Comments on: On Cognitive Biases and Markets http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets.html Sun, 22 Nov 2009 11:45:14 -0500 http://wordpress.org/?v=2.8.4 hourly 1 By: Anonymous http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets.html#comment-438 Anonymous Mon, 20 Aug 2007 15:25:00 +0000 http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets/#comment-438 I think this means you are indicating the pricing differences are most likely, 98% driven by regulatory, objective, incentives and financial structuring and only 2% by cognitive issues.<br/><br/>Are these guys searching for risk and valuation anomalies in the wrong places? The "market" as much as it can be a "thinking unit" may suffer from episodes of cognitive dissonance so to speak. Markets can underestimate risks due to irrationality but their is no reason that they should do this differently at different points in time. Rather they take on risk because it is in their rational interest to do so.<br/><br/>When the market turns their bets are wrong, they have no excuse, nor should they be excused. I think this means you are indicating the pricing differences are most likely, 98% driven by regulatory, objective, incentives and financial structuring and only 2% by cognitive issues.

Are these guys searching for risk and valuation anomalies in the wrong places? The “market” as much as it can be a “thinking unit” may suffer from episodes of cognitive dissonance so to speak. Markets can underestimate risks due to irrationality but their is no reason that they should do this differently at different points in time. Rather they take on risk because it is in their rational interest to do so.

When the market turns their bets are wrong, they have no excuse, nor should they be excused.

]]> By: Yves Smith http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets.html#comment-437 Yves Smith Mon, 20 Aug 2007 13:37:00 +0000 http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets/#comment-437 Let me address the first part of your question: why would one institution value a security differently than another. Off the top of my head, I can come up with a few reasons. One is difference in objectives. Defined benefit pension funds are supposed to manage their assets to produce returns to meet the expected retirement payout. Thus they are long term investors with fairly modest return objectives (their recent behavior not withstanding). They place a bigger premium than other investors on Not Screwing Up and many are very dependent on fund consultants (many of which use methodologies that I regard with some skepticism, the biggest being style diversification). So conformity to conventional investment thinking is also important to them.<br/><br/> By contrast, hedge funds have short term objectives, and typically use leverage. They have an incentive to take big risks. They get big upside fees if they are right, and in the vast majority of cases, no downside if they screw up (very few funds have clawbacks in the case of losses).<br/><br/>Similarly, pension funds and banks, for different regulatory reasons, like AAA paper. There is more demand for AAA paper than supply. Hence the creation of supposed AAA paper by securitization and tranching. <br/><br/>Basically, investors have different objectives and constraints. And they may also have different beliefs. Studies of propaganda in different countries have shown how quickly opinion can change based on media coverage. My perception is that coverage of the financial markets in the UK is much more jaundiced than here. There are doubtless other subtle and perhaps gross differences in coverage across countries (as well as further differences in regulations) that would lead to differences in investor behavior and hence how they might value the same security. Let me address the first part of your question: why would one institution value a security differently than another. Off the top of my head, I can come up with a few reasons. One is difference in objectives. Defined benefit pension funds are supposed to manage their assets to produce returns to meet the expected retirement payout. Thus they are long term investors with fairly modest return objectives (their recent behavior not withstanding). They place a bigger premium than other investors on Not Screwing Up and many are very dependent on fund consultants (many of which use methodologies that I regard with some skepticism, the biggest being style diversification). So conformity to conventional investment thinking is also important to them.

By contrast, hedge funds have short term objectives, and typically use leverage. They have an incentive to take big risks. They get big upside fees if they are right, and in the vast majority of cases, no downside if they screw up (very few funds have clawbacks in the case of losses).

Similarly, pension funds and banks, for different regulatory reasons, like AAA paper. There is more demand for AAA paper than supply. Hence the creation of supposed AAA paper by securitization and tranching.

Basically, investors have different objectives and constraints. And they may also have different beliefs. Studies of propaganda in different countries have shown how quickly opinion can change based on media coverage. My perception is that coverage of the financial markets in the UK is much more jaundiced than here. There are doubtless other subtle and perhaps gross differences in coverage across countries (as well as further differences in regulations) that would lead to differences in investor behavior and hence how they might value the same security.

]]> By: Anonymous http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets.html#comment-434 Anonymous Mon, 20 Aug 2007 10:10:00 +0000 http://www.nakedcapitalism.com/2007/08/on-cognitive-biases-and-markets/#comment-434 On cognitive bias, why would an institution value an instrument differently to another (and thus produce an active market) because it finances itself through short term paper and, or, does not need carry it on its bsheet? On cognitive bias, why would an institution value an instrument differently to another (and thus produce an active market) because it finances itself through short term paper and, or, does not need carry it on its bsheet?

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