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Efficient Markets & the 18th Century Motorist

Efficient Markets & the 18th Century Motorist

Once upon a time investment professionals believed that markets were efficient and produced a price for any particular investment which represented the true worth of that particular asset. This was called the “Efficient Market Hypothesis”.

It led to the proliferation of very complicated formulae to predict future prices. For example, the Black-Scholes equation was used to price options, i.e., the future price of various investments. This equation is well beyond my mathematical abilities, but for those interested, I understand it is this:-

where V is the price of the option as a function of stock price S and time t, r is the risk-free interest rate, and σ is the volatility of the stock.

Are you any the wiser for knowing this? No? Neither am I.

The Efficient Market Hypothesis took a pasting in 2007 - 2009 when the stock market collapsed. The Dow Jones Industrial Average (an index of prices on the New York Stock Exchange) fell from 14,164.43 on 9 October 2007 to 6,594.44 on 5 March 2009. This wasn’t the first stock market crash; there were crashes before in 1929 and 1932, but the 2008 crash was at a time when very complicated equations like the Black-Scholes equation and massive computing power were being used to price risk. The object of all this mathematical whizz-kiddery was to produce a risk free return in excess of the return from risk free assets such as Government securities. A crash was not supposed to happen.

Enter the psychologists

In 2002, Daniel Kahnemnan won the Nobel Prize in economics. Kahnemann, however, is not an economist; he is a psychologist. His great theme is human irrationality. Together with his now deceased colleague, Amos Tversky, Kahnemann pioneered much of the research into what is now called “behavioural finance”. His best-selling book, ‘Thinking, Fast and Slow’ (a good read for those interested), explains that each of us has two systems of thinking; System 1 which leads to gut- driven instinctive decisions and system 2 which is slower, more analytical and effectively involves engaging the brain. Even system 2 is irrational because each of us forgets that the information we use to decide is limited to what we know. We suffer the fallacy of believing that “What We See Is All There Is”. This year the Nobel Prize for economics was won by Richard Thaler, another psychologist.

It is clear from psychological research that we all suffer from bias. Biases evident in financial markets include “anchoring bias” (allowing data to which we were exposed before the decision to influence it, even if not relevant to it); “framing bias” (whereby we reach a decision influenced by how it is presented); “loss aversion” (whereby we dislike losing more than we like gaining any particular asset); and “endowment bias” (whereby we value what we have just because we have it already).

The notion that human behaviour governs markets has revolutionised the world of investment. When I started investing in the stock market (in the 1960s) what mattered was what you knew that other people did not know. Insider trading was acceptable and gossiping over long lunches in the City was how money was made. All that is illegal now and the FCA polices the deals done on the London stock exchange every day looking for suspicious transactions. Investment by gossip was replaced by mathematical finance based on the Efficient Market Hypothesis. Now behavioural finance is all the rage.

Relevance to litigation?

A lawsuit is an investment for the claimant, just like any other investment. Many lawsuits threaten financial ruin to the participants. How we assess the risk/reward of the investment involved is down to our psychology.

The knowledge that humans are poor decision makers is central to the management of how clients assess the risk of litigation. The insurer is always at an advantage over the lay person because the insurer is familiar with litigation risks. The lay litigant is normally very worried by the prospect of something unfamiliar to him. The message that Kahnemann has for solicitors engaged in litigation seems to me that we should not lamely “take instructions”, but should aim to modify our clients’ instincts (system 1 thinking) and to inform their understanding so that they can properly appraise the risk in a law suit in their system 2 decision making.

Back to the future

I like to tell an anxious client about an imaginary 18th century motorist. Accustomed to horse drawn traffic, this unfortunate is propelled into the 21st century, and invited to get into a taxi. He is told (a) that the taxi is driven at speeds which may reach 60 miles per hour or more; (b) that other vehicles are travelling on the same road, some in opposite directions, and miss each other by inches all the time and (c) that there are frequent accidents involving injury but (d) we find all this completely normal.

I ask the client “Does he get into the taxi? Would you go to court?”

It’s all a matter of what you know.