Psychologists to the Rescue!

I don’t often post book reviews, but this one by Eric Falkenstein is particularly intriguing. I’d also like to welcome Eric as our newest contributor to Phil’s Stock World. Eric’s an economist, author of the book "Finding Alpha," and Managing Member of CapRock Advisors. – Ilene

Psychologists to the Rescue!

Courtesy of
Eric Falkenstein of Falkenblog

With Danny Kahneman’s Nobel prize in economics every other week has a big-name author or journalist writing a breathless article about how the new ‘behavioral economics’ will fix sterile financial theory. Alas, way back in 1951 this was a tired theme. George Stigler noted "each decade, for the past nine or ten decades [ie, back to 1851!], economists have read widely in the then-current psychological literature. These explorers have published their findings, and others in the field have found them wanting—wanting in useful hypotheses about economic behavior."

Take, for example, the anchoring bias, where people do not adjust their prior beliefs sufficiently when presented with new data. On the other hand, there’s the case where people do not sufficiently account for base rate information, as for example when they are told a woman is quiet and assume she’s a librarian, not saleswoman, even though there are more saleswomen than librarians. Thus, over, or underreaction to information is a common ‘bias’, and so Kahneman’s classic work Judgment Under Uncertainty: Heuristics and Biases surveys papers from the 1970s! After a generation, the low hanging fruit has been picked, and where are we? Momentum and mean-reversion are part of the ‘new’ finance, and George Soros proudly notes that his theory of markets has markets biased—though it could be in either direction. Yet, these are not really discovered by behavioral economics, but explained by it on a case by case basis. Prospect theory teaches us that people overweight, or underweight, extreme observations in various contexts. These insights are no more useful than saying the effect of X on Y ‘could go either way, depending on a bunch of other information we probably won’t notice until after the fact’.

Finding Alpha A new book about psychiatry, Doctoring the Mind by Richard Bentall argues that the science of the mind is hardly a successful science. He argues that mental illness is on the increase and sufferers in the developed world with access to psychiatric care actually fare worse than patients in poorer countries. It wasn’t too long ago, many psychologists thought a lot of anxiety came from wanting to kill one’s father in order to have sex with one’s mother, an ambition so absurd only a scientist could think it made sense. Then there were lobotomies, homosexuality as a mental illness, criminals having insufficient self esteem (we now know they have too much), autism caused by bad mothering, and on and on. Lastly, have you ever thought that psychologists are happier, more well adjusted people than average? I don’t think so, yet that’s their specialty. So these guys are now going to help economics? I doubt it.

This is not to say I think economics is especially fruitful. My book addresses a rather central issue that I think is flawed in economics. I’m just saying that ‘cognitive biases’ are an embarrassment of riches that lead everywhere and nowhere, which Bentall’s books suggests is hardly surprising.

Tags: Doctoring the Mind, Eric Flakenstein, Finding Alpha, psychiatry, Richard Bebtall

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Psychologists to the Rescue!

Psychologists to the Rescue!