Willful Read online

  These sorts of considerations can’t be modeled by rational choice theory unless that model includes a homunculus who sits on top of a person, controlling the adoption of beliefs and desires to form a new person whose desires can be gratified. We’d then arrive at yet another conundrum: sorting out what the homunculus was trying to achieve.

  Some Consequences of Acting in Character

  Now let’s consider some practical consequences of the theory that people act in character rather than as robotic agents who merely calculate. I will take as axiomatic that people generally act on beliefs they feel entitled to hold and that commitment to these beliefs is for-itself. For-itself action can relate to a preexisting desire you pursue in your own way, even knowing that your way is inefficient. (For example, you’d like to be fashionably dressed, to make a positive impression. Yet you wear a ragged coat. Every single one of your friends tells you it’s a mistake, but you answer, “I just like it, it’s who I am.”) Or it can be purely expressive (you wait in line at the polls to vote for a candidate who shares your beliefs even if your vote has no chance of swaying the election). The key premise is that acting in character on one’s beliefs is not traded at a price for other types of gratification.

  A person acting in character is not necessarily oblivious to incentives. If someone offered you enough money to switch to a better coat, you’d have your price. But so long as no external agents bribe you to change, you’ll observe a sturdy attachment to certain beliefs. That is, you won’t shift on the margin to a slightly more up-to-date coat if the cost goes down.

  The two categories of action—purposeful and for-itself—compete to explain many phenomena, and it’s not always easy to distinguish between them. Each offers its own account of the following ways we form beliefs and act on them.

  Disregarding Expert Opinion

  Why do people bother formulating their own opinions? I hold a few eccentric beliefs in areas where I’m far from expert. Do I know something that has eluded everyone else? Probably not. I recognize that this is strange, yet I’m utterly convinced and nothing is likely to shake those beliefs.

  A PURPOSEFUL CHOICE INTERPRETATION

  Rational people might discount an expert if they suspect she is selling something. Or the value of widely available advice may be competed away; if a food critic recommends a restaurant, then the restaurant might become crowded until the extra cost of waiting for a table equaled the value of the information in the review. Or an employee might rationally ignore an expert out of blame aversion; her boss could blame her for laziness if she relied on advice that turned out to be bad.

  Various cognitive biases could further encourage obstinacy. According to behavioral economics, we overestimate our own abilities, seek out evidence that confirms our preconceptions, and are generally overconfident.

  A FOR-ITSELF INTERPRETATION

  We have a gift for dismissing those who disagree with us. Why else would we argue so passionately that experts have missed a point that is obvious to us? We question their motives, or if their motives withstand scrutiny, question their competence. We reflexively perceive our own opinions as derived from objective evidence and opposing views as suspect. Defying experts is a for-itself act of will. If we adopted new beliefs every time an expert instructed us to, our identities would be shifting, fragile, and incoherent.

  Clinging to False Beliefs

  It’s unusual for people to change their minds and doubly unusual for them to change their minds quickly. According to legend, Keynes quipped, “When the evidence changes, I change my mind. What do you do, sir?”5 But this was rhetoric to intimidate adversaries into coming around to his side. Like most everyone, Keynes held reasonably consistent, cohesive views his entire life.

  In one of the prototypical problems for social scientists studying the persistence of false beliefs, some people continue to insist that childhood vaccinations for mumps, measles, and rubella (MMR) cause autism, even though the single study that made this claim was long ago discredited. When confronted with the data, rebellious parents refuse to change their minds. In a large randomized trial, doctors tried four interventions. In the first, they explained that no evidence links the MMR vaccine to autism. In the second, they explained the dangers of measles, mumps, and rubella. In the third, they recounted the story of an infant whose life was imperiled by measles. Finally, they showed images of children sick from a disease the vaccine would have prevented. Compared to a control group, none of the subjects grew more willing to vaccinate their children, and graphic images of sick children actually strengthened parents’ belief that the MMR vaccine causes autism.6

  A PURPOSEFUL CHOICE INTERPRETATION

  A professed belief in the side effects of vaccinations may be a convenient excuse for parents with a firm grasp on their self-interest. The benefit of a vaccination is partly to protect one’s child from disease but mostly to keep one’s child from spreading it to others. Vaccination is an essentially altruistic act. A selfish person who cared only about her own child’s welfare might prefer that all other children get vaccinated instead, sparing her the inconvenience. Or the failure of these interventions could be attributed to cognitive bias. The subjects might fall prey to the “hostile attribution bias,” a kind of generalized paranoia, and conclude that the interventions are a trick by pharmaceutical companies.

  A FOR-ITSELF INTERPRETATION

  A person committed to the idea that pharmaceutical companies behave recklessly might welcome a study purporting to link autism and vaccination, however flawed. Even after the study was discredited, such a person might defend it and dismiss the countervailing evidence as a business-led conspiracy. Rumors might circulate of dark forces suppressing studies that confirmed a statistical link. To such a person, the story of one child who showed signs of autism after being vaccinated would be persuasive. She just doesn’t like vaccines.

  Favoring Experiential Knowledge

  In ordinary conversation, experience is the gold standard of justification. I was there. I saw it with my own eyes. It takes a lot of theory and a lot of data to defeat that authority. Politicians embellish their humble origins as if experience with poverty gave them special insight into policies to help the poor. Soldiers believe one has to be a veteran to run the armed forces; it’s not enough to be a military historian, no matter how much you know.

  A PURPOSEFUL CHOICE INTERPRETATION

  There are several reasons to favor experiential knowledge, even if we care about knowledge only as a means to an end. First, it is often more reliable. When we hear about something secondhand, truth or completeness may have been degraded along the way, whether or not the distortions were intentional. Second, experiential knowledge is easier to remember. Psychologically, experience generates vivid memories that we retain more easily than information we read. Third, trying something is the most effective way of finding out what you don’t know you don’t know. As Mark Twain put it, “The person that had took a bull by the tail once had learnt sixty or seventy times as much as a person that hadn’t.”7

  Let’s say you heard about a ship setting sail with spare capacity. You might think about renting space on the ship cheaply and loading it with goods to be sold at its destination. You don’t know much about shipping, so you read a book about it and discuss your plan with experts. But you won’t pull the trigger. To act, you would need deeper experiential knowledge—the real stuff, the knowledge of particulars that can’t be fully transferred by explicit instruction. You’d want to hang around ports to see what ships are like. You’d want to get to know people who’d made similar deals. Only this sort of experience yields the localized knowledge that economist Friedrich Hayek ascribed to the “man on the spot,” as opposed to scientific knowledge that can be transmitted freely from person to person.8

  A FOR-ITSELF INTERPRETATION

  Experiential knowledge is central to for-itself behavior. Our identities are formed by what we learn this way.

  Reacting to Extreme Unexpected Events<
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  In the run-up to the financial crisis, the investment bank Lehman Brothers collapsed. After that, anything seemed possible. It was natural to ask, “If the venerable Lehman can fall virtually overnight, why not this extreme event or that one?” In the summer of 2009, I was discussing custody arrangements with an investor in my fund who worked at a public pension plan managing vast sums of money. The fund’s assets were to be held in Bank of New York Mellon, custodian for around $25 trillion in assets, equivalent to half the capitalization of all the stock markets in the world.

  We spent thirty minutes earnestly discussing the likelihood that Bank of New York Mellon would abscond with client assets like Lehman Brothers’ London-based affiliate had, in what the bankruptcy judge called a “truly spectacular” failure to observe rules designed to protect investors.9 I argued that a Lehman-style collapse of the bank could lead to a breakdown of civilized society and that, under such conditions, nothing would be safe.

  As alarmist as this conversation might seem today, at the time it made sense. It was a kind of extreme caution in response to the discovery of a “black swan,” the metaphor for something never seen before. To those afflicted with “black swanitis,” black swans and white swans become equally probable, and even the smallest chance becomes entirely likely. This mindset can be purposeful or for-itself.

  A PURPOSEFUL CHOICE INTERPRETATION

  The appearance of a black swan shakes our confidence in our beliefs, so we proceed cautiously. Under ordinary circumstances we act according to David Hume’s principle of induction, believing that the sun will rise every day because it always has. But in some cases, the routine can change, as it does for Bertrand Russell’s chickens, who don’t fear the farmer because he has treated them well in the past.10 When the farmer shows up one morning and several chickens disappear, it still might not be clear that he will soon wring their necks. Yet a rational chicken should sense that something is afoot and, as a cautionary measure, retreat quietly to the back of the coop.

  Inaction in response to disorientation may even have a biological basis. Evolutionary biologists have long speculated that depression could confer a survival advantage by prompting people to withdraw from failed projects. As Darwin himself argued, “Pain or suffering of any kind, if long continued, causes depression and lessens the power of action, yet it is well adapted to make a creature guard itself against any great or sudden evil.”11 If your life is a mess and everything you try goes wrong, rather than fixing it with incremental steps, you might need to shut down and reassess your strategy.

  A FOR-ITSELF INTERPRETATION

  A person might be able to profit from converting quickly to new beliefs suited to the post-black-swan environment, sure, but she’d feel more responsible adjusting slowly. Sometimes an extreme experience transforms us instantly, for better or worse. This, however, is so rare that it’s mostly the purview of myth and literature—say, when Macbeth encounters the three spooky witches who prophesize his future and turn him into an ambition-crazed maniac. Among the most famous conversions is that of Saul of Tarsus on the road to Damascus. On his way to persecute followers of Jesus, he sees a vision and is struck blind by a great light. Three days later, he regains his sight and switches sides with a vengeance. Or how about Siddhartha? After leaving his father’s palace, he encounters an old man, a diseased man, a decaying corpse, and a wandering monk. Overcome by the suffering he’d witnessed, he leaves his family to live as an ascetic, ultimately finding enlightenment and becoming the Buddha.

  Whatever the reason—purposeful or for-itself—the cure for inaction in the face of sudden upheaval is time. For rational actors, the ground will eventually start to firm up again. Most of those with for-itself black swanitis will gradually reconstitute their beliefs to fit the new environment, while a few will act despite their uncertainty.

  Stock-Picking and Identity

  When I ask my students, “Of those who invest in the stock market, how many pick your own stocks?” hands shoot up. Next, I ask: “How many of you invest in a diversified portfolio, such as the S&P 500?” No hands. Finally, I ask: “How many of you know that a non-diversified portfolio conflicts with economic theory?” They all raise their hands and laugh.

  My students are not alone in ignoring the precept that they can maximize return and minimize risk by holding a portfolio of assets that is diversified. Investors often diversify far less than the capital asset pricing model advises and overweight their portfolio toward their home country more than transaction costs alone can justify. This tendency is a notorious embarrassment to portfolio theory. But we need not resort to cognitive biases to account for it. The explanation lies in the importance of choice, whether or not that choice strictly maximizes profit.

  Suppose people are drawn to four or five investments, based on admiration of certain companies, tips from friends, or trends they believe will benefit certain businesses. They talk about these investments with friends and feel connected to companies in which they own only a small share. They tend to pick stocks from their home country because they identify more readily with its fortunes. (It’s unlikely that retail investors have an informational advantage in their home country. If it were that easy, hedge funds would station analysts in every country.) Even investors who do diversify with mutual funds want to at least choose which fund and the timing of the investment. Long before the inventors of portfolio theory, Harry Markowitz and William F. Sharpe, were born, Kierkegaard scorned the person who “acts as shrewdly in life as the financiers who put their resources into widely diversified investments in order to gain on one if they lose on another—in short, he is not a knight [of faith].”12 Although gaining on one to counterbalance losses on another is a sound strategy for minimizing risk, we sometimes want to stand by our own leaps of faith.

  People who identify with their personal investments tend to shun companies that offend them. There’s little evidence that selling shares of a company with rough labor practices deprives it of capital or influences its conduct. Selling is instead a personal decision, rationalized with specious economic logic. I am too steeped in economic theory to delude myself: divesting of any particular stock would be no more than symbolic. Still, I wouldn’t invest in a tobacco company—I prefer not to make money from selling cigarettes and am not sacrificing much return. At the same time, I acknowledge that some other investor will buy the shares I don’t and the amount of smoking in the world will remain undiminished.

  Just as individuals express themselves through personal investments, groups can express themselves collectively through divestment. The Government Pension Fund of Norway decided to sell its shares of companies involved in the production of fossil fuels. To the extent that Norway’s divestment temporarily reduces share prices below their fundamental value, another investor who is untroubled by such matters will buy. Even if activists could permanently depress the share values of oil giants by a small amount, the effect on the companies’ ability to raise capital would be minuscule. It’s a lot of fuss for little substantive impact, or none at all. Even so, divestment was approved by a democratically elected parliament and expresses the will of the Norwegian people.

  Investments are ultimately more than a means of maximizing wealth; they also allow us to express who we are and what we value while undertaking an unpredictable adventure.

  4

  Making Money in Financial Markets

  Anatomy of a Leap

  I do not believe in astrology. It does not fit with my preexisting beliefs, and no authority I recognize would instruct me to believe in it. As for matching the facts, I’m not impressed: proponents of astrology can offer only anecdotes. But I’m sure I’d be unable to sway an astrologer who is impressed by the times the stars predicted the future and brushes off the times they did not. For such a person, astrology satisfies all four of Peirce’s criteria. For me, it satisfies none. The astrologer and I must agree to disagree.

  I do believe that there are times when a trader can expect to make m
oney in competitive financial markets, but not in ways that can be codified. I’m drawn to arguments that appeal to subtle epistemic considerations, like those we’ll encounter in the following pages. I have spent enough of my life as a trader and in the company of traders to believe that any convincing theory must address why, if markets are so efficient, these seemingly rational people spend so much time trying to beat them. The belief that some people and some institutions can make money fits with my other beliefs. I have a strong impression that it fits the data but, like an astrologer, I draw my evidence from anecdotes. Sometimes people make money, sometimes they lose, yet I hold that some of the winners reasonably and responsibly knew that they were likely to win.

  I can’t subject my belief to rigorous statistical tests. If there were a testable rule for beating the market, everyone would already know it and it would cease to work. Instead, there are lots of rules, many conflicting, and knowing which ones to follow is the whole game. Beating the market should not be easy. Trades hide in the world. I believe I know an opportunity when I see one, but I sometimes turn out to be wrong. Opportunities arise sporadically and almost always involve a unique encounter with the unknown. Investors must be willing to take an out-of-character leap.