Buying the Pot

First of all I would like to present my congratulations to Richard Thaler for winning the Nobel Prize in Economics this year. The award went basically to pioneer work in the field of behavioral economics.

Now, first when people think about economics it's purely about maths. Maths maths maths maths. Integrals, differentiation calculus, matrix algebra and optimization. But every single time I'm sitting in my lectures of Mathematical Economics a quote from the Great Milton Friedman comes into my mind:

Economics has become increasingly an arcane branch of mathematics rather than dealing with real economical problems.

It is true that mathematics forms the basis of economics. Some basic methods in mathematics are needed to solve economical problems such as optimal consumption bundles and utility maximization. But if we take a look at one definition of economics, it states that economics is about studying scarcity and how people use the resources their given. Economics focuses on the behaviour and interactions of economic agents and how economies work. The key-words here are behaviour and interactions.

Economics and financial markets are all about the people. The reasons of why prices vary, the levels of production are altered in the economy, why the stock-market goes up and down and why inflation exist comes from the actions you and I decide to make in different circumstances. It is all about us.

If I would be to perform research of any kinds, it would be probably to the fields of behavioral economics and behavioral finance. Let me explain why.

I don't consider myself as exceptionally good in maths, so often I and my class-mates ponder that how can I be good in economics if I'm just average in math? The answer is simple; I know my people. Through empathy it is possible to know how people feel and what do they think when making economic decisions. The're human just like me and they want to maximize their utility just like me. If you just focus on your environment and analyze people on how they behave every day, you can learn a lot about people and society and also some basics on economics.

Consider for example the awkward situation when someone you've met at some party 1,5 years ago walks on the same corridor in the University. You probably hope that he/she doesn't recognize you and you try to look away. With a high probability, the other person is thinking exactly the same and tries to avoid eye-contact. This for example might support the theory that people tend to act in the same way in the same circumstances.

The basic presumption in both micro -and microeconomics is that all the agents in the economy are rational and predictable. Producers are profit-maximizers and consumers are utility-maximizers. This might be the case in general, but when you take a look at it, you realize that not ALL the agents in the economy work rationally or act in a same way as most of the other people. However, this presumption is important in order to fit different economic models into real-life situation, even though the presumption itself is rather irrational.

Good example is the theory called money illusion. This has to do with the controversial curve called the Phillips curve. A curve invented by William Phillips describes the inverse relationship between unemployment and inflation. Milton Friedman argued that there doesn't exist a relationship between inflation and unemployment. Why? Human behavior!

If the inflation rate is 2 %, then people expect that the inflation is 2 % and decide to negotiate an increase in wages on this rate. Now if in the same time unemployment is reduced with expansionary demand-side policies, this would increase the inflation tare and the demand for labor. In the short run unemployment will decrease when higher wages attract more workers. When the workers realize that their real wages have not risen because of the higher inflation rate, some workers might quit their jobs temporarily, causing the level of unemployment to go back to the natural level. The workers have suffered from money illusion, partly caused by their rational expectations on the inflation rate.

What about the stock-market? Even though there are some fundamentals that control the stock-market it is basically about psychology. Especially different kinds of organizations giving analyzes and preferences over stocks have a considerable power when it comes to steer people towards investing in particular stocks.

If you are into investing, you might have also heard the rule that if the persons of responsibility in a firm decide to sell their own stock, that could be alert that they know something that you don't and that something sends them to short their position. This can cause a mini-panic in the stock-market where the shareholders decide to follow and sell their stocks as well.

On the other end, if the CEO Antti Herlin decides to buy worth of 30m€ stocks of Kone Corporation, that means that the Head is confident on his own business. This can push investors to buy the stock even more and through that the market-value of Kone is increasing, no matter what is really going on in the firm's operations.

The insiders know with 100 % what their actions will cause. So there exists two options: Either they really really know something, or they are trying to get an advantage from the situation.

The latter one can be described probably the Rothschild legend. It tells a tale of Nathan Meyer Rothschild who was following the Waterloo-battle and was certain that England was going to beat Napoleon's army. Rothschild rushed to London for the stock exchange and started to sell rapidly English bonds. Soon whispers started to go around that Rothschild knows that France has won the battle. This caused a panic where the investors were selling all of their bonds in fear. When the panic was about to end and the value of the bonds was extremely low, Rothschild bought a huge amount of these bonds back. Soon the news broke that England has won in Waterloo and this sent the value of the bonds sky-rocketing and Rothschild made a fortune from the trade. True or not, this represents the role of investor behavior in the financial markets.

If you know yourself and the other people, you are not the fool in the market. The fool is usually the one who doesn't know who the fool is. People say that the stock-market is a game of lottery. No, it is not. It is a game of poker. If you want to make money, you need to analyze the people you are against and act with it. You might think that poker is about mathematics and probabilities as well, but it is also about psychology and human interaction.

We often think that the world is a rational place that can be explained with science and mathematics. That is wrong because we are people. People are irrational, unreliable and can be wrong and cannot be interpreted with quantitative methods. And when it comes to making money in the economy, buying the pot is the situation where you want to put yourself in.

Text: SW
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