By Barry Ritholtz, Washington Post, December 15, 2012
“The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.” — Joan Robinson
This time of year is filled with retrospectives and “best of” lists. I’d prefer a more enlightened discussion about bad ideas. Or rather, zombie ideas: the memes, theories and policies that refuse to die, despite their obvious failings. Why do we embrace the terrible, fall in love with the wrong, bet money on the fictitious? Nowhere is this truer than in the fields of economics and investing. Together they have produced a long list of thoroughly debunked ideas. Despite this, many of these zombie ideas still have a vice grip on amateurs and professionals alike. What is it about us and this intellectual voodoo? We keep repeating the same mistakes over and over. It is maddening. Let’s count the ways:
1 Shareholder value: Since the early 1980s, this theory had claimed that corporate management should concentrate primarily on increasing share prices. In practice, it is fraught with problems: Short-term focus on quarterly earnings leads to a decline in long-term research and development, typically to the detriment of a company’s long-term prospects. Short-termism and stock-option compensation causes management to focus on immediate quarterly returns. It has also led to earnings “management,” accounting fraud and a raft of management scandals. Shareholders derive much less value than the name implies.
2 Homo economicus: A primary principle underlying classical economics, it states that humans are rational, self-interested actors possessing an ability to make objective, intelligent judgments about matters of investing and money. This turns out to be hilariously wrong. We are all too often irrational, frequently emotional and regularly engage in behaviors that work against our self-interest. Homo economicus? Try Nogo economicus.
3 Economics as a science: Consider how wrong the economics profession has been about, well, nearly everything: They misunderstood the risks of derivatives; economists developed models that assumed home prices would not fall (!). They misunderstood why the recovery from the 2001 recession produced so few jobs or why the current recovery was worse in so many ways. Oh, and despite myriad signs, they missed the worst recession since the Great Depression even as it was on top of them. The sooner they admit that their field is not a hard science, the better off we all will be.
4 Austerity: Conceived from the puritanical idea that we must pay a penance for our sins, the Austerians (as we like to call them) insist that a post-bubble economy can be cured with spending cuts and tax increases, producing a balanced budget. When the United States tried this in 1938, it helped send the nation back into recession. More recently, Greece was forced to adopt austerity measures as part of its financial-rescue terms. It pushed the country into a depression. Austerity measures in Britain and Ireland and Spain — indeed, everywhere they have been imposed in Europe — have all led to recessions. Despite the wealth of evidence showing that this is a terrible idea, it refuses to die.
5 Tax cuts pay for themselves (supply-side economics): Sometimes bad ideas start as good ones. When tax rates are so high as to cause all manner of tax avoidance strategies — think confiscatory rates of 75 to 90 percent — reducing them makes sense and can change investor behavior for the better. Where we run into trouble is when this concept gets extrapolated to an absurd degree. Claiming that any tax cut will pay for itself by producing greater economic activity has now reached that point. No, Virginia, cutting taxes 3 percent does not lead to more revenue. Get over it.
6 The efficient-market hypothesis: This is the mother of all academic zombie ideas. The concept is that markets are “informationally efficient.” That lots of self-interested investors hunt down every last data point about any given asset class or stock. And pricing perfectly represents all of the given information available at the time. Therefore, no one can outperform the markets for long.
Except they have. Fund managers such as Peter Lynch, Warren Buffett, Ray Dalio and Jim Simons have consistently beaten markets over such long stretches that it cannot be merely by chance. Perhaps the even bigger anomaly that this concept runs into are the all-too-regular booms and busts — the massive mispricings of assets — that economic bubbles and crashes produce.
7 Markets can self-regulate: Another example of an idea that started out reasonably enough but soon after went off the rails. After 30 years of postwar economic growth, there was a credible argument that government regulations had become too costly, time-consuming and complex. With inefficiencies holding back small businesses, paring the worst of the regulatory burden should be productive.
As so often occurs, this good idea was taken to an illogical extreme. Instead of removing onerous, expensive regulations, zealots such as then-Sen. Phil Gramm (R-Tex.) argued against all regulations. Markets can regulate themselves much better than some bureaucrat or lawyer. Besides, the self-interest of companies and the efficient market would more effectively police behavior than any government agency ever could. We know how that turned out.
8 Gurus, shamans and prognosticators: Wall Street produces market wizards at a prodigious pace. It may be NYC’s single-biggest export. We love experts to tell us what is going to happen in the future. Never mind that their track record is awful, we prefer the mysticism of the television guru to actual thought.
The data about these experts should give us pause: The more confident an expert sounds, the more likely he is to be believed by TV viewers. Unfortunately, the more self-confident an expert appears, the worse his/her track record is likely to be. And forecasters who get one single big outlier correct are more likely to underperform the rest of the time.
Why is it that we are ensnared by bad ideas? A lot of the reasons have to do with our own makeup and the structure of our society.
● Fooled by randomness (a.k.a. luck): Just because something is a bad idea does not mean it cannot, through pure chance, lead to a winning investment. (It is very difficult for people to acknowledge just how lucky they got once money is made by a bad idea).
● Greed and sloth: There is a ready supply of dupes waiting to be robbed, dreaming of enormous rewards for little or no work. Bernie Madoff was no different than Charles Ponzi, and yet people lined up to hand him money by the billions.
● Institutional mandates: In academia, whatever the dominant paradigm of the moment is tends to drive jobs, tenure, even entire careers. Publish or perish leads to a repetition of “accepted” ideas, while outside-the-box research often finds getting published to be a challenge.
● Status quo: Powerful forces are comfortable with how profitable things are, and they exert tremendous force to keep them that way. Think tanks, academia and corporate consultants create a ready constituency for old, bad ideas on their behalf.
● Narratives persuade more than data: A good story is far more persuasive than data. Zombie ideas are modern fairy tales. Comprehending a data series is challenging, requiring skill, intelligence and hard work. A compelling story, on the other hand, can be understood by a child.
● Incompetency: Skilled people have a greater understanding of their limitations for a given task; unskilled people do not. This is called the Dunning-Kruger effect, and it tells us that the worse we are at any given talent, the weaker our own meta-cognition about it is.
● Bias: Bad ideas often conform to our erroneous world views. Consider the impact of selective perception and confirmation bias — they assuage our egos and are made to fit our prejudices. Bad ideas hang around in part because we seek them out and embrace them.
●Darwinism works slowly: As a reader suggested, it often takes a while for reality to catch up with bad ideas. Consider the divine right of kings, communism and the designated hitter as bad ideas that took centuries to fall.
These zombie ideas remain a stable of academia, economics and investing. We should not be surprised at this. Recall what Max Planck — who won a Nobel Prize for physics in 1918 for originating quantum theory — famously said: “Truth never triumphs — its opponents just die out. Science advances one funeral at a time.”
Investing and economics should be so lucky . . .