Magical Thinking and Emotional Biases

Despite the widespread mistrust of politics, great faith continues to be placed in our leaders. Investors are again focusing on a series of votes in Europe, dissecting daily opinion polls and every utterance from politicians. The hope is that democracy will provide the solution to decades of bad economic management – all that is needed, it seems, are new governments. Elections are driving investor confidence, oscillating between risk-on and risk-off. But there may be better signals than votes and polls. There is little sign that new governments are able to fix struggling economies and banks. Indeed, politicians constantly pinning the blame on the bank sector do nothing for lending and growth. Psychology suggests investors should look at behaviour rather than just words.

If not elections, where will the signals come from? Riots and strikes are more likely ways in which the impossibility of the democratic task becomes evident. A candid assessment of economic prospects does not win many votes. While politicians see the danger of short termism in corporate strategy – setting up the Kay Review – the challenge of the electoral cycle is overlooked. Politicians whose key objective is to be re-elected within a year or two have little incentive for long term solutions. Electoral imperatives are driving the series of unrealistic pronouncements and quick-fixes.

The complexity of politics is part of the problem. Behavioural finance describes the irrational human faith in mysterious processes as magical thinking. We do not know whether political pronouncements can save the Euro. But many would like to believe it will all work out, even if we don’t quite know how.

The decisions we make are not always objective. Economics might be capable of rational analysis, but most feel emotional about politics, currencies and sovereignty. This mix of facts and feelings sets the scene for bad judgement – when emotions get in the way of logical decisions. Unfortunately, in this conflict, feelings usually win out, no matter how misguided they might be. We want to trust the politicians who promise simultaneous growth and austerity.

Much of our ability to project the future depends on our ability to visualise it. Currency break-ups do happen, but infrequently. Few will recall the details of a surprisingly rapid split in the Czechoslovakian currency, for example. Then, a political break-up triggered a currency split in just six weeks.

Instead, a Greek exit from the Euro becomes an abstract issue, less easily assessed. Humans like examples, and find it harder to learn from things that happen rarely. That is why supermarkets inflate their prices of items like shoe polish. We buy them infrequently enough to have forgotten what we last paid. Understanding unusual events, like currency break-ups, is not something the human brain is good at.

What should investors watch, if votes are not the key to Europe’s prospects? Possibly, bank deposits might be the confidence signal. The bond market and inter-bank lending might enjoy some hedging and protection, but individual depositors have a keen focus on bank and currency risks. When state guarantees on deposits leave much uncovered, and little interest is being paid, the riskiest banks could see withdrawals.

We should pay more attention to such moves, as they represent an unbiased assessment of whether tail risks have really been removed. Bond and equity markets might think extreme outcomes have been ruled out, but uncovered depositors are the true test. And, the weakness of the Euro versus the US Dollar shows companies and individuals alike are voting with their feet. Voters might well elect parties determined to retain the Euro, whilst converting all they can into a harder currency. Voters in Europe would be more impressed if they saw Eurocrats putting their pensions into Greek bonds.

Grown-up investors should not believe in magic, and look for hard evidence instead. Money moves might prove better signals than the ballot box.

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