) than capybaras are at predicting the stock market (since they have no concept of money or numbers), think about this: Capybara Day could produce extremely accurate predictions, provided only that people actually believed it. The prophecy of rising or falling stock prices could very easily become self-fulfilling. If it were a cultural habit of ours to consult capybaras about the stock market, capybaras would become good predictors of the stock market.

That might seem a bit far-fetched, but think about this: Why is there a January Effect? (To be fair, some researchers argue that there isn’t, and the apparent correlation between higher stock prices and the month of January is simply an illusion, perhaps the result of data overfitting.)

But I think it probably is real, and moreover has some very obvious reasons behind it. In this I’m in agreement with Richard Thaler, a founder of cognitive economics who wrote about such anomalies in the 1980s. December is a time when two very culturally-important events occur: The end of the year, during which many contracts end, profits are assessed, and tax liabilities are determined; and Christmas, the greatest surge of consumer spending and consumer debt.

The first effect means that corporations are very likely to liquidate assets—particularly assets that are running at a loss—in order to minimize their tax liabilities for the year, which will drive down prices. The second effect means that consumers are in search of financing for extravagant gift purchases, and those who don’t run up credit cards may instead sell off stocks. This is if anything a more rational way of dealing with the credit constraint, since interest rates on credit cards are typically far in excess of stock returns. But this surge of selling due to credit constraints further depresses prices.

In January, things return to normal; assets are repurchased, debt is repaid. This brings prices back up to where they were, which results in a higher than normal return for January.

Neoclassical economists are loath to admit that such a seasonal effect could exist, because it violates their concept of how markets work—and to be fair, the January Effect is actually weak enough to be somewhat ambiguous. But actually it doesn’t take much deviation from neoclassical models to explain the effect: Tax policies and credit constraints are basically enough to do it, so you don’t even need to go that far into understanding human behavior. It’s perfectly rational to behave this way given the distortions that are created by taxes and credit limits, and the arbitrage opportunity is one that you can only take advantage of if you have large amounts of credit and aren’t worried about minimizing your tax liabilities. It’s important to remember just how strong the assumptions of models like CAPM truly are; in addition to the usual infinite identical psychopaths, CAPM assumes there are no taxes, no transaction costs, and unlimited access to credit. I’d say it’s amazing that it works at all, but actually, it doesn’t—check out this graph of risk versus return and tell me if you think CAPM is actually giving us any information at all about how stock markets behave. It frankly looks like you could have drawn a random line through a scatter plot and gotten just as good a fit. Knowing how strong its assumptions are, we would not expect CAPM to work—and sure enough, it doesn’t.

Of course, that leaves the question of why our tax policy would be structured in this way—why make the year end on December 31 instead of some other date? And for that, you need to go back through hundreds of years of history, the Gregorian calendar, which in turn was influenced by Christianity, and before that the Julian calendar—in other words, culture.

Culture is one of the most powerful forces that influences human behavior—and also one of the strangest and least-understood. Economic theory is basically silent on the matter of culture. Typically it is ignored entirely, assumed to be irrelevant against the economic incentives that are the true drivers of human action. (There’s a peculiar emotion many neoclassical economists express that I can best describe as self-righteous cynicism, the attitude that we alone—i.e., economists—understand that human beings are not the noble and altruistic creatures many imagine us to be, nor beings of art and culture, but simply cold, calculating machines whose true motives are reducible to profit incentives—and all who think otherwise are being foolish and naïve; true enlightenment is understanding that human beings are infinite identical psychopaths. This is the attitude epitomized by the economist who once sent me an email with “altruism” written in scare quotes.)

Occasionally culture will be invoked as an external (in jargon, exogenous) force, to explain some aspect of human behavior that is otherwise so totally irrational that even invoking nonsensical preferences won’t make it go away. When a suicide bomber blows himself up in a crowd of people, it’s really pretty hard to explain that in terms of rational profit incentives—though I have seen it tried. (It could be self-interest at a larger scale, like families or nations—but then, isn’t that just the tribal paradigm I’ve been arguing for all along?)

But culture doesn’t just motivate us to do extreme or wildly irrational things. It motivates us all the time, often in quite beneficial ways; we wait in line, hold doors for people walking behind us, tip waiters who serve us, and vote in elections, not because anyone pressures us directly to do so (unlike say Australia we do not have compulsory voting) but because it’s what we feel we ought to do. There is a sense of altruism—and altruism provides the ultimate justification for why it is right to do these things—but the primary motivator in most cases is culture—that’s what people do, and are expected to do, around here.

Indeed, even when there is a direct incentive against behaving a certain way—like criminal penalties against theft—the probability of actually suffering a direct penalty is generally so low that it really can’t be our primary motivation. Instead, the reason we don’t cheat and steal is that we think we shouldn’t, and a major part of why we think we shouldn’t is that we have cultural norms against it.

We can actually observe differences in cultural norms across countries in the laboratory. In this 2008 study by Massimo Castro (PDF) comparing British and Italian people playing an economic game called the public goods game in which you can pay a cost yourself to benefit the group as a whole, it was found not only that people were less willing to benefit groups of foreigners than groups of compatriots, British people were overall more generous than Italian people. This 2010 study by Gachter et. al. (actually Joshua Greene talked about it last week) compared how people play the game in various cities, they found three basic patterns: In Western European and American cities such as Zurich, Copenhagen and Boston, cooperation started out high and remained high throughout; people were just cooperative in general. In Asian cities such as Chengdu and Seoul, cooperation started out low, but if people were punished for not cooperating, cooperation would improve over time, eventually reaching about the same place as in the highly cooperative cities. And in Mediterranean cities such as Istanbul, Athens, and Riyadh, cooperation started low and stayed low—even when people could be punished for not cooperating, nobody actually punished them. (These patterns are broadly consistent with the World Bank corruption ratings of these regions, by the way; Western Europe shows very low corruption, while Asia and the Mediterranean show high corruption. Of course this isn’t all that’s going on—and Asia isn’t much less corrupt than the Middle East, while this experiment might make you think so.)

Interestingly, these cultural patterns showed Melbourne as behaving more like an Asian city than a Western European one—perhaps being in the Pacific has worn off on Australia more than they realize.

This is very preliminary, cutting-edge research I’m talking about, so be careful about drawing too many conclusions. But in general we’ve begun to find some fairly clear cultural differences in economic behavior across different societies. While this would not be at all surprising to a sociologist or anthropologist, it’s the sort of thing that economists have insisted for years is impossible.

This is the frontier of cognitive economics, in my opinion. We know that culture is a very powerful motivator of our behavior, and it is time for us to understand how it works—and then, how it can be changed. We know that culture can be changed—cultural norms do change over time, sometimes remarkably rapidly; but we have only a faint notion of how or why they change. Changing culture has the power to do things that simply changing policy cannot, however; policy requires enforcement, and when the enforcement is removed the behavior will often disappear. But if a cultural norm can be imparted, it could sustain itself for a thousand years without any government action at all.

How following the crowd can doom us all

JDN 2457110 EDT 21:30

Humans are nothing if not social animals. We like to follow the crowd, do what everyone else is doing—and many of us will continue to do so even if our own behavior doesn’t make sense to us. There is a very famous experiment in cognitive science that demonstrates this vividly.

People are given a very simple task to perform several times: We show you line X and lines A, B, and C. Now tell us which of A, B or C is the same length as X. Couldn’t be easier, right? But there’s a trick: seven other people are in the same room performing the same experiment, and they all say that B is the same length as X, even though you can clearly see that A is the correct answer. Do you stick with what you know, or say what everyone else is saying? Typically, you say what everyone else is saying. Over 18 trials, 75% of people followed the crowd at least once, and some people followed the crowd every single time. Some people even began to doubt their own perception, wondering if B really was the right answer—there are four lights, anyone?

Given that our behavior can be distorted by others in such simple and obvious tasks, it should be no surprise that it can be distorted even more in complex and ambiguous tasks—like those involved in finance. If everyone is buying up Beanie Babies or Tweeter stock, maybe you should too, right? Can all those people be wrong?

In fact, matters are even worse with the stock market, because it is in a sense rational to buy into a bubble if you know that other people will as well. As long as you aren’t the last to buy in, you can make a lot of money that way. In speculation, you try to predict the way that other people will cause prices to move and base your decisions around that—but then everyone else is doing the same thing. By Keynes called it a “beauty contest”; apparently in his day it was common to have contests for picking the most beautiful photo—but how is beauty assessed? By how many people pick it! So you actually don’t want to choose the one you think is most beautiful, you want to choose the one you think most people will think is the most beautiful—or the one you think most people will think most people will think….

Our herd behavior probably made a lot more sense when we evolved it millennia ago; when most of your threats are external and human beings don’t have that much influence over our environment, the majority opinion is quite likely to be right, and can often given you an answer much faster than you could figure it out on your own. (If everyone else thinks a lion is hiding in the bushes, there’s probably a lion hiding in the bushes—and if there is, the last thing you want is to be the only one who didn’t run.) The problem arises when this tendency to follow the ground feeds back on itself, and our behavior becomes driven not by the external reality but by an attempt to predict each other’s predictions of each other’s predictions. Yet this is exactly how financial markets are structured.

With this in mind, the surprise is not why markets are unstable—the surprise is why markets are ever stable. I think the main reason markets ever manage price stability is actually something most economists think of as a failure of markets: Price rigidity and so-called “menu costs“. If it’s costly to change your price, you won’t be constantly trying to adjust it to the mood of the hour—or the minute, or the microsecondbut instead trying to tie it to the fundamental value of what you’re selling so that the price will continue to be close for a long time ahead. You may get shortages in times of high demand and gluts in times of low demand, but as long as those two things roughly balance out you’ll leave the price where it is. But if you can instantly and costlessly change the price however you want, you can raise it when people seem particularly interested in buying and lower it when they don’t, and then people can start trying to buy when your price is low and sell when it is high. If people were completely rational and had perfect information, this arbitrage would stabilize prices—but since they’re not, arbitrage attempts can over- or under-compensate, and thus result in cyclical or even chaotic changes in prices.

Our herd behavior then makes this worse, as more people buying leads to, well, more people buying, and more people selling leads to more people selling. If there were no other causes of behavior, the result would be prices that explode outward exponentially; but even with other forces trying to counteract them, prices can move suddenly and unpredictably.

If most traders are irrational or under-informed while a handful are rational and well-informed, the latter can exploit the former for enormous amounts of money; this fact is often used to argue that irrational or under-informed traders will simply drop out, but it should only take you a few moments of thought to see why that isn’t necessarily true. The incentives isn’t just to be well-informed but also to keep others from being well-informed. If everyone were rational and had perfect information, stock trading would be the most boring job in the world, because the prices would never change except perhaps to grow with the growth rate of the overall economy. Wall Street therefore has every incentive in the world not to let that happen. And now perhaps you can see why they are so opposed to regulations that would require them to improve transparency or slow down market changes. Without the ability to deceive people about the real value of assets or trigger irrational bouts of mass buying or selling, Wall Street would make little or no money at all. Not only are markets inherently unstable by themselves, in addition we have extremely powerful individuals and institutions who are driven to ensure that this instability is never corrected.

This is why as our markets have become ever more streamlined and interconnected, instead of becoming more efficient as expected, they have actually become more unstable. They were never stable—and the gold standard made that instability worse—but despite monetary policy that has provided us with very stable inflation in the prices of real goods, the prices of assets such as stocks and real estate have continued to fluctuate wildly. Real estate isn’t as bad as stocks, again because of price rigidity—houses rarely have their values re-assessed multiple times per year, let alone multiple times per second. But real estate markets are still unstable, because of so many people trying to speculate on them. We think of real estate as a good way to make money fast—and if you’re lucky, it can be. But in a rational and efficient market, real estate would be almost as boring as stock trading; your profits would be driven entirely by population growth (increasing the demand for land without changing the supply) and the value added in construction of buildings. In fact, the population growth effect should be sapped by a land tax, and then you should only make a profit if you actually build things. Simply owning land shouldn’t be a way of making money—and the reason for this should be obvious: You’re not actually doing anything. I don’t like patent rents very much, but at least inventing new technologies is actually beneficial for society. Owning land contributes absolutely nothing, and yet it has been one of the primary means of amassing wealth for centuries and continues to be today.

But (so-called) investors and the banks and hedge funds they control have little reason to change their ways, as long as the system is set up so that they can keep profiting from the instability that they foster. Particularly when we let them keep the profits when things go well, but immediately rush to bail them out when things go badly, they have basically no incentive at all not to take maximum risk and seek maximum instability. We need a fundamentally different outlook on the proper role and structure of finance in our economy.

Fortunately one is emerging, summarized in a slogan among economically-savvy liberals: Banking should be boring. (Elizabeth Warren has said this, as have Joseph Stiglitz and Paul Krugman.) And indeed it should, for all banks are supposed to be doing is lending money from people who have it and don’t need it to people who need it but don’t have it. They aren’t supposed to be making large profits of their own, because they aren’t the ones actually adding value to the economy. Indeed it was never quite clear to me why banks should be privatized in the first place, though I guess it makes more sense than, oh, say, prisons.

Unfortunately, the majority opinion right now, at least among those who make policy, seems to be that banks don’t need to be restructured or even placed on a tighter leash; no, they need to be set free so they can work their magic again. Even otherwise reasonable, intelligent people quickly become unshakeable ideologues when it comes to the idea of raising taxes or tightening regulations. And as much as I’d like to think that it’s just a small but powerful minority of people who thinks this way, I know full well that a large proportion of Americans believe in these views and intentionally elect politicians who will act upon them.

All the more reason to break from the crowd, don’t you think?