The power of intellectual voodoo is seductive, writes Barry Ritholtz.
"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:
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 returns. It has also led to earnings "management", accounting fraud and a raft of management scandals. Shareholders derive less value than the name implies.
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, emotional and regularly engage in behaviours that work against our self-interest.
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.
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. Despite the wealth of evidence showing that this is a terrible idea, it refuses to die.
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, reducing them makes sense and can change investor behaviours 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.
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 and Warren Buffett have consistently beaten markets over such long stretches that it cannot be merely by chance.
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.
Gurus, shamans and prognosticators: Wall Street produces market wizards at a prodigious pace. It may be New York'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.