Thursday, July 31, 2008

Are Markets Rational?

Traditional definition of economics is all about the efficiency of markets, "the Price is Right!" (1) , and the optimization of Supply and Demand. Furthermore, it advocates that individuals make rational decisions based on all available information.

That's the theory, but is that necessarily true in real life?

In a simplistic example; when deciding whether to have fruit or a chocolate chip cookie, the rational decision would be to choose the fruit, as it's much healthier. However, when given a choice, many of us would choose the cookie - I know I would!

For a more relevant example, we can easily turn to the current housing crisis. When given the choice between putting no money down for a house, and in addition taking an ARM (adjustable rate mortgage) as opposed to a traditional 20% down payment and fixed interest mortgage rate, we have seen many individuals choosing to go with the first option.

What makes ARMs attractive, initially, is the fact that they usually offer a lower rate than the standard interest rate. However, this is only temporary, and after a set period, the interest rate then fluctuates based on some hybrid or common index of interest rates. The risk is if the interest rates go up, it will significantly increase one's monthly mortgage payments. In addition, many ARMs can be structured by lenders which make it unfavorable to pay off the principle early, in the form of fees.

Unfortunately for many, the rates have gone up, due to the Fed's concern regarding inflation. As a result, many saw their monthly mortgage payments double or triple. Very often, an individual's monthly income does not provide enough flexibility to handle sudden increases in required mortgage payments. When an individual is unable to pay the new mortgage amount in full, what happens is that whatever amount they do submit, first goes towards the interest -- not the principle! This results in negative amortization, whereby the principle (original amount to be paid) increases! This can be exasperated in situations where already the individual did not put any down payment towards the principle. The negative amortization leads to a downward spiral where the interest applied to the principle increases, thereby increasing the monthly mortgage, very often leading to foreclosure.

If interest rates are high and there is some future expectation that rates continue to decline, ARMs may make sense if the individual intends to pay off the mortgage relatively quickly or if they flip the house. However, at some point the rates will go back up, so if the expectation is that you will hold onto your home for 15 or 30 years, this could lead to financial difficulties. So ARMs require very careful assessment, as well as some level of financial savviness - which a majority of Americans do not have according to a recent NY Times blog on Freakonomics.

So does this imply that we are always doomed to making the wrong choices? Fortunately, the answer is NO! In a recent book, "Nudge: Improving Decisions about Health, Wealth, and Happiness", written by Richard Thaler and Cass R. Sunstein, the authors demonstrate that while individuals have difficulty to make rational decisions, conscious interventions can be applied to ensure that the right decisions are being made. Thaler and Sunstein are Behavioral economists who speak to a different philosophy, which advocates that social, psychological or emotional biases need to be taken into account when explaining or making market decisions.

So we know an individual may not always make rational decisions 100% of the time, but what about organizations - for example Corporations or Wall Street?

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Tuesday, July 29, 2008

Brave New World - Part 2

I came across an interesting article in Psychology Today, I somehow came across this link, and I confess I can't remember how I came across this link, but that's neither here nor there.

It was talking about our political beliefs, and how they are influenced by upbringing, education, and fear of death (9/11 effect)! This study also looked at characteristics of conservatives vs liberals. For example, conservatives tend to be much more black and white, whereas liberals tended to see gray - no surprise.

The conventional wisdom is that our early political stance is very much shaped by our parents, and the opinions of those who influence our thinking. Generally speaking if your parents voted democrat, you would tend to vote the same. In addition, the level of education you had also influenced your political ideology - up to a point. For example generally the more education you had, the more likely you would be liberal, with the exception of professionals in banking, finance, etc.

But what I found most fascinating was the shift of political beliefs AFTER 9/11. The authors saw a trend that after 9/11, there was a phenomenon where traditional liberals turned into conservatives.

According to the authors:
"For liberals, conservatives, and independents alike, thinking about death actually makes people more conservative—at least temporarily."
As an example, the famous ad of the little girl sitting in the field plucking a daisy, with a mushroom cloud going off in the background was an ad used by Lyndon B. Johnson in 1964.

The article further goes on to claim:
"Solomon demonstrated that thinking about 9/11 made people go from preferring Kerry to preferring Bush. "Very subtle manipulations of psychological conditions profoundly affect political preferences," Solomon concludes. "In difficult moments, people don't want complex, nuanced, John Kerry-like waffling or sophisticated cogitation. They want somebody charismatic to step up and say, 'I know where our problem is and God has given me the clout to kick those people's asses.'" "

But using the concept of "fear" is not a new marketing tool. It's been there since the birth of Marketing. In fact, the Gillette "Safety Razor" ad campaign in the early 1900s was using this as a marketing tool to sell their product:
Gillette Safety Razor: 'When you use my razor, you are exempt from the dangers that men often encounter who allow their faces to come in contact with brush, soap, and barbershop accessories used on other people'
They were basically trading on the public's anxiety that if I don't use this product I could inadvertently attract diseases.

But again, are we then resigned to being so manipulated?

Interestingly enough, the authors propose that when test subjects are told to take a moment to think it over, they generally were able to be rational, and suppress their impulsive decisions when confronted with negative images.
"People have two modes of thought," concludes Solomon. "There's the intuitive gut-level mode, which is what most of us are in most of the time. And then there's a rational analytic mode, which takes effort and attention."

"The solution, then, is remarkably simple. The effects of psychological terror on political decision making can be eliminated just by asking people to think rationally. Simply reminding us to use our heads, it turns out, can be enough to make us do it."

Why do I bring all of this up? As this is an election year, there is a lot of advertising and coverage that the average American Voter will be subjected to, and it is my hope, that people will vote rationally, as opposed to impulsively based on "fear-based" advertising.
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