Richard Thaler's "Misbehaving" Volume 1 // Part 4

 As stated previously, Part 4 of this Blog will not be lining up with Chapter 4 of the book, rather I will be grouping the last chapters, 7, 8, and 9, into the final part. These are made up of Finance, Welcome to Chicago, and Helping Out. 

The first chapter, Finance, is broken into 6 sections; The Beauty Contest, Does the Stock Market Overreact?, The Reaction to Overreaction, The Price is Not Right, The Battle of Closed-End Funds, and Fruit Flies, Icebergs, and Negative Stock Prices. The keen-eyed among you may recognize this is a lot of sections, and it certainly is. Finance is tied for the longest and largest chapter in the entire book. The Finance Chapter opens up with a small introduction detailing what its main topic will be; behavioral economics in financial markets. Thaler states how financial markets, like the ever-famous stock market, allow for a unique combination of both high reward (there is a LOT of money floating around in there, which makes for high stakes) and the ability to capitalize on others mistakes (one financier's bad day is another's good). Drawing back to our beloved Econ, in a perfectly optimized market, everyone would pick the best option and there would be no real "losers," just those who didn't end up winning as much as others. But it doesn't take a Doctorate in Economics for someone to know there are certainly losers in the stock market. So then one raises the question, "Why?"

Now the first section, The Beauty Contest, was a tough one to get through. It is essentially 20 pages of dense economic theory and high-level analysis. Even what it is named for, an analogy given by a professor for how financial markets work, isn't given till the second to last page. I will try my best to explain it here but I am accepting that most likely it will not make any sense. In short, Thaler describes financial markets (as a whole, not from the perspective of individuals) as being somewhat self-correcting and balanced because whenever someone "wins" or "loses," that is indicative of an equal and opposite reaction happening as well. In other words, financial markets should be moderately fair at all times because people are equal amounts gaining and losing equity. 

The rest of the sections, as well as the other two chapters for that sake (which I will group together for simplicity's sake), deal with mainly the ideas surrounding efficient market hypothesis. Efficient Market Hypothesis (EMH) is in short, the prevailing idea that no matter what, both the prices and variation within a financial market will be balanced and flat in the long run. This is essentially what Thaler was getting at in the first section, just given a name and a far less complex explanation. This theory is ultimately built within two different principles; you can't beat the market and the price is "right." Now anyone can look and see that one of the sections is named "The price is not right," but in actuality, this section, in addition to the other chapters, simply explains why these things don't exist in the real world (as opposed to the perfectly optimizing Econ world). I can summarize the entire idea in one phrase. "peeps be wack, peeps be dumb, peeps be fraudulent."

The first relates back to both the Finance Chapter introduction as well as the first section. Drawing back on this idea that financial markets love to remain in equilibrium, let's delve into why an individual can't simply "win" the investment game (at least legally that is). Given omnipotent (all-knowing) information, a financier would be able to accurately know which stocks will rise and which will fall, meaning they would be able to buy and sell as needed in order to perfectly optimize profits. This would be considered beating the market when someone is able to perfectly play the ups and downs. Now there is only one way to achieve this without being omnipotent, insider trading. When an individual is giving non-public information that allows them to operate within the markets at an unfair rate to others, that would be considered winning. Now if you are neither a fraudster nor omnipotent, then any stock trading will have to be based on information available to everyone in the world. Given this, stock trading can be boiled down to simply a constant 50/50 chance of winning or losing. You either buy or sell, win or lose. What this means is that in the greater view of things, for every gain there is a loss, and for every loss there is a gain, so everything remains balanced. You can't beat the market because there aren't really any gains or losses in total. 

Let me move to the second point, the price is always "right." Now when I mention this I am not referencing everyones favorite TV show, but rather the idea that a stock is always priced as it ought to be. There is never a stock that is overvalued or undervalued, just risk-y and risk-less stocks. Thaler uses a theoretical interaction to showcase this, which I will try to get the jist of here. There are two men playing golf with one another, Adam and Bill. Both these men are investment bankers and both use middlemen (who charge service fees) in order to facilitate trades. This means that any trade made outside of their direct influence has a built-in marginal loss. The men are talking about the recent changes and trends in the market when Adam mentions he is thinking of buying 100 shares of Corporation X stock. Bill responds by stating how he was thinking of selling 100 of his shares of Corporation X stock, so they should exchange and skip over all the middleman fees so they both come out ahead. Now, in a perfect world where both these men are Econs, they would then begin to suspect something about each other. Adam would wonder why Bill is so eager to drop stocks, maybe implying a suspected dip in the future price. Bill would wonder why Adam is so eager to pick up stocks, implying a possible future spike in prices. Both men would then realize they ought to remain as they are and no trading is done. This is why the price is ultimately "right." In an Econ world, no one would ever make a trade without substantial reason to do so profit-wise, and no one would have access to data denoting such changes (because they are not omnipotent).