Rod Fort’s challenge to anyone who could outdo college football preseason polls (Not Exactly Julian Simon …) reminded me about a Henry Manne piece appearing in the Wall Street Journal (subscription required) back in June. With my World Cup myopia, I let it slip. Manne, a major defender of efficient market ideas, assesses the contributions of behavioral methods in finance. Here’s an excerpt:
Perhaps the most important behavioralist contribution to economics has been their reminder that the market-model claim of rationality often does not comport with actual human behavior. Economists frequently failed to qualify economic pronouncements as being limited in application to aggregate behavior. Too many assumed that if markets in the aggregate behave rationally, it must be because the “marginal” participant — the trader who has the correct information about what a price should be — was himself a perfectly rational maximizer. This better-informed and rational trader would always arbitrage away any discrepancies from efficiency that a market displayed.
But there is a vast difference between economics and psychology, and we can thank the behavioralists for forcing economics back into its correct posture of dealing with aggregate behavior. We can also thank the behavioralists for demonstrating that the marginal trader/arbitrage theory cannot explain all price formation, since we have no way, a priori, of knowing that this hypothetical individual will be rational. Nor can we any longer assume that the arbitrageur (apart from a purchaser of 100% of the securities of a given company) will have all the information necessary to set the correct price.
While some may think that Manne ceded too much ground, Gary Becker said much the same in 1973 (“A New Theory of Consumer Behavior). Most of the propositions in economics, even though theoretically worked up from an idealized individual, explain outcomes a lot better when applied to some group of 30, 50, 100 or more.
The upside of this is “wisdom of crowds” or “law of large numbers” kind of insight is that it helps buttress points like Rod made. The flip side for sports economists is that in making application of theories and principles at the individual coach, player, or manager level, we need to recognize that the rational choice approach may be as good or better than any other, but it still leaves a lot of error.
Separately, Rod’s bet raises an interesting question as to whether the “wisdom of crowds” works the same with investors who have “skin in the game” as with voters who don’t. The voting literature finds a lot of ideological or expressive voting behavior. This might be a subject worth investigating using sports polls. As a stab in this area, in a 1996 Applied Economics article I found that where a team started in the preseason polls influenced where it ended up (“path dependence”) even after taking into account winning percentage and schedule strength.