René Girard XVII: Behavioral Finance
The text below is an old draft of an excerpt from the book Catharses.
A central problem of investment theory is calculating value of a business. A fundamental approach is to make the value equal to the sum of all the future cash flows a business will generate, adjusting each future cash flow to its present value. A hundred dollars ten years from now is worth less than a hundred dollars today, the difference being all the money a hundred dollars today can earn over those ten years by being invested into a venture of a similar risk - adjusted for expected inflation. Present values of cash flows in ever more distant future converge to zero, and their sum adds up to a finite present-value sum. This approach to valuation of businesses is called the present value approach.
The basic limitation of the present value approach stems from all the uncertainties of the future: how much money will the company make each year, how long will the company survive, what will be the rate of inflation, and what will be the average rate of returns on other businesses at any point in time (the discount rate). Uncertainties are so great that this approach, although it makes sense in theory, yields a vast variation in valuations, based on loose and biased assumptions on what the future holds.
Another fundamental approach is to add up all the assets that a company owns, subtract all its liabilities, and say that this is the value of the company. However, this approach often calls for inclusion of intangible assets such as “goodwill”, which roughly translates to a reputation that the company enjoys. After all, if one simply replicates the company’s physical assets, one is not promised the same prosperity, because the pre-existing company has built a reputation that will draw customers to it. But what is the cash value of a company’s goodwill? The asset-based approach also suffers from a great degree of uncertainty. It is often used in stable, boring businesses, and often as a conservative estimate.
The other methods of valuation are not fundamental, but they are mimetic. The first and the more trivial one is the method of benchmarking a company against its peers. An analyst looks up the prices at which comparable businesses have been sold or valued, averages them out and adjusts for minor differences. There is no fundamental idea here about what a business is worth; one simply compares it to other businesses. This method is often used in support of the fundamental approaches.
The dominant method of deciding the value of big companies is a democratic method: let the stock market decide. Stock of large publicly traded companies is exposed to trade among millions of buyers and sellers. The idea is that such a large number of opinions will average out to the fundamental, true value of the company. The positive biases will be cancelled out by negative ones, the optimism of some investors will be tempered by the pessimism of others, and hidden interests of one conspiratorial group will be balanced out by those of their enemies. The idea here is that the stock market taken as a single organism is rational, or efficient.
In business school, they also tell you about the other view of the stock market, namely, that it is irrational, or inefficient. There is talk of herd mentality, investors deluded by their own greed, overconfidence, self-interested forecasting, confirmation bias, ambiguity aversion, and many other concepts of a similar vein. Indeed, there are whole seminars, courses, and even degrees to be earned in each of these concepts. While I am not aware of any MBA program that explicitly incorporates René Girard’s work into financial theory, a student of Girard will immediately recognize the view that markets are irrational as an essentially mimetic view.
Much fascinating work has already been published on all the reasons and ways in which markets are irrational, and many investors have been able to cash in on their insights (though it is extremely rare that a single investor does so repeatedly). Indeed, there is a formal field of study on this subject – it is called behavioural finance. It would be interesting to see a study featuring a rigorous application of mimetic theory to behavioural finance. Many of the current concepts are high-level and look like they could use some scientific reduction. Indeed, many of them are infused with the gnostic penchant for developing theories – myths really – that provide a fascinating but convoluted explanation for the observed behaviour, and then building a sort of cult following of privileged knowers around them. Unfortunately, a mimetic theory of behavioural finance doesn’t appear to exist, so we are left merely to dabble in some ideas in this here essay.
A great place to start our discussion is the great phenomenon of the stock market bubble. The vast literature on this topic is riddled with high-level concepts that multiply rather than reduce causes. The scholars accept human irrationality, but they nevertheless struggle to liberate themselves from the idea that the irrationality is based on intrinsic and objective factors of human behaviour, which are often seen as arising from evolutionary history.
As one example, the herd mentality of doing what everyone else does is seen as a formerly beneficial survival mechanism, harking back to the days, I suppose, when humans lived in herds. Another example is the dynamic of ambiguity aversion and confirmation bias. Investors don’t like ambiguity and prefer to delude themselves into clarity by selectively accepting only information that confirms their convictions, just like most animals prefer to live in a familiar niche and not wander off alone into the bush, where they risk either starvation or becoming a meal to predators.
Mimetic theory analysis of the stock bubble provides a simpler and clearer picture. In a stock bubble, the value of a stock decouples from any measure of its fundamental value. This is much like how, in mimetic theory, the intrinsic worth of any object of desire becomes less relevant the more rivals compete over it. As a market bubble begins to grow, fundamental valuations are forgotten, and the value of a stock becomes predominantly determined by what others are willing to pay for it. Similarly, in a Shakespearean love triangle, as rivals struggle over a woman, her value becomes increasingly determined by the rival’s willingness to obtain her, rather than by her intrinsic beauty (or virtue).
In both stock market and romantic rivalry, there is a positive feedback loop: the multitude of suitors inflate the value of the object by striving for it, and as the value increases, the striving increases too. In both cases, as competition intensifies, the suitors become infatuated with each other rather than the original object of desire, and the intensity with which they imitate each other’s willingness-to-pay for the object comes to dominate any “rational” evaluation.
Shakespearean tragedy and stock market bubbles both end in destruction. In the former, the mimetic inflation ends in the death of one or more characters, while the stock market bubble ends in massive losses of wealth to investors. But I would argue that there is a key difference in the final act. In drama, the model of one’s desire ends up killed, while in the stock market bubble, the model flips his behaviour, and he does so for the very good reason of making fabulous amounts of cash.
Investors in a growing market bubble are dominated by models, or mediators, that direct their desire towards a rising stock. This desire is purely mimetic, again, because behind a stock in a bubble there are no dividends nor growth in real assets or production. The tantalizing expectations of the future triumph of the company are absorbed by osmosis as it were from the overwhelming opinion of others. For months leading to the Bitcoin bubble, my LinkedIn feed was jammed with posts lauding the revolutionary virtues of the virtual currency. Playing the rationalist contrarian, I laughed at all the fools who entertain such empty fantasies. However, the joke was on me, because I failed to realize that the ubiquitous hype for bitcoin was the hot ocean water that will generate the powerful hurricane of bitcoin price growth. I should have bought bitcoin then instead of laughing!
In the inflationary bubble, the masses of people buy a stock because “experts” buy the stock. These experts are the models that everyone follows. Just like suitors will praise a woman’s angelic face or perfect figure, financial experts will praise the hot company’s fundamentals on blogs on TV shows. Now, many of us would argue that there is such a thing as objective physical beauty just as there is objective business value, but the point is that in a bubble, any objectivity becomes completely distorted and ends up paling in comparison to the hype. All the praise is bent by the ulterior motive of creating desire in the eyes of the other.
The bursting of the bubble is always triggered by one of the heavily invested experts deciding to sell their stock, in order to make a massive profit from the price increase. At this point, the subjects who have so obsessively imitated the expert will in fact continue to imitate him by also selling their stock. This creates a catastrophic reversal in the direction of imitation; suddenly, everyone is imitating everyone in the belief that the stock is overpriced. The victims are all those who bought at the wrong time and are then forced to sell at the wrong time, in order to avoid worse losses.
Stock market bubbles feature manic behaviour that suggests a single cause, rather than a combination of several peculiarities of the irrational human mind. They operate on the same principle as advertising and social media. To create a stock market bubble, one needs to create a mimetic stampede, to convince a critical mass of individuals of the desirability of the stock. This is done by creating hype through social networks. Once that is accomplished, the bubble takes a life of its own.
The big early investors then only need to play the game of when to cash out. The longer they wait the more money they make, but if they wait too long the mimetic hype may cool down, or, what is usually the case, someone eventually pulls the trigger because the first person who cashes out is the person who earns the most money. Once this first stone is thrown, the rest of the mob engages in a bloody lapidation, of the circular-firing-squad type.
An infamous variant of the mimetic inflation seen in stock market bubbles is the one seen in Ponzi schemes. Here too, mimetic desire plays the central role. Ponzi schemes always feature a charismatic leader who creates an esoteric aura of a financial guru possessing abilities and insights denied to ordinary mortals. His methods are that of a magician. He wins the confidence of his admirers by awe and sleights of hand: he moves in exclusive circles, lives in a mansion, owns a yacht, gives rare interviews to select initiates.
The leader of the Ponzi scheme is an external model. He may be like Bernie Madoff, who cannot teach you his secrets but who is willing to apply them to your money. Or, like the multi-level marketing leaders, he may be more of a man of the people who is earnest about getting you too to share his winner’s mentality, which you can then prove by buying his products and then trying to get followers of your own. However, in this case too, the imitation remains external, because one can never breach the higher levels of the pyramid and usurp the place of one’s models. One can only try to construct lower levels of the pyramid with one’s own following, labour that, however inspired, invariably fails to generate the hoped-for financial transcendence.
The sense of inferiority engendered in victims of Ponzi schemes is necessary for it to work. First, like in any con, it builds confidence in the master’s abilities. It short-circuits any suspicion or critical judgement of the master that may arise from noticing red flags. Finally, it makes the victim blame himself for any disappointments or failures, such as the failure to sell the multi-level marketing product.
Ponzi schemes that are illegal are those that involve objectively false information. Madoff lied to his clients that he was earning a return on their money when in reality he was paying them dividends from their own principal investment. This is why he went to jail for life. There are many who would like to criminalize multi-level marketing schemes as well, but this is proving difficult because the claims that such schemes make regarding the value of their products and the possibilities of wealth creation for their acolytes cannot be proven false to legal standards. There is no clear line between fraudulent and merely unrealistic promises because there is no clear line between objective and subjective value. At some point in time, it may be clear to us that we are on one edge of the spectrum or the other, but in the broad middle space, there is a bedevilling interplay of value and mimetic desire.
Curiously, in the business world, the mimetic generation of value out of nothing often leads to real, objective value. A charismatic Silicon Valley founder may spend years charming investors into handing over their savings to his venture, generating millions and even billions of dollars, all the while his company’s financial fundamentals look abysmal. An objective or fundamental analyst may conclude in this case that the perceived value of the business is entirely mimetic, and he may even be tempted to bet on its future failure. Yet, as long as the founder can keep the mimetic desire polarized in his direction, he can continue raising cash, and maybe one day his company will in fact become profitable.
Moreover, his company may become profitable because its products carry the mimetic value that he has imbued into them. After all, the vast majority of consumer products, sold by fundamentally very healthy companies, have no strictly utilitarian value. What is the utilitarian advantage to owning an iPhone rather than a Samsung Galaxy? A Ferrari rather than a sedan? An Italian designer shirt? Many financial analysts who take reservations against over-hyped products forget that the entire system is built on hype, and always was – “not that there is anything wrong with that.”
The one Silicon Valley founder that comes to mind today in connection to mimesis is Elon Musk, who is as of recently by far the richest man in the world. The investment world is divided into two bitterly warring camps: one that sees Musk as an industry titan bringing humanity into the next technological age, and the other that sees him as an owner of cash-guzzling black holes and therefore, a peddler of pipe dreams. The visions of the two camps are diametrically opposed, yet both have hard facts on their side. On one hand, Tesla makes real cars and SpaceX makes real rockets, and both companies possess enormous funds of capital. On the other hand, neither company generated any profit – until Tesla did last year.
Which warring camp will win does not depend on the current objective reality. The outcome of the war will be determined on the mimetic battlefield. At some level at least both sides seem to be aware of this; that is why both are very active on social media, clamouring for the strength of their camp and battling for the hearts and minds of the others. Their goal is to convert their mimetic desire, one may even say their daydreams, into everyone’s reality.
If Musk manages to maintain a sufficient number of hearts and minds on his side, he can maintain a flow of capital to develop to a point where his business(es) reach economies of scale and become too dominant for their competitors. If he fails to do so, the mimetic desire will polarize in other directions, or even flip aggressively against him and his vision. Mimesis creates power distributions - admirers attract more admirers, and haters attract more haters. Once the mimetic battle has been decisively won, the winner may begin to convert his mimetic capital into material advantages, like economies of scale or the network effect (it is more convenient to use a piece of technology the more other users it has).
It is a deeper philosophical question to consider the grand trajectory of technological progress. I for one am not convinced that Silicon Valley will play as great of a role in it as it believes it will. Yet, the short-term tactics seem to hang in the balance of a mimetic battle taking place in the valley and in similar places across the globe. It is hard to think of an immediate practicality of colonizing Mars, but it is also hard to think of the practicality of Greek sculpture, which has been popular for about twenty-five centuries (with a notable bear market in Medieval times). If enough people find the idea of going to Mars appealing, then people will go to Mars, and people will compete and perhaps even go to war to get there.
In his acute understanding of the mimetic nature of desire, Musk is following in the steps of previous Silicon Valley Founders, whose unique genius was to understand that technology is sold as consumer products have always been sold – through desire – and not within the materialistic and utilitarian framework of early modern ideologies of Francis Bacon or Karl Marx. Steve Jobs put it this way:
“Technology alone is not enough. It's technology married with the liberal arts, married with the humanities, that yields the results that makes our hearts sing.”
Americans have been at the forefront of fusing technology with desire. This explains the curious gap between that nation’s love of technology and its citizens’ lack of interest in technical education, as well as their obsession with the science fiction genre. Subjection of technology to desire also explains why the American and generally Western visions of technology swing so violently between utopian fantasy and terror.
Read more in the book Catharses.
