(This article first appeared in Real Estate Investor's Monthly.)
In several previous issues, I wrote about behavioral economics. It is the relatively new study of the irrational biases humans frequently apply to financial decisions. Tim Harford’s 2008 book The Logic of Life has the subtitle “The rational economics of an irrational world.”
As the subtitle implies, Harford is somewhat skeptical of behavioral economics. He does not think we are quite as irrational as the behavioral economists claim. In his efforts to prove that, Harford has produced a sort of Freakonomics II. That is, he applies economic analysis in ways that produce politically-incorrect results.
For example, house values drop about 4% when a registered pedophile moves into a neighborhood. Bill O’Reilly raves self-righteously about how horrible such people are, but the market says exactly how horrible they are: 4%, not 3%, not 5%.
One finding of Harford is that some irrational biases discovered by behavioral economists are less widespread than they claimed. For example, Harford tested for endowment bias—valuing something you already own at more than an identical thing that you do not own.
He suspected that the lab experiments of behavioral economists were invalid because they were artificial situations with subjects who did not care about the outcome. To test that, Harford redid the experiment with pin collectors.
There is a group of people out there who collect and trade pins the way others do with baseball cards. And they conducted the test at the national pin convention, instead of with grad students at a university.
What they found was that inexperienced pin collectors behaved much as the behavioral economists predicted. That is, they overvalued pins they already owned when faced with opportunities to trade them away. But experienced collectors were far more rational and showed no signs of the endowment effect.
Harford dismissed the behavioral economics lab experiments as games of “let’s pretend.” The pin collectors, on the other hand, were not pretending. Also, the lab experiments involved nothing but novices in the trading in question. The pin convention had a variety of beginners and experienced pin traders.
For your own investing, the meaning is that you must guard against the irrationality found by behavioral economists when you are new to the niche you are pursuing. As you become more experienced, the danger lessens.
Harford even performed economic experiments with rats and they exhibited the same rationality the more experience they had with the problem in question. You may wonder how rats make economic decisions. Answer, they get rewards like food and drinks and they must pay varying prices usually expressed as the number of times they have to push a lever. In other words, physical exertion is their currency.
Why are rats economically rational? Evolution made them that way because all living things must be efficient, which is another word for rational broadly defined, in order to survive.
Harford was also working with rats to prove that rationality of economic decision makers is not a function of IQ. Rational decision making is a more basic life function, perhaps part of our reptilian reflexive brain. That is not to say that our intelligent reflective brain cannot override our reflexive one.
Harford also reports that some retarded people have also exhibited rational economic decision making when they had experience with the decision in question.
Harford’s Las Vegas chapter has interesting stuff about the application of mathematics, particularly game theory, to poker and other situations where your decisions depend, in part, on the decisions of opponents.
The real estate investment applications of this are negotiations, auctions, and litigation. In particular he discusses bluffing (acting strong when you are weak), reverse bluffing (acting weak when you are strong), and the need to mix in non-bluffs (acting strong when you are strong) occasionally so the opponents cannot tell when you really are strong or weak.
Players who never bluff will never win a big pot. If you never bluff, the other players will all drop out whenever you behave as if you are strong. The converse is not true. If you always bluff, you will sometimes win when you have good cards, but you won’t last that long because you will lose all your money betting big when you have weak cards.
Only a mixture of bluffing or reverse bluffing sometimes, but not others, will optimize your success. Harford says the best strategy in poker is to bluff when your cards are awful, not mediocre. That way the opponent cannot afford to fold too easily. Perhaps counterintuitively, bluffing with really awful hands makes you win more money when you have good cards because the opponents stay in longer against you.
One of the findings in Harford’s book is that we find it easier to be good in the future than right now. That is a good reason to follow Jane Bryant Quinn’s advice to set up automatic savings plans and such whenever possible.
Two economists devised a plan called Save More Tomorrow that earmarks a proportion of future pay raises of corporate employees to retirement accounts. The plan quadrupled the amount the people in question saved over time.
The lesson is you should look for opportunities to decide to be good in advance, then set up the situation such that you are forced to be good when the future arrives or prevented from being bad when the future arrives. For example, you will probably eat a healthy box lunch. Whereas, if you go to a restaurant, you will be tempted to eat too much or less healthy food by the menu or rack of snacks at the check-out counter.
You are probably either an employee or have employees. Bureaucracy is bad for such situations. One solution to bureaucracy in organizations is to structure it so each person’s contribution is clearly measurable. Salesmen on commission, for example. My little family company operates on piece rates. That is, when my sons do work on my orders, Web site, or books, they get paid by the function they perform, not a salary.
Even huge companies have salesmen on commission or subsidiaries that are paid based on performance. It’s not easy to do in every case. And if you are not careful, it can cause problems.
In Vietnam, some brass hat got the bright idea to grade stevedore units by the weight they off-loaded. So they started off-loading dense cargo like cement and steel and let less dense cargo like cornflakes and hospital cotton sit in the harbor to the point that delay penalties were triggered. You usually must set both positive and negative measuring criteria in incentive programs.
The problems of bureaucracy, either where you work or in your company, all stem from inability to accurately measure the contributions, or lack thereof, of the bureaucrats. When that happens, it all reverts to office politics which is destructive of productivity.
Harford also found that workers become more productive when their coworkers are more productive and can see the less productive workers’ poor productivity. So get rid of the slackers and make sure everyone can see everyone else’s productivity.
Watch out that you do not reward employees for ambient conditions. I discussed recently this with regard to group ownership of mutual funds and real estate. You only reward the manager for performance that beats the market, not for market-wide “performance.” You need to make sure you do the same with micro incentive plans where you or your employees work.
It’s analogous to world track records. If your tailwind exceeds a certain level, the record does not count.
Racial segregation is a hot topic in real estate. Harford reveals surprisingly mild reasons for seemingly severe segregation. Even today, you often see neighborhoods that are 100% white or 100% black. Evidence of racial hatred? No, says Harford, based to a large extent on research by Thomas Schelling.
Imagine a checkerboard where every other checker is black or white in all four directions: horizontal, vertical, diagonal toward upper left, and diagonal toward upper right. If you change the color of just one checker of either color, you immediately cause a minority/majority situation. That is, instead of having equal numbers of black and white neighbors, one checker now finds itself in the minority in its immediate neighborhood.
When it is a person, they were OK with being one of two equal racial groups. And they do not mind being in the majority, but being in the minority makes them mildly uncomfortable. As a result, eventually, they move to where the ratio is again 50-50 or they are in the majority. But the cumulative effect of multiple individuals who feel only that slight preference is anything but slight. The whole neighborhood flips.
So all-black and all-white neighborhoods are probably not the result of racial hatred. Rather they are stark manifestations of only slight or mild preferences for not being in a minority in their neighborhood. The research also reveals the fragility of the racial balance in a 50-50 integrated neighborhood.
Harford reports another study which enabled poor people to move to nicer neighborhoods. Surprisingly, it found that some things, like being a victim of a crime, were dramatically improved, but others, like school grades, employment, income, test scores, and the commission of crimes (as opposed to being a victim of them) were unchanged by moving to the “better” environment.
Harford reports that salaries are higher in major metro areas, but that cost of living is higher still. In other words, the average city dweller has a lower standard of living in many respects than the average suburban or rural resident.
Recently, England surpassed the U.S. in per capita income for the first time in about 100 years. Why? The value of the dollar fell in relation to the pound. But when I was in London in May, I noticed that while the British may have more purchasing power than the average American, they had a lower standard of living that manifest itself in the form of smaller houses and vehicles.
So if the salaries in big cities are not high enough to cover the higher costs of living there, why do rational people live there? Economic analysis reveals that people in cities get bigger raises over time, apparently because they learn more, faster in big cities than they do in less densely populated areas. In short, we learn from each other and the more each others there are, the more we learn and the more productive we become.
When people move out of the city, they retain their big incomes, but stop getting the big raises, When they return to the city, the bigger raises resume.
Businesses in big cities also have more competitors which spurs them to more innovation and productivity.
The greater number of restrictions on construction in cities costs about $10,000 per resident per year in lost real estate value. Buildings in, say, New York, are getting less tall. They should be getting more tall. But government interferes. This is part of why costs of living are so high in cities.
Cities use lots of energy, but are the most efficient in using energy per capita. A New Yorker with no drivers license cares little about gasoline prices. JTR