A Truth That Distorts Reality

Human Behavior And The Creation of an Alternate Reality

Of Behavioral Economics, Value Investing and Hedge Funds

There is a schism between behavioral economics and traditional economics. George Soros, considered by many as one of the greatest investors of all time, was a strong proponent of Karl Poppers General Theory of Reflexivity. George Soros is also known as “The Man Who Broke The Bank of England” because of his famous short sale of the British Pound. Soros argues that rapidly rising and falling markets are typically characterized by disequilibrium and as such human biases enter into economic transaction. In simple terms, the efficient market hypothesis may not always work.

Granted that there have been many other successful investors who have used other methods to create wealth. But, icons like Soros teach us something valuable simply because their consistent success yields field evidence of their beliefs.

Hedge fund managers have varied views of markets and behavior of market participants. What is truly amazing is that diverse views can yield success at different points in time. So, what may work once may not work always.

Consider the success of passive investing and Vanguard in particular. Jack Bogle’s firm is one of the biggest wealth managers (roughly $4 trillion in assets under management) that relies on index fund investing to provide consistent success that virtually no investor, money manager or hedge fund can claim to provide over extended periods. The sheer size of Vanguard’s AUM is approximately bigger than Germanys GDP. In simple terms, seeking alpha higher than the index on a long term basis could be considered futile by many.

The rational market theory also suggests that most market participants are rational and that the price of a security is a close approximation of a rational valuation of a company based on mostly logical brains operating in a common environment. However, value investors typically pick up a security on the assumption that the security is undervalued. Information assymetry you say. But, what if their decisions were based on a more detailed reading of publicly available information such as reading the annual reports of the same company consistently for ten years and therefore expending more effort than the average Joe investor. Michael Burry, presumably did more research on residential real estate and tranches of Mortgage Backed Securities(MBS) than average investors to discover early indicators of the subprime crisis. He is quoted as being influenced by Benjamin Graham’s book Security Analysis.

There is a possibility that some value investors simply understand the true value of a company by doing more home work and applying brute force research and as a result create information assymetry by their efforts and not because assymetry exists naturally.

These alternate views of markets, securities reflect alternate perceptions of reality.

Perception as Reality

Think of the success of a Placebo or the deleterious effects of hypochondria. Perception can truly create a self fulfilling prophecy and is a truth that can distort reality. For people of faith everywhere Karma offers a very powerful explanation of seemingly unexplained occurences.

In the recent past, I have been amazed at how powerful a small and different perception can distort a much larger reality.

The media, marketeers and advertising agencies can be looked at as shapers of perception and therefore creators of an alternate reality. Word association, perceptual scale (giving a feeling of being present without being physically present) are all tools of the trade.

Election results, to a large extent, are the figment of voters perception. Voters buy into Politicians version of reality although it could turn out to bite them in the back.

The Bottom Line

Stress testing models has acquired a new significance because of Black Swan events such as the subprime crisis. A reality very few conceived of but nonetheless engulfed the world.

All of us make mistakes and we may continue doing so. In the age of social media, alternate realities are democratized until fiction becomes fact to the chagrin of those who rely on logic and reason for every decision without considering the impact of irrational human behavior.

One can never be too careful but recognizing unintended consequences of any action and the power of perceptions to overpower reality can help us weigh more alternate realities than our biases allow us to. In doing so, we could end up making lesser mistakes.

In the words of Ray Dalio, Bridgewater Associates:

“Though how nature works is way beyond man’s ability to comprehend, I have found that observing how nature works offers innumerable lessons that can help us understand the realities that affect us.”

If you liked this story, please click on the ❤️ below and recommend this story to others.