Blog

Playing the market – A good economist understands psychology is a key part of economics

28/06/2013

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

Here on The Value Perspective we are aware we could be more charitable to economists. We know they are not bad people really and they do have a job to do – we just feel that, in the part of their job that involves forecasting, there lies room for improvement. For once, however, we are going to be nice about economists – just not quite yet.

One classic chart supporting our generally disparaging view of the profession was published by Societe Generale in January 2008 and shows – as a group and on average – economists never once predicted a recession in the US between 1971 and 2007. “Economists never forecast recessions until well after they have begun – that is if they manage to forecast them at all,” noted the accompanying commentary.

That is pretty damning but, while you might have thought economists could at least have taken a shot at forecasting a US recession over the best part of four decades, there are plenty of sound behavioural reasons to explain why they did not. Not the least of these is it is human nature to be overly positive – and particularly so with regard to markets and investments.

Behavioural theorists have also revealed a tendency for people’s confidence in their predictions to increase in line with how much they have researched and know about a subject – although sadly the actual accuracy of those predictions does not improve. That is why, in Right as rain, we commended weather forecasters for acknowledging their limitations when it comes to predicting the future.

One instance regularly cited to show the overconfidence of economists comes from an interview on the economy Ben Bernanke gave to US current affairs show 60 minutes in December 2010. Asked if he thought he could act quickly enough to prevent inflation from getting out of control, the US Federal Reserve Chairman replied: “We could raise interest rates in 15 minutes if we have to.

“So there really is no problem with raising rates, tightening monetary policy, slowing the economy or reducing inflation at the appropriate time. Now, that time is not now.” The interviewer then asked: “You have what degree of confidence in your ability to control this?” To which the Fed Chairman replied: “One hundred percent.”

Bernanke has since received a significant amount of flak for that response but – and here comes the niceness – The Value Perspective is going to give him some credit here. He is arguably one of the most educated economists on the planet and so it is fair to assume he knows – with 100% confidence – there is no chance he can have 100% confidence in the Fed’s ability to control inflation.

But he also understands the psychology of the market and so, again, it is fair to assume he knew if his response was qualified in any way, it could have repercussions. In effect, he was signalling – saying something we believe he knew to be untrue because that is an important part of how he manages the psyches of people and thus markets without actually doing anything to slow or accelerate the economy.

Most people think economics is a science in the way that physics is a science but it is not. Economics is a social science and psychology plays a huge part in that. Bernanke may not always have a perfect grasp of market psychology – his recent comments on “tapering” QE being a case in point – but he got it right in that 60 minutes interview. One hundred percent.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.