We hear, frequently, about how important "confidence" is for markets. Clearly this is true: when people are confident in the future they make investments and when they're not they hunker down under the bed with a stash of cash and a shotgun. Unfortunately confidence is a self-fulfilling prophecy and we are, it seems, particularly prone to living out our fantasies, no matter how stupid they may seem in retrospect. You see, confidence is a psychological trick of the mind, a phantasm evolved to lure us into unwise investments, as wicked a behavioural bias as you'll find in a long list of the usual suspects.
Clever Hans
In the late 1800's Germans were enthralled by the advent of a new mathematical genius, one who helped to change our understanding of the way that that science works. However, while Einstein was still beavering away as an unknown patent clerk his countrymen were entranced by the genius of a horse called Clever Hans.
As it turned out the horse was smart, but not in the way most investigators originally thought. In fact anyone dealing in human behaviour needs to protect themselves against so-called Clever Hans Effects but, unfortunately, most of us don't do so – including many of the people who run the economies of the world. As is so often the case we're defeated not by the markets but by our own brains.
Horsing About
Here's the conundrum that faced the investigator charged with understanding the mystery of Clever Hans:
"A horse that solves correctly problems in multiplication and division by means of tapping. Persons of unimpeachable honor, who in the master's absence have received responses, and assure us that in the process they have not made even the slightest sign. Thousands of spectators, horse-fanciers, trick-trainers of first rank, and not one of them during the course of many months' observations are able to discover any kind of regular signal".
The reason that no investigator could figure out the signals used to make Clever Hans discern the answers to the problems posed was dead simple: there weren't any. The horse was able to correctly answer quite complex arithmetic questions without direction from its handler.
Eliminating the Obvious
Having eliminated the probable, analysts proceeded to come up with a range of increasingly improbable and frankly stupid ideas. Some came to the conclusion that…
