Blog - Investing Notes

February 16, 2007 - The Diversity and Persistence of Quacks

Suppose quack financial advisors offered their services to naive investors. What would happen? In the December 2005 version of his paper entitled "The Market for Quacks", Ran Spiegler applies game theory to a scenario that fits by analogy. He imagines a group of "quacks" in a price competition to attract and retain "patients" who recover with some probability, regardless of whether they pay a quack for "treatment." If the patients were rational, they would induce that the quack services are worthless and would acquire none. However, if the patients succumb to anecdotal evidence (random, casual stories rather than statistically reliable analyses), he deduces that:

• The market for quacks would be active and the anecdotally-driven patients would thereby suffer welfare losses.
• As the probability of "recovery" decreases, the prices charged by quacks would increase due to diminished quack competition (fewer positive anecdotes).
• Patient demand would increase with the number of treatment options (number of quacks and anecdotes), so moderate competition among quacks would not reduce quack pricing or average patient welfare loss.
• In fact, quacks would actively minimize the effect of price competition by offering maximally differentiated treatments [among financial advisors, highly specialized investment strategies].
• Having some true experts among the quacks would not be effective in driving quacks out of market, because the anecdotally-driven patients would not be able to tell the difference between experts and quacks.
• When patients are anecdotally driven, both quacks and true experts would have an incentive not to reveal their actual success rates, even when high, because of the effect of revealed rates on prices.

In summary, naive customers for services with outcomes for which it is hard to distinguish skill from luck will attract and sustain a diverse set of quacks.

The author seems not to give any break to quacks. Some of them, being anecdotally-driven themselves, may believe that they are owls and not ducks.

There must be some analogy to biological evolution here, wherein a persistent diversity in and of itself has species survival value within a randomly changing environment.

For related research, see Blog Synthesis: The Wisdom of Analysts, Experts and Gurus.