Blog - Investing Notes

April 4, 2007 - Investors as Social (Relative Wealth) Climbers

Are investors/traders motivated primarily by absolute wealth or relative wealth? Is outperforming peers a strong motivation? In the February 2007 draft of his paper entitled "Why Risk is Not Related to Return", Eric Falkenstein examines evidence for and implications of relative wealth as the principal motivator of investors. Using a wide range of examples, he argues that:

• Directly measured risk seldom relates positively to average returns. In fact, there is no measure of risk that produces a consistently linear scatter plot with returns across a variety of investments (stocks, banks,
  stock options, yield spread, corporate bonds, mutual funds, commodities, small businesses, movies, lottery tickets and bets on horse races).
• Humans are social animals, and processing of social information (status within group) is built into our brains. People care only about relative wealth.
• Risk is a deviation from what everyone else is doing (the market portfolio) and is therefore avoidable and unpriced. There is no risk premium.
• The poor returns to idiosyncratic risk derive from the tendency of overconfident investors to select investments with high idiosyncratic volatility as the (delusional) path to highest returns.
• Since risk (deviation from the norm) is by definition inversely related to popularity, asset prices may exhibit momentum or bubbles over intermediate horizons based on expectations rather than profits.
• The benchmark for an investor depends on peer group, consistent with home bias in portfolio holdings.

In summary, status may be more powerful than wealth as a motivator, with significant implications for investor/trader behavior.

Note the similarity of the above with the results of the game theory analysis described in our blog entry of 3/27/07, which concludes that competing forecasters rationally take extreme positions to ensure that they are relatively more accurate, at the expense of absolute accuracy. This behavior makes them appear to be overconfident.

There may also be be a parallel with biological evolution, wherein environments friendly (unfriendly or risky) to biochemistry attract many (few) competitors, while in general all species have roughly equal competition-adjusted survivability.

For related research, see Blog Synthesis: Animal Spirits Round-up. See also our blog entries of 5/26/05 on the Adaptive Markets Hypothesis.