Don Steinmann's Investment Tip of the Week

Don Steinmann's
Investment Tip of the Week

Magic Numbers

My tip this week is not my usual advice/commentary about investing and the markets. This is something I wrote in a different context. I am a member of the Los Angeles Society of Financial Analysts and I’m on behavioral finance board. Behavioral finance studies investor behavior at the micro and macro level and how it affects the financial markets. For our latest semi-monthly behavioral finance newsletter, I wrote the following about trust of authority. I thought some of you might be interested.
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With the financial crisis slowly disappearing in the rear view mirror (we hope), we now come to the finger pointing phase. Who is at fault? Regulatory agencies? Wall Street? Main Street? Obviously someone was asleep at the wheel or this could never have happened. How can we have enough regulation or foresight so that this doesn’t happen again?

The answer may be that we cannot prevent something similar from happening because of the inescapable problem of human behavior. People have an innate trust of authority; it’s one of the heuristics of our existence. A recent and telling example came up during the recent Major League Baseball season.

During the run up to the end of the season, leaders of the six baseball divisions begin to track what is called the ‘magic number’. It’s the combination of the wins by the first place team and losses by the second place team that is needed for first place team to win the division. The countdown of the magic number is tracked by Major League Baseball, the teams involved, the local newspapers, and all the sports websites.

The race between the first place Los Angeles Dodgers and the second place Colorado Rockies was counted down with the magic number around 20. It was watched especially keenly at the end of the season as the Dodgers kept losing. The Dodgers were stuck at a magic number of two. Then a strange thing happened. Overnight the number became one without any games played. It turned out that the magic number was off by one. All of these sources had been dutifully reporting the magic number incorrectly and it was not discovered until the season was almost over.

What happened? Major League Baseball (the authority) had told everyone what the magic number was. And the Dodgers, Rockies, Los Angeles Times, ESPN, and every other sports authority dutifully reported the wrong number. If you think this is a trivial error, you’re not a baseball fan. How could a mistake be made about something so simple for so long? Shouldn’t someone have caught this?

The problem is the trust of authority. Major League Baseball told everyone the magic number, and so no one bothered to check until the season was almost over. Likewise, when an authority like Goldman Sachs told everyone that a basket of mortgages could be turned into a AAA debt, no one bothered to check if that was really true, including the rating agencies. It’s likely that our trust of authority will lead us to similar errors in the future, no matter how many regulations we pass.

So what can we do about it? Do we just throw up our hands? No, fortunately we are not slaves to our tendencies to trust authority. If it’s important enough (and winning the division should have been important enough to the Dodgers) we can double check. We can do the math. We can check the background story. And if things don’t add up then we can do the really hard thing. Stand our ground even though ‘the authority’ says we’re wrong. It is hard to do sometimes, but our innate behaviors influence, they do not rule us.

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