Tuesday, November 13, 2007

We, the Dumb Agents

As posted on DumbAgent.com:

Here at DumbAgent.com, we are using economics and economic theories in order to enhance personal wealth. This isn’t really a new idea and, in some ways, it has become all the rage in recent months. We can see this through books such as Freakonomics (and a review of it by yours truly is shamelessly plugged right here.) by Stephen Levitt, Discover your inner economist by Tyler Cowen and The Economic Naturalist by Robert Frank (Go Big Red). So why start this weblog? Good question. Let’s see if we are any different from what’s already out there.

Economics can teach us many things. We can learn how to maximize utility and minimize costs in many different circumstances. In other words, it can tell us how to behave in an economically rational manner. But will this help us in a practical manner, as in helping us make financial decisions? Let’s experiment with a certain scenario to see how this works:

Say that all you need in life is a new TV and a new car. One day you read an ad in the paper for a car that’s being sold at 10% off, but the sale is ending in 15 minutes, while right next to it is another ad for a TV being sold at 50% off and this sale is also ending in 15 minutes. The shops for each of the items are on opposite ends of town; each 10 minutes away from your home (which is somewhere in the middle).

In other words, you are faced with a decision between buying a car with a 10% discount or a TV with a 50% discount. Which would you choose? Well, easy enough, 50% is more than 10%, so let’s buy the TV.

You may ask what‘s wrong with this. Well, a 10% discount on even a cheap car can save you around $2,000, while a 50% discount on a high end TV will save no more than $500. A very simple percentage calculation can mislead you because it is counter intuitive (and for this reason expensive items will always tend to show a dollar amount as a discount, while cheaper items will show a discount in terms of a percentage).

Fair enough?

This is a lesson in economics that can benefit us all and not unlike those you can learn from the books mentioned before. So let’s bring this to the stock markets, since that is where we tend to apply most of our financial decision making skills. Let us say there are two firms you can invest in: the TV store and the car dealership, with their respective discounts. Which would you choose? Taking into account what you have learned above the choice is obvious: the car company will provide the greater absolute savings and therefore the most sales.

But is that true? If all consumers have read what you have read then it is. But if a majority went with their first instinct without having learned the economics lesson, then the TV company will make more sales and its stock price will increase more than the car dealership’s.

Economics is an important mechanism to teach us how people ought to behave. Unfortunately it is a very faulty mechanism at teaching us how people actually do behave. In order to make a profit in the stock market it will not pay to be economically rational if all other participants are not as well.

This blog will not talk about lofty economic ideas that sound cool because they counter conventional wisdom. Well, it might, but it will only do so if these ideas can also help increase your bottom line. We will be applying theories, not to anecdotal occurrences, but to everyday occurrences that can help whoever reads it with their personal finances.