Behavioural finance

Recommended by my awesome derivatives professor, I took a behavioural finance course in the final quarter. Spanning the gap between my inherent desire for reason and the obvious realization that the world is not so, it also included elements of psychology, leadership and game theory. Having just finished my final lecture, it is time for contemplation: numerous take-aways, great in-class discussions, extremely competent professor, and (my favourite) a tool to understand why so many things we learn in school are inherently wrong due to human nature.

The best example, and perhaps the most fun, was a game we played: Everyone in the room writes down a number between 0 and 100. The numbers were then all averaged, and the winner of the $20 prize was the person with the number closest to 2/3 of that average. Mathematically there is an optimal solution, but for non-mathematicians, the way to think about it is what happened if you were playing against a large sample of trained baboons. They would write down random numbers between 0 and 100, implying that their average would 50. You should therefore write two-thirds of that number (33) to claim the $20. However, although you may sometimes think so, most of your classmates have more thinking capabilities than your average baboon. They are in business school, have gotten decent grades, and since you figured out that 33 is a good number, they probably will also. Thus the actual average will be 33, so you should write 22. But then they will figure this our as well, so you should write 15 - and so on. This gets you to the realization that the optimal number you should write is 0.

Let us pivot to think about the stock market. If the optimal value of an asset / a firm can be determined, then smart people investing should be able to figure this out and price the asset / firm accordingly. The underlying notion of functioning markets is that investors are rational - implying that the value of the asset / firm is fully reflected in its price.

Back to the game: so far, so good. You are a perfect specimen of rationality, intellectually supreme, and a model student of your University. You are also not going to win the $20. Because the actual game is not picking the correct number, it is essentially assessing what the ratio of baboons to business intellectuals in your class is, and what those baboons are likely to pick as a number. You can also think about the baboon's developing intellectuality, so how many times they go through the problem. Just because he realizes that the average of the class is going to be 50 and puts 33, he may not realize that others will think the same way.

That game, unfortunately, I am less good at. Having played this game several times now, people tend to do 2-3 iterations of the problem, so somewhere between 15 and 20 is a good bet. The smaller the class, the more a potential baboon can wreck havoc and the more other factors will have an effect, such as whether you think the semi-hungover junior in the corner who buttoned his shirt asymmetrically this morning actually understood the rules.

I picked "17" in a small class (13 people), which would have been bang on if only somebody hadn't put 93 (!). Being overly competitive I unfortunately blurted out that that is not even a possible winning number, even if everyone picked 100 - apologies. But is does show that just because you are in a business school, doesn't mean you are not a baboon.

Relating back to the stock market idiom, the takeaway is pretty obvious. It doesn't matter what the true value is, it only matters what people think the true value is. Markets should be inherently efficient, but because people are not, neither will they. If you give a good model to a huge group of baboon investors, the real skill which will create value is understanding baboon psychology. I picked the wrong business major.