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By Somnath MukherjeeIn the legendary Sherlock Holmes story The Adventure of Silver Blaze, ace race horse Silver Blaze goes missing and its trainer killed.
Strangely enough, the guard dog didn’t bark – Holmes deduced from the dog that didn’t bark that the culprit was an insider.
Finally, that is exactly what was found, an inside-job.
In this case, given the several potential lines of possibilities of when/how Silver Blaze could go missing, Holmes “satisficed”, i.e., used a reasonable assumption, rather than trying to piece together a bunch of imaginative threads to find a solution.
Even an ultra-rational, intelligent person like Holmes was subject to the reality of Bounded Rationality.
Bounded Rationality (BR), a Nobel-prize winning idea from psychologist Herbert Simon, essentially describes how (and why) human beings very often don’t have the ability or luxury of making the perfect rational choice.
Hence, they “satisfice” by making a choice basis what they have as data and what they can process given their limitations.
Even Sherlock wasn’t immune.
A similar case can be made for key canons of economic policymaking.
Traditionally, policymakers have accepted the axiom that low interest rates trigger inflation (and vice versa).
However, Japan (for over four decades), Europe and the US (for over a decade now) have adopted unconventional monetary policies to keep interest rates low (to the extent that nearly a third of all sovereign bonds outstanding today have negative yields), but inflation in all three major developed economies has remained stubbornly low.
Xavier Gabaix, an economist from New York University, offered an elegant explanation to the conundrum – he assumes, contrary to most macroeconomists – that people are not perfectly rational.
They, in fact, have very limited mental capacity or attention span to decode multiple, inter-linked, non-linear scenarios – precisely what Herbert Simon postulated as BR.
Ergo, when Central Banks (CBs) reduce interest rates, the Average Javed does not discern an immediate change in his circumstances.
His outlook is for the next three months, not the probability of a recession (or a recovery) coming in three years’ time which the CB is trying to address.
And what do rate cuts do in the near term? It pays less on his deposit; it indicates to him that he needs to save more today for his nest egg.
Therefore, he reduces consumption today, resulting in lower inflation today.
He isn’t looking at a potential recovery basis the rate cuts in the next three years which would increase his income and discount the same to increase consumption today.
Makes intuitive sense?
Most ordinary people would identify with it, and now the instances of Japan, Europe and the US put a remarkable empirical imprimatur to the intuitive logic.
Now, policymakers around the world, including in India, looking askance at easy monetary policy to kick-start growth and inflation – need to temper expectations and perhaps look elsewhere.
Gabaix throws up an alternative – in the form of fiscal policy.
A big tax cut or cash transfer gives an immediate windfall to taxpayers, and short-sighted and bounded by bounded rationality that they are, they tend to spend that on fresh consumption – kick-starting a growth/inflation spiral.
If CB policy actions are circumscribed by Bounded Rationality, lesser mortals (like money managers) have little chance.
First, a look at the data.
In the last two decades, as India’s mutual fund (MF) industry has grown manifold, the first victim of its success has been fund manager alpha (or outperformance against its benchmark).
From an estimated 60-70 per cent of all equity MFs outperforming their relative benchmarks about decade back, research shows that the numbers have reversed – 60-70 per cent of them do not generate any alpha.
While there are some linear reasons to explain this phenomenon (size of MF, for example, is sometimes a binding structural constraint), a substantial part is attributable to BR.
Contrary to some notions, fund managers/ equity analysts aren’t terribly different from the average Javed, and have the same issues in putting together multiple interlinked non-linear variables (that affect a company, and therefore, its stock price) over a long period.
They too, like the average Javed, take recourse to simplified, easily discernible filters in order to arrive at their views on how a company (and its underlying stock) is going to perform.
The outcomes are unsurprising – as a test, look at the variation of earnings estimates given by equity analysts at the beginning of the year and the actual earnings print at the end of the year.
In the last seven years, estimates of even the well-tracked Nifty index constituent stocks have not only been at significant variance to actual earnings, but they have also been off by a factor of 2-3x on occasions.
Not only are such variations common at a single analyst’s level, but they are at similar magnitude even when consensus estimates (the simple average of the estimates of all analysts covering a stock) are taken.
In short, even “experts” suffer from the same cognitive limitations that Average Javed has.
The solution to this, for investors, is to recognise their (and their equity advisors’) limitations and adopt strategies that potentially profit from those weaknesses.
Analysts tend to herd together on estimates; their estimates often have strong serial correlations – these often give opportunities for investors to find mispriced stocks.
In a nutshell, the ability to admit “I don’t know” and starting from there – is a more optimal start than trying to get to a perfect solution.
(The author is managing partner at ASK Wealth Advisors.
The views and opinions expressed in this article are personal.)
Stock Market
Bounded rationality is key to outcomes, be it central bank policies or investments
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