Note to recruiters

Note to recruiters: We are quite aware that recruiters, interviewers, VCs and other professionals generally perform a Google Search before they interview someone, take a pitch from someone, et cetera. Please keep in mind that not everything put on the Internet must align directly to one's future career and/or one's future product portfolio. Sometimes, people do put things on the Internet just because. Just because. It may be out of their personal interests, which may have nothing to do with their professional interests. Or it may be for some other reason. Recruiters seem to have this wrong-headed notion that if somebody is not signalling their interests in a certain area online, then that means that they are not interested in that area at all. It is worth pointing out that economics pretty much underlies the areas of marketing, strategy, operations and finance. And this blog is about economics. With metta, let us. by all means, be reflective about this whole business of business. Also, see our post on "The Multi-faceted Identity Problem".

Thursday, August 22, 2013

ECONOMICS: A philosopher's skepticism on Prospect Theory (and its refinements)

So, I sent an email to Tyler Cowen who was kind enough to offer an explanation of what he thinks might be going on with Prospect Theory. I am still extremely skeptical about Prospect Theory being much more than a descriptive theory of what may be going on. 

Now: One may not be able to prove in a give situation whether Prospect Theory is operating. This much is already known. What I am arguing here is different. I am arguing that it may never be possible to know if Prospect Theory is happening in a given situation. 

I am raising the following epistemological question related to Prospect Theory (and its refinements) : how do we know that Prospect Theory is a true theory in the sense that is falsifiable AND one with provable predictive power? All I am asking is for Prospect Theory to meet a few basic requirements. How do we know that Prospect Theory is a true theory of human behavior in markets if it does not meet even the basic requirements?

The easiest thing to do would be to start off with an example. Let us first ask ourselves the following question. Prospect Theory adherents claim that Prospect Theory can provide an explanation for the fact that riskier investments don't always have greater returns than less risky one. We need to answer the following questions first. Why is there a reason to believe that there should be an explanation for the fact that riskier investments don't always have greater returns than less risky investments? Why not a plethora of explanations? 

Let us think about companies a bit. With companies, people have only a partial idea of what is actually going on within companies, that is, they don't have perfect iformation. Their aggregate guesses could be off with some non-zero probability p. Now given this (and here is the logical leap where Kahneman screws up), you can apply any number of "bias"-based theories to explain the exact same phenomena that Prospect Theory claims to explain. The "overconfidence effect" is as good as any. The "anchoring bias" could be used to explain the exact same thing. In fact, in the place of Prospect Theory (and its refinements), you could substitute many different theories (Theory X1, X2, ..., Xn).

Following the Prospect Theory model, I believe one can also answer the following questions (after all, "losses loom larger than gains"):

1. Why did Columbus sail to the West to reach America and not sail East?

2. Why did Caesar cross the Rubicon?

3. Why did Brutus kill Caesar?

4. Why Brutus kill Brutus?

et cetera.

As is well known, the way Prospect Theory has been established is via lab experiments. There needs to be a bridge, as it were, to the real world, since these are lab experiments only. Thus far,  this bridge has not been very forthcoming. There is no bridge. With the above post, I am hypothesizing that such a bridge may, in fact, never be built. 

Anyway, without further ado, below is the relevant portion of my mail to Tyler Cowen. Enjoy!
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First, an explanation. The catalyst for this was this post on Brad DeLong's blog:

which leads us to the Economist:

One conundrum concerns average returns. Why do some securities consistently have lower returns than others? For example, stocks that experience an initial public offering (IPO) have lower returns than those that do not. Economists have generally used a theory called the Capital Asset Pricing Model (CAPM), developed during the 1960s, to resolve this conundrum. CAPM says that riskier investments—those with higher volatility than the market—should have a higher rate of return. This sounds intuitive. But there is shaky empirical support for the notion; the most volatile stocks do not have the highest returns.
Prospect theory provides an alternative explanation. Mr Barberis argues that stocks with the lowest returns are those with the highest “positive skewness”. Positive skewness is found if a stock has many years of average returns, punctuated by the occasional high return. If a stock has positive skewness, investors are entranced by the chance—even the very smallest chance—of becoming very wealthy. They reckon that an occasional good performance could be turned into a very occasional stunning performance. The stock they own could just be the next Microsoft. It almost definitely will not be, but investors are poor at assessing future probabilities. Due to this poor “probability weighting”, investors overweight the unlikely state of the world in which they make a lot of money. They pile in, and returns fall.
It may well be that Prospect Theory may well never have any real world impact. The reason why I say that it may well never have any real world impact is somewhat subtle and, here it is - the main issue is that while Prospect Theory appears to "explain" a lot of things, you can "explain" all those things using many, many types of biases. What drives the nail in the coffin is this - a number of other biases can be used to explain the exact same thing, and there is no reason to believe that it is *this* very bias, loss aversion bias, or *that* very bias, the gain-loss curve bias, that is causing this problem. For instance, "overconfidence bias" can be used to explain the exact same thing as above. ( I will do one as an exercise. I can do a number of others.) This means that there is no reason to believe that it is Prospect Theory operating on a massive scale that is causing the effects that you are seeing.

EXERCISE 1

For the full example, see what I have below. Let us start reading again, this time starting with Paragraph 2.

Prospect theory provides an alternative explanation. Mr Barberis argues that stocks with the lowest returns are those with the highest “positive skewness”. Positive skewness is found if a stock has many years of average returns, punctuated by the occasional high return. If a stock has positive skewness, investors are entranced by the chance—even the very smallest chance—of becoming very wealthy.
[Anand's note] Good so far. I am on board with everything up until here.

 They reckon that an occasional good performance could be turned into a very occasional stunning performance. The stock they own could just be the next Microsoft. It almost definitely will not be, but investors are poor at assessing future probabilities. 
[Anand's note] Maybe investors are simply being over-confident. I am not denying that people are poor at assessing probabilities. That part is true. We already know that. But maybe it is not Prospect Theory kicking in, but simply old fashioned over-confidence,.
Due to this poor “probability weighting”, investors overweight the unlikely state of the world in which they make a lot of money. They pile in, and returns fall.
 [Anand's note] Overall I am persuaded that, due to the cultural environment in America, investors are just much more confident about a lot of thing than they ought to be. This over-confidence leads them to pile in.
Thus, I have explained this phenomenon without using Prospect Theory but using a different bias as explanation.

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Post script

Another example :
The longstanding difference between the rate of return of stock market and government bonds is also puzzling. For most of the 20th century, the rate of return for government bonds was around 6 percentage points lower than that for stocks. Traditional consumption-based models of asset prices which rely on expected utility theory cannot account for this disparity. But prospect theory can. Investors find the idea of losing more painful than they find the idea of winning pleasurable. So when they look at the high distribution of returns in the stock market, they are scared. Buying stocks could lead to losses, and they would find this very difficult. By contrast, bills do not have a high distribution of returns. Investors feel safe. As a result, due to “loss aversion”, investors demand a higher average return from stocks than bills.

Again, let us read this a second time. This time more closely.

The longstanding difference between the rate of return of stock market and government bonds is also puzzling. For most of the 20th century, the rate of return for government bonds was around 6 percentage points lower than that for stocks. Traditional consumption-based models of asset prices which rely on expected utility theory cannot account for this disparity. 
[Anand's note] Good so far.

But prospect theory can. 
[Anand's note] Actually a number of "bias"-based theories can. This is what I am going to talk about below (please see below).

Investors find the idea of losing more painful than they find the idea of winning pleasurable. So when they look at the high distribution of returns in the stock market, they are scared. Buying stocks could lead to losses, and they would find this very difficult. By contrast, bills do not have a high distribution of returns. Investors feel safe. As a result, due to “loss aversion”, investors demand a higher average return from stocks than bills.

[Anand's note] Okay, so when they look at the high distribution of returns in the stock market, they are scared. Okay. But maybe it is not that. People often attach more confidence to groups as compared to individuals. Also, they tend to anthropomorphize companies ('Microsoft appealed for ..."). Maybe, just maybe, they are not able to overcome their bias towards being overconfident about the prospects of a company, which seems to be actively "investing", "recapitalizing", et cetera. So they buy more stocks. That pushes up the returns of stocks. As a result, due to "overconfidence”, investors demand a higher average return from stocks than bills.Maybe that is what is going on. 

My point is not just this. My point is - why can't it simply be a matter of historical coincidence that stock returns were higher than bond returns by x1%?Maybe it is that there was a certain level of innovation and entrepreneurship in the economy and that level of innovation and entrepreneurship caused stock returns to be X % and bond returns to be Y %. Maybe X does not have to be necessarily much higher than Y. Maybe there is no explanation for why X has historically been much higher than Y. Maybe innovation will slow down enough in the next few decades that stock returns will get depressed to levels below what they were historically. Maybe looking for an explanation is the wrong thing to do.

In a nutshell - I am saying as a philosopher that this might be the wrong alley to go down on. Maybe all alleys are wrong. Maybe this is a problem for the field of epistemology to figure out why Prospect Theory even got so much attention