All About Perception

A man once ran the finest hot dog stand in the city. The man was so successful that he sent his son to Harvard to do an MBA. After graduation the son said: “Dad, based on current economic statistics, we’re heading for a recession. You’ve got to stop using all that sauce, and you dish out onions as if they were free.” Reluctantly, dad cut back on the sauce and the onions and moved to a cheaper brand of hot dog with a more traditional sawdust ratio. Just in time, because it turned out his son was right – business took a real dive.

Fat tails – the observation that events at the extreme ends of the statistical bell curve happen more often than expected - are all the rage. Witness the unlikely sales of The Black Swan, Nassim Nicholas Taleb’s fascinating book about rare events.

Systems Analysis has long explained fat tails through simple concepts of feed-forward and feed-back. Systems exhibit seven components – take an automobile:

• inputs, processes and outputs: the "doing" components, the engine, wheels, chassis, brakes, steering and fuel systems of a car;
• feedback: news about performance - the speedometer;
• monitoring: reacting - slowing down because of the speedometer;
• feed-forward: anticipating - signalling a manoeuvre;
• governance: adjusting the system to meet our goal - deciding where to drive.

Bob Giffords, the technology analyst, groups together feed-back, monitoring, feed-forward and governance components as “feed-through”, highlighting the effect of people’s perceptions on the probability of future events. If people change their perception of a risk, e.g. terrorism, that perception feeds through to alter future behaviour, such as passenger levels on public transport.

Perceptions matter. Thousands of Fat-Tailed Maniacs decide the fates of financial markets. Share buying and selling is gambling against perceptions. When you buy a share, you bet against past investors prepared to sell to you today; when you sell a share you bet against future investors prepared to buy today. Indirectly, you realise that future investors may not value the share so highly because the future investors to whom they will need to sell may not value it so highly, and so on: feed-through. The secret to stock market success is to guess what average opinion thinks average opinion will be, as in Keynes’s famous beauty contest example.

Systems with feed-through – and human systems are marked by this - typically have non-normal event distributions. In other words: the root cause of fat tails is people. Non-normal distributions trouble financial analysts. Human-originated fat tails are hard to distinguish from more normal distributions and complex to analyse.

Herbert Simon, the psychologist, said: "What information consumes is rather obvious: it consumes the attention of its recipients." Looking at financial failures, what failed often was not the firm, but people’s perceptions of other people’s perceptions. Bank runs are caused by people believing that other people will withdraw their money before they do. Clearly the media have a big role in accelerating feed-through.

James Surowiecki, in The Wisdom of Crowds [2004], shows that large numbers of people can arrive at good answers to complex problems if four conditions apply:

• diversity of opinion – private, even eccentric views;
• independence –opinions uninfluenced by other opinions;
• decentralisation –local knowledge;
• aggregation – a mechanism for collective decision, e.g. a price.

The greater the independent diversity of opinion, the more likely the herd will reach the right answer. Markets clearly meet three conditions – diversity of opinion, decentralization and aggregation, but not Surowiecki’s second condition, independence. When you give a bad weather forecast predicting rain tomorrow, it does not make rain tomorrow more likely. But when you give a bad forecast predicting a share will fall tomorrow, you do make it more likely. "Talking a market" up or down frequently moves a market up or down. "The trend is your friend – the trend is your enemy."

In a world of inter-connected media global information creates global perceptions that feed-through to global bubbles. The challenge for financial reformers is to slow feed-through’s many mechanisms, such as market prices, valuations or regulatory standards, yet satisfy the clamour for increased transparency. Markets will behave better when we can solve the paradox of providing global information without overwhelming diversity in local opinions.

Now I went to Harvard, so I’ve always wished my father had used "Yale" in the story, but that’s feed-through for you.

Michael Mainelli is Chairman of the think-tank, Z/Yen, and Mercers’ School Memorial Professor of Commerce at Gresham College.

[An edited version of this article first appeared as "All About Perception", Financial World, IFS School of Finance (December 2008/January 2009) page 41.]