Pragma Synesi – interesting bits

Compendium of interesting bits I come across, with an occasional IMHO

Is envy, not greed, the root of all evil?

Is our quest to stand out from the crowd, rather than greed, driving our behaviour and the markets?  Makes a lot of sense to me.  From the Globe and Mail, May 27, 2010:

Green from envy

By Timothy Taylor

Gordon Gekko got it wrong: Envy, not greed, is what really matters

When Oliver Stone’s upcoming sequel to Wall Street (Wall Street 2: Money Never Sleeps) is released this fall, there will be renewed debate on whether “greed is good.” People may disagree with Gordon Gekko, just as his protégé Bud Fox ultimately did in the original film, but most will accept that greed is, if not good, then at least centrally relevant to the argument. Since the 1980s, you could say that greed has become the economic and cultural meta-factor: either the juice that drives markets and innovation, or the corrosive force bent on bringing the global economy to its knees (again).

But what if the Gekkos and the Foxes were arguing about the wrong variable entirely? What if greed were secondary, a shadow cast by a different meta-factor altogether? That’s what Eric Falkenstein, a U.S. economist with a growing following, argues in his book Finding Alpha, published by Wiley last year. Falkenstein does not believe the market is driven by greed. He thinks the market is driven by envy.

The distinction is critical because of how modern economists define something called “utility,” the pleasure people derive from their wealth and the things they consume. Utility is a matter of individual preference, and economists tend to agree it has diminishing returns. “The 20th Twinkie adds less pleasure than the first,” says Falkenstein, just as a loonie on the street is either a bonanza or hardly worth stooping for, depending on how many you already have.

Nevertheless, the theory assumes that everyone-destitute or possessed of millions-would choose having the loonie over not having it. That would be a “greed-based utility,” where winnings are strictly preferred over losses. It’s not an esoteric idea. Greed-based utility is an assumption lying at the heart of the Capital Asset Pricing Model (CAPM) that has been taught to every finance MBA since the 1960s (including this one), and is the basis for how trillions of dollars of investments are managed in the real world. If utility isn’t greed-based, then CAPM simply can’t explain reality.

And it doesn’t. Falkenstein argues that the real world diverges in two critical ways. The first, captured by something called the Easterlin Paradox, based on the 1974 research of economist Richard Easterlin, shows that reported well-being does not rise with per capita income and actually fell in the United States between 1960 and 1970, even as wealth accumulated.

But even that anomaly isn’t as troublesome to Falkenstein as the absence of market risk premiums. If greed drives our actions, both math and intuition tell us that higher-risk assets-those with higher volatility relative to the S&P 500-should generate higher returns than lower-risk assets. If they don’t, no rational investor would buy them.

But across a range of asset classes-equities, bonds, mutual funds and so on-Falkenstein argues that higher-risk assets do not generate higher returns. Others have scratched their heads over this one. In 1998, an interviewer asked William Sharpe, one of the authors of the CAPM theory, if the model was dead. “It would be irresponsible to assume that it is not true,” he said, adding: “That doesn’t mean we can confirm the data.”

However, if our actions are based not on absolute wealth but relative wealth-an envy-based economy-the market would need no risk premium. Falkenstein developed the empirical case for this in his January, 2010, paper “Risk and Return in General: Theory and Evidence.” But other researchers have pointed to similar envy-indicating results, including Cornell economist Robert Frank, whose research showed that most people would choose to live in a world where they made $100K and their peers made $85K, over a one in which they made $110K and their peers made $200K.

Asset bubbles, likewise, are explained better by envy than greed. Risky investments seem less dangerous when everybody buys them. And in a benchmarking environment, underperforming your peers is itself the riskiest bet. “If you had the foresight in 2002 to avoid the subprime housing bubble,” Falkenstein says, “you would have been underperforming your peers for years. It wouldn’t take long for your boss to say: I want somebody who can make money in this space.”

The implications of an envy-based economy are broad. A recent U.K. House of Commons Treasury report suggested that more women in London City boardrooms might have led to better risk management prior to the market meltdown, the assumption being that women are inherently less greedy than men. As the committee chairman put it, “Diversity at the top is one way to challenge potentially dangerous groupthink.”

But if people are primarily envious, women would arrive at those boardroom tables with the same benchmarking tendencies as their male colleagues, the same acquisitive emulation of their peers, prone to the same envious impulses.

The fact is, investors could actually benefit from a bit more greed. We would then demand the appropriate risk premium for volatile investments and bail out of any risky assets that weren’t paying them. In that sense, Foxes and Gekkos alike might agree to revise the sleek-haired financier’s dictum. Maybe greed isn’t good in an unmitigated sense. But compared to envy, on occasion, greed might actually be a little better.

August 20, 2010 - Posted by | behaviour, economics, neuroeconomics | , , , , ,

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