Not all that long ago, Armin said something that frightened me. We were traveling between one meeting or another and, in the midst of waxing poetic on operational improvements, a topic on which he had much to say and for which I had an endless appetite, he announced, "...but you will eventually outgrow Sub Rosa." He must have seen the sudden protests I was already composing in my head coming a mile away, for I didn't get the chance to verbalize them.
"No, no, you will. You have already matured as an investor to the point where private equity will bore you, if it does not already. As you have no doubt already discovered, few deals are about the kind of smart investing you seem to crave. Yes, Sub Rosa can and does realize gains through operational improvements, but consider why that is so. Usually, we find targets where the owner-operator simply did not have the will to execute on difficult decisions because of the attachment to the company." It struck me that he said "owner-operator," as if the sellers we had courted all this time were long-haul truck drivers. "Often, I suspect, a sharp management consultant would have done just as much good and cost the owners far less in opportunity costs. In reality, most of the transactions we have managed to complete are about our access to capital and the luck of opportunity." It is pretty hard to argue with that kind of self-reflection in a senior partner.
This is the kind of conversation with Armin that, as is often the case, caused me to slip into a deep meditative state, thinking about the economic lenses through which I view the world.
I can probably best describe my thinking, to the extent regular readers of Going Private haven't already gotten a strong dose, by example. That is, in the form of the kinds of ideas and concepts that interest me and prompt further thought (or in some cases, even sleepless nights).
Bubbles, and the dangers of investing into them and out of them- as well as the dangers of betting against them, have occupied a good part of my investment brain of late. No surprise then that the yummy likes of Abnormal Returns picks a Sunday (damn you and your Sunday links, Abnormal Returns!) to drag to the surface old concepts from the deeper reaches of my economics education. This Sunday? Information Cascades. Therein we are pointed to real estate bubble reflective articles in the New York "Were all these people stupid? It can’t be." Times and the always interesting Calculated "inaction of policy makers" Risk.
The take-away from the Maxwell Smarts at the New York Times, or in this case Professor Robert J. Shiller "professor of economics and finance at Yale (draw your own conclusions here) and co-founder and chief economist of MacroMarkets LLC", is that certain hardwiring in the brain causes questionable decision making. This, it seems, contributed in large measure to the housing bubble.
A long line of study in this area has resulted in a deeper understanding of a number of cognitive phenomena including the likes of bounded rationality, confirmation bias, endowment effect, hyperbolic discounting, irrational escalation, mere exposure effect, pseudocertainty effect, zero-risk bias, loss aversion, base rate fallacy, and so forth, which may tend to color otherwise rational decision making.
Categories of these phenomena and their study, like Heuristics, Framing and Anomalies, make up the larger schema of "behavioral economics," which, removed from the obfuscating umbra of academia, is probably more commonly understood as "ways market actors can be irrecoverably stupid."
One of the problems I see with behavioral economics is that the tendency is to diminish the perceived agency of market actors in the investing process. One or another cognitive feature easily becomes reason to throw up collective hands and attempt to redesign (or unwind) markets or market actions to compensate for flawed thinking. Let us, dear reader, focus for a minute on the most ready example, information cascades.
The term stems from an article, A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades, written in 1992 by Sushil Bikhchandani, David Hirshleifer and Ivo Welch. From the abstract:
An informational cascade occurs when it is optimal for an individual, having observed the actions of those ahead of him, to follow the behavior of the preceding individual without regard to his own information. We argue that localized conformity of behavior and the fragility of mass behaviors can be explained by information cascades.
And from Professor Shiller?
As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.
Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.
Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.
And here is the part that disturbs me. It is subtle, because it is so tempting to be lulled into the thinking that enables it. Take another look:
Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.
Optimal behavior is defined relatively, but, more over, cognitive flaws are now apparently part of "absolutely rational and calculating." There is a careful nuance added to the information cascade definition that permits this interpretation, but it strains the bounds of credibility in my view. More on this later.
And less we conclude this was a momentary slip, the Professor concludes:
It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop- in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.
Excessively pessimistic rational individuals. Yep.
In any other context this sort of rationalizing of rationality would sound fantastically naive. How well could any of us be expected to respond to "Well, Cindy and Bob were buying a house, so I thought I should do the same"? If your mother were present to hear this pale excuse, surely she would quickly intone "So if Cindy and Bob jumped off a building, would you do it to?" Granted, I don't know your mother. Perhaps she has a Ph.D. in behavioral economics, but I suspect an easier explanation: she simply isn't stupid.
As an excuse put plainly, it is merely sad. As a cognitive flaw, however, it quickly becomes a reason for bailouts, and curbs on those of us uncaring and cold enough to resist the herd mentality, and who may have taken some sheep to the cleaners in the process.
Still, informational cascades have some other features which make them less than compelling excuses for investment missteps.
In our model, individuals rapidly converge on one action on the basis of some but very little information. If even a little new information arrives, suggesting that a different course of action is optimal, or if people even suspect that underlying circumstances have changed (whether or not they really have), the social equilibrium may radically shift. Our model, which is based on what we call "informational cascades," explains not only conformity but also rapid and short-lived fluctuations such as fads, fashions, booms and crashes. In theories of conformity discussed earlier, small shocks lead to big shifts in mass behavior only if people happen to be very close to the borderline between alternatives. Information cascades explain why society, on the basis of little information, will systematically tend to land close to the borderline, causing fragility.
As you might expect from this passage, cascades exist where decisions are borderline. This is, in fact, the nuance I referred to above that allows all actors to be individually "rational" in making the correct selection where the aggregate of the information available to them would clearly point to the opposite "correct" decision. This implies either that little information to make a decision exists, or that it exists but that little has actually been collected. This, at least in my mind, begs the question, why are such information light dilemmas resulting in major investment decisions?
As I pointed out in an earlier post:
Debt can either magnify returns generated by true alpha, or disguise (that is increase information asymmetry in) returns that may or may not have anything to do with alpha. The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand[ing] is not to invest.
It strikes me as quite tortured to label a market actor who possesses so little actual information about the contemplated transaction that he or she might be caught up in a cascade as "rational." Particularly where, as here, the costs of an erroneous decision are extremely high and the decision is not forced.
