Category Archives: behavioural finance

30/4/19: Journal of Financial Transformation paper on cryptocurrencies pricing

Our paper with O’Loughlin, Daniel and Chlebowski, Bartosz, titled "Behavioral Basis of Cryptocurrencies Markets: Examining Effects of Public Sentiment, Fear and Uncertainty on Price Formation" is out in the new edition of the Journal of Financial Transformation Volume 49, April 2019. Available at SSRN: or

9/10/17: Nature of our reaction to tail events: ‘odds’ framing

Here is an interesting article from Quartz on the Pentagon efforts to fund satellite surveillance of North Korea’s missiles capabilities via Silicon Valley tech companies: However, the most interesting (from my perspective) bit of the article relates neither to North Korea nor to Pentagon, and not even to the Silicon Valley role in the U.S. efforts to stop nuclear proliferation. Instead, it relates to this passage from the article:

The key here is an example of the link between the our human (behavioral) propensity to take action and the dynamic nature of the tail risks or, put more precisely, deeper uncertainty (as I put in my paper on the de-democratization trend, the deeper uncertainty as contrasted by the Knightian uncertainty).

Deeper uncertainty involves a dynamic view of the uncertain environment in which potential tail events evolve before becoming a quantifiable and forecastable risks. This environment is different from the classical Knightian uncertainty in so far as evolution of these events is not predictable and can be set against perceptions or expectations that these events can be prevented, while at the same time providing no historical or empirical basis for assessment of actual underlying probabilities of such events.

In this setting, as opposed to Knightian set up with partially predictable and forecastable uncertainty, behavioral biases (e.g. confirmation bias, overconfidence, herding, framing, base rate neglect, etc) apply. These biases alter our perception of evolutionary dynamics of uncertain events and thus create a referencing point of ‘odds’ of an event taking place. The ‘odds’ view evolves over time as new information arrives, but the ‘odds’ do not become probabilistically defined until very late in the game.

Deeper uncertainty, therefore, is not forecastable and our empirical observations of its evolution are ex ante biased to downplay one, or two, or all dimensions of its dynamics:
- Impact - the potential magnitude of uncertainty when it materializes into risk;
- Proximity - the distance between now and the potential materialization of risk;
- Speed - the speed with which both impact and proximity evolve; and
- Similarity - the extent to which our behavioral biases distort our assessment of the dynamics.

Knightian uncertainty is a simple, one-shot, non-dynamic tail risk. As such, it is similar both in terms of perceived degree of uncertainty (‘odds’) and the actual underlying uncertainty.

Now, materially, the outrun of these dimensions of deeper uncertainty is that in a centralized decision-making setting, e.g. in Pentagon or in a broader setting of the Government agencies, we only take action ex post transition from uncertainty into risk. The bureaucracy’s reliance on ‘expert opinions’ to assess the uncertain environment only acts to reinforce some of the biases listed above. Experts generally do not deal with uncertainty, but are, instead, conditioned to deal with risks. There is zero weight given by experts to uncertainty, until such a moment when the uncertain events become visible on the horizon, or when ‘the odds of an event change’, just as the story told by Andrew Hunter in the Quartz article linked above says. Or in other words, once risk assessment of uncertainty becomes feasible.

The problem with this is that by that time, reacting to the risk can be infeasible or even irrelevant, because the speed and proximity of the shock has been growing along with its impact during the deeper uncertainty stage. And, more fundamentally, because the nature of underlying uncertainty has changed as well.

Take North Korea: current state of uncertainty in North Korea’s evolving path toward fully-developed nuclear and thermonuclear capabilities is about the extent to which North Korea is going to be willing to use its nukes. Yet, the risk assessment framework - including across a range of expert viewpoints - is about the evolution of the nuclear capabilities themselves. The train of uncertainty has left the station. But the ticket holders to policy formation are still standing on the platform, debating how North Korea can be stopped from expanding nuclear arsenal. Yes, the risks of a fully-armed North Korea are now fully visible. They are no longer in the realm of uncertainty as the ‘odds’ of nuclear arsenal have become fully exposed. But dealing with these risks is no longer material to the future, which is shaped by a new level of visible ‘odds’ concerning how far North Korea will be willing to go with its arsenal use in geopolitical positioning. Worse, beyond this, there is a deeper uncertainty that is not yet in the domain of visible ‘odds’ - the uncertainty as to the future of the Korean Peninsula and the broader region that involves much more significant players: China and Russia vs Japan and the U.S.

The lesson here is that a centralized system of analysis and decision-making, e.g. the Deep State, to which we have devolved the power to create ‘true’ models of geopolitical realities is failing. Not because it is populated with non-experts or is under-resourced, but because it is Knightian in nature - dominated by experts and centralized. A decentralized system of risk management is more likely to provide a broader coverage of deeper uncertainty not because its can ‘see deeper’, but because competing for targets or objectives, it can ‘see wider’, or cover more risk and uncertainty sources before the ‘odds’ become significant enough to allow for actual risk modelling.

Take the story told by Andrew Hunter, which relates to the Pentagon procurement of the Joint Light Tactical Vehicle (JLTV) as a replacement for a faulty Humvee, exposed as inadequate by the events in Iraq and Afghanistan. The monopoly contracting nature of Pentagon procurement meant that until Pentagon was publicly shown as being incapable of providing sufficient protection of the U.S. troops, no one in the market was monitoring the uncertainties surrounding the Humvee performance and adequacy in the light of rapidly evolving threats. If Pentagon’s procurement was more distributed, less centralized, alternative vehicles could have been designed and produced - and also shown to be superior to Humvee - under other supply contracts, much earlier, and in fact before the experts-procured Humvees cost thousands of American lives.

There is a basic, fundamental failure in our centralized public decision making bodies - the failure that combines inability to think beyond the confines of quantifiable risks and inability to actively embrace the world of VUCA, the world that requires active engagement of contrarians in not only risk assessment, but in decision making. That this failure is being exposed in the case of North Korea, geopolitics and Pentagon procurement is only the tip of the iceberg. The real bulk of challenges relating to this modus operandi of our decision-making bodies rests in much more prevalent and better distributed threats, e.g. cybersecurity and terrorism.

22/5/16: Lying and Making an Effort at It

Dwenger, Nadja and Lohse, Tim paper “Do Individuals Put Effort into Lying? Evidence from a Compliance Experiment” (March 10, 2016, CESifo Working Paper Series No. 5805: looks at “…whether individuals in a face-to-face situation can successfully exert some lying effort to delude others.”

The authors use a laboratory experiment in which “participants were asked to assess videotaped statements as being rather truthful or untruthful. The statements are face-to-face tax declarations. The video clips feature each subject twice making the same declaration. But one time the subject is reporting truthfully, the other time willingly untruthfully. This allows us to investigate within-subject differences in trustworthiness.”

What the authors found is rather interesting: “a subject is perceived as more trustworthy if she deceives than if she reports truthfully. It is particularly individuals with dishonest appearance who manage to increase their perceived trustworthiness by up to 15 percent. This is evidence of individuals successfully exerting lying effort.”

So you are more likely to buy a lemon from a lemon-selling dealer, than a real thing from an honest one... doh...

Some more ‘beef’ from the study:

“To deceive or not to deceive is a question that arises in basically all spheres of life. Sometimes the stakes involved are small and coming up with a lie is hardly worth it. But sometimes putting effort into lying might be rewarding, provided the deception is not detected.”

However, “whether or not a lie is detected is a matter of how trustworthy the individual is perceived to be. When interacting face-to-face two aspects determine the perceived trustworthiness:

  • First, an individual’s general appearance, and 
  • Second, the level of some kind of effort the individual may choose when trying to make the lie appear truthful. 

The authors ask a non-trivial question: “do we really perceive individuals who tell the truth as more trustworthy than individuals who deceive?”

“Despite its importance for social life, the literature has remained surprisingly silent on the issue of lying effort. This paper is the first to shed light on this issue.”

The study actually uses two types of data from two types of experiments: “An experiment with room for deception which was framed as a tax compliance experiment and a deception-assessment experiment. In the compliance experiment subjects had to declare income in face-to-face situations vis-a-vis an officer, comparable to the situation at customs. They could report honestly or try to evade taxes by deceiving. Some subjects received an audit and the audit probabilities were influenced by the tax officer, based on his impression of the subject. The compliance interviews were videotaped and some of these video clips were the basis for our deception-assessment experiment: For each subject we selected two videos both showing the same low income declaration, but once when telling the truth and once when lying. A different set of participants was asked to watch the video clips and assess whether the recorded subject was truthfully reporting her income or whether she was lying. These assessments were incentivised. Based on more than 18,000 assessments we are able to generate a trustworthiness score for each video clip (number of times the video is rated "rather truthful" divided by the total number of assessments). As each individual is assessed in two different video clips, we can exploit within-subject differences in trustworthiness. …Any difference in trust-worthiness scores between situations of honesty and dishonesty can thus be traced back to the effort exerted by an individual when lying. In addition, we also investigate whether subjects appear less trustworthy if they were audited and had been caught lying shortly before. …the individuals who had to assess the trustworthiness of a tax declarer did not receive any information on previous audits.

The main results are as follows:

  • “Subjects appear as more trustworthy in compliance interviews in which they underreport than in compliance interviews in which they report truthfully. When categorizing individuals in subjects with a genuine dishonest or honest appearance, it becomes obvious that it is mainly individuals of the former category who appear more trustworthy when deceiving.”
  • “These individuals with a dishonest appearance are able to increase their perceived trustworthiness by up to 15 percent. This finding is in line with the hypothesis that players with a comparably dishonest appearance, when lying, expend effort to appear truthful.”
  • “We also find that an individual’s trustworthiness is affected by previous audit experiences. Individuals who were caught cheating in the previous period, appear significantly less trustworthy, compared to individuals who were either not audited or who reported truthfully. This effect is exacerbated for individuals with a dishonest appearance if the individual is again underreporting but is lessened if the individual is reporting truthfully.”

21/5/16: Manipulating Markets in Everything: Social Media, China, Europe

So, Chinese Government swamps critical analysis with ‘positive’ social media posts, per Bloomberg report:

As the story notes: “stopping an argument is best done by distraction and changing the subject rather than more argument”.

So now, consider what the EU and European Governments (including Irish Government) have been doing since the start of the Global Financial Crisis.

They have hired scores of (mostly) mid-educated economists to write, what effectively amounts to repetitive reports on the state of economy . All endlessly cheering the state of ‘recovery’.

In several cases, we now have statistics agencies publishing data that was previously available in a singular release across two separate releases, providing opportunity to up-talk the figures for the media. Example: Irish CSO release of the Live Register stats. In another example, the same data previously available in 3 files - Irish Exchequer results - is being reported and released through numerous channels and replicated across a number of official agencies.

The result: any critical opinion is now drowned in scores of officially sanctioned presentations, statements, releases, claims and, accompanied by complicit media and professional analysts (e.g. sell-side analysts and bonds placing desks) puff pieces.

Chinese manipulating social media, my eye… take a mirror and add lights: everyone’s holding the proverbial bag… 

21/5/16: Banks Deposit Insurance: Got Candy, Mate?…

Since the end of the [acute phase] Global Financial Crisis, European banking regulators have been pushing forward the idea that crisis response measures required to deal with any future [of course never to be labeled ‘systemic’] banking crises will require a new, strengthened regime based on three pillars of regulatory and balance sheet measures:

  • Pillar 1: Harmonized regulatory supervision and oversight over banking institutions (micro-prudential oversight);
  • Pillar 2: Stronger capital buffers (in quantity and quality) alongside pre-prescribed ordering of bailable capital (Tier 1, intermediate, and deposits bail-ins), buffered by harmonized depositor insurance schemes (also covered under micro-prudential oversight); and
  • Pillar 3: Harmonized risk monitoring and management (macro-prudential oversight)

All of this firms the core idea behind the European System of Financial Supervision. Per EU Parliament ( “The objectives of the ESFS include developing a common supervisory culture and facilitating a single European financial market.”

Theory aside, the above Pillars are bogus and I have commented on them on this blog and elsewhere. If anything, they represent a singular, infinitely deep confidence trap whereby policymakers, supervisors, banks and banks’ clients are likely to place even more confidence at the hands of the no-wiser regulators and supervisors who cluelessly slept through the 2000-2007 build up of massive banking sector imbalances. And there is plenty of criticism of the architecture and the very philosophical foundations of the ESFS around.

Sugar buzz!...

However, generally, there is at least a strong consensus on desirability of the deposits insurance scheme, a consensus that stretches across all sides of political spectrum. Here’s what the EU has to say about the scheme: “DGSs are closely linked to the recovery and resolution procedure of credit institutions and provide an important safeguard for financial stability.”

But what about the evidence to support this assertion? Why, there is an fresh study with ink still drying on it via NBER (see details below) that looks into that matter.

Per NBER authors: “Economic theories posit that bank liability insurance is designed as serving the public interest by mitigating systemic risk in the banking system through liquidity risk reduction. Political theories see liability insurance as serving the private interests of banks, bank borrowers, and depositors, potentially at the expense of the public interest.” So at the very least, there is a theoretical conflict implied in a general deposit insurance concept. Under the economic theory, deposits insurance is an important driver for risk reduction in the banking system, inducing systemic stability. Under the political theory - it is itself a source of risk and thus can result in a systemic risk amplification.

“Empirical evidence – both historical and contemporary – supports the private-interest approach as liability insurance generally has been associated with increases, rather than decreases, in systemic risk.” Wait, but the EU says deposit insurance will “provide an important safeguard for financial stability”. Maybe the EU knows a trick or two to resolve that empirical regularity?

Unlikely, according to the NBER study: “Exceptions to this rule are rare, and reflect design features that prevent moral hazard and adverse selection. Prudential regulation of insured banks has generally not been a very effective tool in limiting the systemic risk increases associated with liability insurance. This likely reflects purposeful failures in regulation; if liability insurance is motivated by private interests, then there would be little point to removing the subsidies it creates through strict regulation. That same logic explains why more effective policies for addressing systemic risk are not employed in place of liability insurance.”

Aha, EU would have to become apolitical when it comes to banking sector regulation, supervision, policies and incentives, subsidies and markets supports and interventions in order to have a chance (not even a guarantee) the deposits insurance mechanism will work to reduce systemic risk not increase it. Any bets for what chances we have in achieving such depolitization? Yeah, right, nor would I give that anything above 10 percent.

Worse, NBER research argues that “the politics of liability insurance also should not be construed narrowly to encompass only the vested interests of bankers. Indeed, in many countries, it has been installed as a pass-through subsidy targeted to particular classes of bank borrowers.”

So in basic terms, deposit insurance is a subsidy; it is in fact a politically targeted subsidy to favor some borrowers at the expense of the system stability, and it is a perverse incentive for the banks to take on more risk. Back to those three pillars, folks - still think there won’t be any [though shall not call them ‘systemic’] crises with bail-ins and taxpayers’ hits in the GloriEUs Future?…

Full paper: Calomiris, Charles W. and Jaremski, Matthew, “Deposit Insurance: Theories and Facts” (May 2016, NBER Working Paper No. w22223: