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The Idea of Behaviour Traps

We all get trapped into 'behaviour traps'. This is a variant of the Pavlovian Syndrome, where we get rewarded for certain behaviours. In the physical (natural) world, this works for us sometimes

"Insanity is defined as doing the same thing again and again, expecting different results." So goes an old joke. I would like to add a corollary to that: "Insanity is defined as doing the same thing again and again, expecting the same results."

We all get trapped into 'behaviour traps'. This is a variant of the Pavlovian Syndrome, where we get rewarded for certain behaviours. In the physical (natural) world, this works for us sometimes, so we go to the same place expecting food/water, for example. Maybe that is why we have anthropological chips in our brain that reinforce Behaviour Traps.

In our modern economic world, however, the situation is different. The phenomenon of Fallacy of Composition ensures that what is good for the goose is not good for the geese. For example, say, in a small village, one man goes and buys a Bank share...and gets rich. The next-door-neighbour does the same, and so does his neighbour. In a little while, this trickle of investors turns into a veritable flood.

After some time, look at the queue lined up to buy banking stocks. They are the same guys who bought somewhere in the middle. This behaviour worked for them, so it reinforces their confidence. They now put in ever-larger amounts, confident that this (behaviour) will work for them. And so a bubble is built. This is what happened in 1992, 2000 and (maybe) 2005…!

We see these Behaviour Traps in the real economy too, not just in the (irrational) asset markets. Most companies cannot time their investments at cyclical bottoms because they are caught in Behaviour Traps. Banks are most likely to be prey to this behaviour. Money being the ultimate commodity market, banks do most of their business when they can do it, ie, when demand for credit is maximum. This usually coincides with the top of the Business Cycle. No large bank can ever resist the rush of business, otherwise it would not be large. This is the time when the maximum percentage of assets will turn sticky, leaving the bank to bail itself out of an NPA bloom in the middle of the bust. That is why the world's largest banks have never been the world's best banks, at least in portfolio quality. Most housing bubbles are linked to credit bubbles, almost like an economic law.

The whole phenomenon of the 'double feedback mechanism' is linked to this underlying idea of a Behaviour Trap. You buy a house, which goes up in price. Elated, you take a loan on the old house and buy another house…and so on, till your credit is exhausted or house prices drop. This is what has caused the American Housing Bubble 2004-05, and may be causing (I think) the New Indian Housing Bubble 2006…!

So ultimately, you observe that house prices are going up because house prices are going up. This credit-soaked demand is riding on the availability of cheap money. Slowly, a consensus evolves..."house prices never go down. At worst, they will flatten for some years". People will forget that they flattened at a time when houses were owned with savings, not with debt. Today, they have linked house-buying to profits, regardless of whether they buy with own equity or with debt. This is a Behaviour Trap.

Governments, that most irrational of economic players, can hardly be exempt from such obvious linearity. They have seen Pain Aversion policies (commonly called Populistic Policies) work for them at the hustings. So promise the moon, or 'free power to the farmers' and waltz your way to the Parliament. At some point, the poll results for the same behaviour will change, when the power sector is in a shambles. That will be the point of inflexion.

The above is a largely generic explanation of one of the big irrationalities in humans. Just knowing it is usually enough to deal with it, at least at a personal level. In markets, however, you should look for give-away signs of other people's Behaviour Traps that could be extremely profitable.

I would love to receive feedback from readers who see this phenomenon in various pockets of markets. It is perhaps the single biggest of a guarantee of a trend reversal. The only problem is locating the timing and range of a trend reversal. But at least you have one of the issues sorted out…how many people can guarantee that someday, somewhere, you will make money on a punt?

For example, I see that properties in Gurgaon are going at a rental yield of 1 per cent (ie, yearly rents are 1 per cent of the market value of the property). Yet, there is enough liquidity in the new projects, some of which are over-booked. The only explanation for this phenomenon is the Behaviour Trap.

Something like this must be happening to FII flows. The continuous and relentless flows into India, will someday become a Behaviour Trap for the last institutions to set up or invest into India. Playing to the Principle of Institutional Stupidity, it will become impossible for any individual executive to stay out of India, just like the headlong and irreversible rush into China recently.

Behaviour Traps reverse with some clear give-away signals, which can be discussed later. The only cautionary note is that traders should punt on a reversal, only after clear signals of a 'topping-out'. Punting on a reversal can be very dangerous to your financial health.