While the discipline of behavioral finance is relatively new, the performing art of magic has long exploited many of the same principles about human nature and decision-making. While much is made of the smoke-and-mirrors market we exist in, Nic Colas, of ConvergEx Group [10], reviews the 'Basics' of this ancient form of entertainment, courtesy of a recent Smithsonian magazine article by Teller [11] (the quiet half of Penn & Teller), and draws some analogies to the modern world of investing and economic analysis. The crossover points include pattern recognition, overconfidence, and the illusion of free choice. Nothing in my hands, nothing up my sleeves…
The Magic Of The Markets
One of the few Christmas presents I distinctly remember from my youth was an amateur magic set, given to me by my favorite uncle. It had all the staples, from a “fixed” deck of cards to top hat with a fake bottom to a magic wand. At the tender age of eight, however, I rapidly discovered that I was a tremendously lousy magician. I enjoyed explaining the structure of the tricks to my audience far more than keeping the necessary aura of secrecy. This flaw in my personality, my uncle assured me, would get me drummed out of the business, and sooner rather than later.
I had a flashback to that internal conflict as I read a newly published article by Teller, the quiet half of the Penn & Teller stage act, online in Smithsonian magazine [11]. In the piece, he outlines seven principles of magic and reveals the secret behind one of his tricks, a seemingly simple card stunt that actually has quite a few components.
Magic as entertainment exploits many of the same human foibles that make investing and economic analysis so difficult. Everyone in the crowd at a show sees the same thing – what the magician wants them to see – but the outcome is still unexpected. And seemingly magical. We all know there must be a “Trick,” but everything goes by so fast that we simply miss it. Understanding the movement of asset prices or the impact of economic policy is much the same, I think. When you look at a stock price chart, for example, and review how a given equity has performed, the “Trick” that explains why the company did well (or poorly) is usually obvious. But at the time, it likely seemed more like magic.
Teller’s list of some of the essential characteristics of a magician’s craft reads like a cautionary tale to investors. Here are his points, with a little of my own interpretation of how they apply to better understanding economic analysis and capital markets behavior. His list is represented, verbatim, in bold. Everything else is my own interpretation unless otherwise stated.
#1 - Exploit pattern recognition.
There is a reason why magicians use playing cards in so many tricks. We all know the number of cards in a deck, the numbers and face cards involved, and so forth. So when something unexpected occurs, it seems surprising because we thought knew the pattern (52 cards, 4 suits, etc) and understood the odds of say, the magician guessing “Our card” from the seemingly random collection at hand.
How many times have your heard “This company has a razor/razor blade business model?” Or, “The stock market usually rallies in the fourth year of a presidential election cycle?” Humans are simply desperate for patterns to emerge in their lives. With so much going on, life would be a lot simpler if events could follow some repeatable form. So we look for them, even in complex environments such as global business model analysis or capital markets pricing behavior. And we are as surprised as when we’ve seen a great magic act when they don’t follow our preconceived notions of a repeatable pattern.
#2 - Make the secret a lot more trouble than the trick seems worth.
In the Smithsonian article Teller relays a story of how he and Penn pulled 500 roaches out of a hat on the Letterman show. The stunt took months to prepare and less than a minute to pull off. The illusion was successful because the audience could likely imagine that the trick was “Doable,” but who would spend the clearly inordinately large amount of time perfecting something that would pass so quickly? And with roaches? Yikes!
I think great stock research strongly resembles the roach trick – you need to put in a huge amount of effort to get a small amount of useful, actionable, and legally obtained information. This has only gotten more difficult with the advent of Internet in the 15 years, since all the easy material is out there for everyone to see. It might take a legion of rocket scientists, or a cadre of mall walkers, or a survey of thousands of consumers. Real investment “Edge” takes a huge amount of effort.
#3 - It’s hard to think critically if you’re laughing.
Humans have a tough time with critical reasoning if they are distracted. Humor is a great way to turn off the reasoning mind of 500 people staring at a magician.
The analog in investing is obvious, since any emotion in the enemy of rational thinking. Doesn’t matter if you are fearful, overconfident, or somewhere in between. You aren’t thinking critically.
#4 - Keep the trickery outside the frame.
It is human nature to watch anything that is moving quickly, a fact that magicians use to great effect. The toss of a coat over a chair, a loud noise, the silly antics of a partner on stage – all serve to redirect the audience’s attention away from the real action.
Most of us spend a lot of our day considering the news headlines of the market, and that is misdirection, pure and simple. Take, for example, the national unemployment rate, which has been trending downward in recent months. What if the headline crossing the tape on the next Jobs Report Friday read “Even fewer able bodied Americans interested in working… Unemployment Rate drops further.” You might not feel so good about that news, and yet the labor force participation rate is just an important a component to the well-being of the U.S. economy as the unemployment rate.
#5 - Combine at least two tricks.
Teller spent 18 months (an great example of Rule #2) perfecting a short routine where a bouncing ball appears to jump through a hoop at his command, after first doing other tricks. The hoop jump is meant to confirm the first illusion – that anyone can command an inanimate object.
Monetary policymakers in both the U.S. and Europe have clearly mastered this rule. In a crisis, they know to launch several initiatives at once. Creating money out of thin air (or, really, bits and bytes on a computer) is a neat trick, of course. But then directing that capital to the banking system, bond markets, distressed financial institutions and other locations serves to make the illusion of liquidity even more powerful to the audience of the markets.
#6 - Nothing fools better than the lie you tell yourself.
Good magicians let you notice various aspects of their act on your own. You get to inspect a pack or cards, or see that a box appears to be empty. You believe it because of what you convince yourself you have seen. Once that belief is solidly lodged in your brain, the subsequent parts of the trick appear magical.
The role of artificially low interest rates on equity valuations is one example of this rule of magic at play in global stock markets. Since the Capital Asset Pricing Model uses the risk free rate on government bonds at the bedrock of stock valuations, a share of a profitable business should be worth more as interest rates drop. It is harder, however, to accurately factor the “real” level of interest rates when central banks are pushing them lower so convincingly. And you have to factor in the notion of “Risk free” into the equation as well, since the growth of sovereign debt in recent years makes that assumption harder to accept.
#7 - If you are given a choice, you think you have acted freely.
Magicians will tell you to “Pick a card, any card.” As a result you feel some level of control – since you picked randomly, your choice must have come from a random deck. As Teller succinctly puts it in his article: “Choice is not freedom.”
Market participants have noticed this fact with the recent – and pernicious – high correlations between previously unlinked asset classes. While this force towards common outcomes has weakened in the last few months, investors are now on the hunt for new “Asset classes” that appear to act differently than existing ones. They are searching for new choices that might allow for real freedom rather than the illusion of choice.
Rounding out this brief discussion, it seems to me that investors can benefit from reminding themselves that their own powers of perception are severely limited. If we can be regularly fooled by a Las Vegas magic act, then many of the same flaws in our thinking must be at play when we watch the screens at work. We seek out patterns that don’t really exist. We confuse choice with freedom. We grow emotional and limit our ability to process information. Watching a show, this is amusing. Making investment decisions, not so much.