Unpredictable stock prices and how our irrationality makes us prisoners of trade
A woman monitors trade at the Nairobi Securities Exchange. Lack of rational thinking makes prediction of a stock market almost impossible. FILE
What you need to know:
In seeking to betray each other, commerce has a way of making sure we pay high cost and lose out.
Tanui and Juma have been arrested for robbing a bank and are held in separate isolation cells with no means of speaking to or exchanging messages with each other.
Tanui and Juma are good friends but they also have young families which they strongly care for and would give anything to go back to.
A clever prosecutor makes the following offer to each of them: “You have two options. You may confess or remain silent. If you confess and your accomplice remains silent I will drop all charges against you but will use your testimony to make sure that your accomplice gets three years imprisonment.
‘‘Likewise, if you choose to remain silent and your accomplice confesses then he will go Scot-free while you serve three years. If both of you confess you will get two years apiece behind bars. Meanwhile, if both of you remain silent you get only one year apiece. If you wish to confess, you must leave a note with the jailer before my return tomorrow morning.”
And therein lies the dilemma. First, this ‘‘confession’’ is basically a cleverly disguised betrayal of each other.
Desirable betrayal
However, it sounds like a desirable betrayal because whatever action the other party takes will result in a lesser sentence (two years if both confess and Scot free if one doesn’t.)
However, there seems to be an even bigger reward if both decide to remain loyal to each other and keep silent for they will only get one year’s sentence.
But by remaining silent each risks being betrayed by the other party, who may confess, and find themselves serving three years.
If they really care for each other, it makes sense that they think about their well-being as well as the well-being of their accomplice and keep silent.
However, if they don’t trust each other they would feel safer confessing to risk two years rather than the whole three years.
This problem, christened ‘‘The prisoner’s dilemma’’ by Albert Tucker, is an example of how two individuals may not cooperate even where it is in their best interest to do so. When this experiment was conducted, an overwhelming number of people chose to confess. It felt like the logical choice.
But, while not only displaying the selfish beings that we can be as humans, in pure economic terms it does not portray the best possible outcome that the two individuals could get when they chose to confess.
Let me share another hypothetical game with you. Suppose someone gave me Sh1,000 and three options.
I can share some, all or none of the money with you the reader. But here is the trick. If you accept my offer then we will each keep the money as per my proposal.
If you reject my offer, neither of us gets anything. So assume I choose to give you Sh800 and keep Sh200. Will you accept my offer? Chances are that I am unlikely to make such an offer and you most definitely will take it; right?
Now assume I decide to be fair and suggest that we share the money equally; Sh500 each. Chances are you will accept my offer.
Assume that I reverse my first hypothesis. I offer you only Sh200 while I keep Sh800. Will you take my new offer? When this experiment was carried out an overwhelming number of respondents rejected the offer when it was lopsided against them.
The question is, is rejecting Sh200 rational? As a rational human being, economics makes a basic assumption that whenever possible you make decisions that optimise your economic well-being.
But here we are and you are being offered Sh200 which you decline — you would have become Sh200 richer.
As Daniel Pink laments in his book, Drive: The Surprising Truth About What Motivates Us, Sh200 is definitely better that zero and your cognitive calculator knows that — but because you are human your notion of fair play or desire for revenge or simply your irritation overrides your sense of economic rationality.
But here we are and we have been taught that economic theory is based on the fact that players are rational calculators of their economic self-interest. But as we have established above, the assumption is ill founded.
Let me give you another hypothesis. You would think the most likely person to win an Economics Nobel Prize would be an economist, right?
Well, not always. In 2002 American psychologist Daniel Kahneman won the prize. Together with Israeli Amos Tversky, Kahneman argued that the basis of economic theory was misguided and that human beings are less rational than was theorified.
In his book, Thinking First, Thinking Slow, the Economics Nobel Laureate argues that as human beings we are lazy thinkers. We rely on repetitive thinking patterns and are predisposed to prejudice and mental shortcuts.
Arguing that most of the time we employ ‘‘fast thinking techniques’’, he adds that our sense of rationality is almost always way below our expectations. It is this lack of rationality, for instance, that makes prediction of a stock market almost impossible.
In the end, the price of stocks is not just depended on fundamentals. To an extent, it is the average of the mental perceptions that buyers have about a company.
Stock price, therefore, is no different than the prisoner’s dilemma. In seeking to betray each other, commerce has a way of making sure that we too are betrayed and hence pay a higher cost and losing out economically.
Maybe the prisoner’s dilemma’s biggest lesson is this; that we are all prisoners of commerce. Or to paraphrase Bill Clinton, it’s the economy, stupid!
