The Failure of Invariance

I received a number of questions on my previous post, As Good As It Gets

Readers asked why I was wedded to the idea that inflation would not re-appear. I am not wedded to the idea at all, in fact I would prefer inflation to return. It would make my life easier.

I am interested because the absence of inflation is not within the majority of expected outcomes.

I just want to ensure I am prepared should the low inflation scenario play out.

At a behavioural level I am curious. We are all looking at the same tea leaves and coming up with different results.

At the moment I am re-reading sections of Against the Gods by Peter L. Bernstein (clearly I lead a rich and varied life).

Of particular interest is Chapter 16 The Failure of Invariance.

The chapter’s title is borrowed from the work of two Israeli psychologists, Daniel Kahneman and Amos Tversky (Prospect Theory – A Beginner’s Guide).

Kahneman and Tversky use the term “failure of invariance” to outline how inconsistent choices are made when the same problem appears in different contexts.

Failure of Invariance Part 1

“The failure of invariance is far more prevalent than most of us realise. The manner in which questions are framed in advertising may persuade people to buy something despite negative consequences that, in a different frame, might persuade them to refrain from buying.”

We can all agree with the above but what happens when we apply this to more weighty issues? For example phase locking behaviour.

The best way to describe phase locking behaviour in financial markets to consider the following and let your memory do the rest:

  • The Long Term Capital Management event of 1998.
  • The Global Financial Crisis (GFC).

It is not unreasonable to say that these events were always going to occur (I also think that exploring what could have been done to prevent these events is a waste of intellectual capital).

A banking crisis was always going to occur. We are lucky the cracks first appeared in the US and not Europe.

The ECB is too charter bound to have acted in a timely manner (hopefully the words financial stability have now been written next to price stability in the ECB’s charter). If the ECB had to act before the Fed we would be trading shells for food.

You won’t find the words “fortunate” or “lucky” in much of the commentary on the GFC.

If the GFC was such a shock to the financial system, then risk premia across all asset classes should be structurally higher.

Does failure invariance help to explain why the bond market can change benchmarks but the equity market cannot?

In my working life time there has been a massive change to the risk free benchmark. The risk free benchmark moved from the US 30yr bond to the US 10yr bond.

If the bond market can move in 20 years on the curve why can’t the equity market accept that a P/E of 15X is low?

Failure of Invariance Part 2 – Mental Accounting

“The failure of invariance frequently takes the form of what is known as “mental accounting,” a process in which we separate the components of the total picture. In doing so we fail to recognise that a decision affecting each component will have an effect on the shape of the whole. Mental accounting is like focussing on the hole instead of the doughnut.”

Mental accounting is of particular interest. Anyone working in financial markets is an analyst of some description. We love to break things down.

Daniel Grioli’s Hitting the Target highlights sell discipline inconsistencies.

Can mental accounting help to provide an explanation?

When a company is sold purely because price has reached our valuation target we are focussing on the hole not the doughnut.

  • What if our valuation target is too conservative?
  • What if, on achieving our valuation target, the company’s share price reverts to mean and is able to perform in line with the market?
  • If our valuation target is achieved, is it a short?

Where are the Black Swans?

Out of respect for Karl Popper I have not mentioned black swans…until now.

There are many financial market participants studying black swans.

If many are researching the same black swan, it is not a black swan.

At best it might be standard kitchen variety tail risk.

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