Substack Library
GlossaryBetting on Human Nature
September 12, 2021If someone forwarded this to you, you can sign up here.
Assuming economic actors are rational…, droned the Professor.
It was 1995. I was in graduate school studying economics. He was a teacher out of central casting––brown tweed blazer, tan khakis, trim beard. Intuitively, I thought rationality was a dumb assumption though at the time I lacked evidence to provide a rebuttal.
Now, however, it’s very clear many human beings struggle mightily to think in terms of reason and probability, which has significant implications for both investments and politics.
The consensus around how logical we are has gradually shifted. In 2002, Daniel Kahneman won a Nobel prize for injecting psychology into economics. He assembled data that ingenously illustrated bias. My favorite anecdote from his book Thinking Fast, Thinking Slow is that the odds of being granted parole by an Israeli judge spikes markedly after meals and sinks before them. The 2008 credit crisis was an additional marker. Former Fed Chairman Alan Greenspan confessed to being flabbergasted at how short-sighted banks were about extending loans. In an interview, Greenspan admitted losing faith with “the presumption of neo-classical economics that people act in self-interest.”
COVID should eliminate any remaining doubts. The US is giving away miracle vaccines and tens of millions of eligible people are not vaccinated. Vaccination rates are even lower in other countries. In Russia, just 27% of the population is vaccinated! (We are airing a podcast with a Moscow doctor in the midst of this challenge soon).
A Covid shot can be thought of as insurance policy against a low likelihood but terrible outcome, death, that has directly impacted around 7 to 8 million people (judged by excess mortality). Like Kahneman’s experiments, Covid illustrates millions of people won’t act rationally. In terms of investing, a lack of rational behavior has implications for both the merits of diversification and how to factor in climate change.
Diversification is in part an insurance policy against irrational people buying or selling the assets you own. Markets — real estate, stocks, bonds, bitcoin — price relative to each other. If the price of an asset rises, the yield falls. In response to the pandemic, the government bought bonds, driving their price up, yields down. As a result, money left the bond market and poured into other markets, leaving some prices improbably high including, for some readers, the stock of the tech company they work at.
Professional short sellers are investors that target what they deem to be expensive assets, like Tesla, and make money when prices fall. Famous short sellers like Mike Burry (of The Big Short fame) and Jim Chanos are supposedly short Tesla and likely frustrated that the stock, priced equivalent to 15 Fords, is gaining in value, as the chart from Rose Technology below illustrates. Tesla is in the S&P 500, meaning if you have savings you are likely exposed. The point: spread your bets.

Second, given human biases, it now seems reasonable to bet policy makers won’t fix climate change, which is significantly more complicated to visualize than Covid. While I hope I am wrong and will vote for candidates with appropriate policies, I expect that in the coming years the earth will become hotter, sea levels rise and the violent weather we are witnessing will becomes even more violent. The below chart, again by Rose, shows a range of outcomes for shifts in the sea level based on something called RCP8.5, which is that no substantial change in behavior occurs. Note the wide range of potential outcomes.

Rising sea levels will flood population centers on the sea, like Shanghai or New York. The below chart illustrates what a 2 meter rise in water might look like, the mid-point of the range. I am not a climate change expert, the mid-point looked like a reasonable place to start.

As with Covid, this shift will be enormously and tragically disruptive to many peoples’ lives. But just as with Covid, rich countries will spend money to blunt bad outcomes. In terms of investments, it leads me to want to own things like air conditioning (which requires copper and aluminum) and sea walls (which require steel and concrete). A basket of these stocks (producers of steel, aluminum, copper, concrete) has already risen quite a bit, though this is more due to the prices of copper and aluminum rising than concrete. (Full disclosure, I own these securities). It seems to me it may rise further (though this isn’t investment advice).

Looming over this is a political question. How much can we trust the good sense of the common person? That question is complex enough to justify a separate essay. Suffice to say Authoritarianism’s answer is “no” and Democracy’s answer is “yes.” At last count, 63% of the eligible, above 12, US population was vaccinated. Maybe that is as rational as we get.
If you enjoy these posts, become a paid subscriber. That will support the team that makes these posts and podcasts happen.