Archive for January 2nd, 2008

Should we believe in financial advertisements?

January 2, 2008

I have always taken advice on financial products – mutual funds, stock-selection etc. with a pinch of salt. The thinking goes back to the basics of finance- no matter how good you are, you just cannot predict the price of a share, bond etc. The best information you have is today’s price. Hence, none of the advice really works.

Despite this, we see huge marketing activity in financial sector. We have TV channels, newspapers dedicated to covering financial markets offering advice, suggestions etc. They are sponsored by financial companies who offer stock tips, mutual fund recommendations etc?

This superb paperfrom Mullainathan and Shleifer (one of the best minds in the business) analyses the financial advertisements. They use the behavior finance angle to explain how these finance firms advertise their wares (as Mullainathan is a behavior finance expert and Shleifer makes sense to anything and everything)

In this paper, we compare traditional and behavioral models of persuasion. In the traditional model (Stigler 1961), persuasion is communication of information. “Advertising may be defined as the provision of information on the availability  and quality of a commodity” (Stigler 1987, p. 243). In other words, persuasion involves offering information in order to change beliefs. In the behavioral model, in contrast, persuasion does not aim to change existing beliefs. Rather, characteristics of the product are integrated into the prevailing beliefs of the customer using either factual or spurious messages. There are few outright lies, but many more insinuations aimed at harnessing a pre-existing and possibly false belief.

That is excellent stuff.

They take this idea to test how financial products are advertised and focus on mutual funds (MF). They say a financial product can highlight return, risk or both in their products. Their finding is MF advertise returns when markets are doing well, and risk when markets are doing badly. Ideally, if you believe in your MF, the stance shouldn’t change. But MF know their business. They know people are aware of the market movements and anything contrary to their beliefs will not be accepted. They do a further break-up and find MF advertise growth funds in good times and value in bad times. 

The conclusion is even better:

This conclusion on the nature of persuasion bears on a key question in the analysis market efficiency in general, and price bubbles in particular, namely whether financial institutions play a stabilizing role. Previous research has focused on one form of professional activities, namely arbitrage, and has shown that institutions often play a destabilizing role (DeLong et al. 1990, Brunnermeier and Nagel 2004). But, as Kindelberger (1978) has  recognized long ago, institutions play another important role: they can facilitate or discourage the speculation by individual investors.

Our analysis shows that, at a minimum, financial institutions encourage speculation rather than contrarian behavior through their persuasion strategies. If such persuasion works (something we do not show), its effect is to destabilize prices.

But there is also a broader point. This paper, like Mullainathan and Shleifer (2005), shows that competitive markets in information deliver what consumers want. This, however, need not be the whole truth, or even the data most needed for consumers’ well-being. Whether public policy can improve on these outcomes remains a wide-open question.

The paper is quite a lesson and we see this happening rampantly in Indian financial markets. I pointed out that most mutual fund companies are coming out with infrastructure funds. Why? One reason is that infrastructure is a buzzword but this paper also helps in making us understand that MFs are simply acting on the existing beliefs in the investors.

We are bombarded by the word infrastructure from media and this makes us believe that it is going to be the sector to invest as everybody is talking about it. So, MFs are doing nothing but cashing in.

Now, I don’t mean to say infrastructure is a hype. It is a must if Indian economy has to grow. But this simple ‘name-game’ will not help.  We need viable infrastructure projects and not much emphasis is given to this. The media doesn’t cover this well enough to give you a clearer picture.  Like the way we know which infra stocks went up, we also need to know what were the new projects, the status of the old projects etc. No one seems to care about all this and this is when things get scary.


Assorted Links

January 2, 2008

There has not been much blogging going on  due to the heavy holiday season.

1. Mahalanobis points to an interesting story- the stock picking monkey won again. Americans are amazing, I thought this monkey picking stocks is limited to the text books but they prove it.

2.Econbroswer on dollar in the new year.

3. Willem Buiter offers some lessons learnt in the crisis

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