Do we like free markets? Yes. But.
That quote is a key theme in Phishing for Phools: The Economics of Manipulation & Deception by George Akerlof and Robert Shiller. The authors, two of America's leading economists, note that free markets are capable of generating unimaginable wealth and innovation. And yet, this system also "tends to spawn manipulation and deception." Because the goal of every business person is to get you to spend your money, they will often come up with ingenious ways of tricking you. This frequently results in consumers choosing things that aren't very good for them.
Akerlof and Shiller point to the Cinnabon breakfast treat as an amusing example of how the free market system exploits our weaknesses automatically. Humans are naturally attracted to the scent of cinnamon, so it was almost inevitable that an entire business would emerge to exploit that vulnerability. Life may indeed "need frosting" – as Cinnabon's motto declares -- but most of us probably shouldn't start our day with a pastry containing 880 calories.
Understanding the two peculiar terms from the book's title is essential for grasping its central argument. The authors define the word "phish" as "getting people to do things that are in the interest of the phisherman, but not in the interest of the target." In other words, "phisherman" are those businesses that are trying to get you to buy something that may not be in your best interest.
A "phool," according to the authors, is "someone who for whatever reason is successfully phished." Each of us might get phished because our cognitive biases might lead us to misinterpret reality or we might just lack adequate information.
After defining these terms, the authors show us how the notion of "phishing for phools" works across various industries. For example, Big Pharma appears to be especially rife with manipulation. The authors describe how the pharmaceutical companies orchestrate the rollout of a new drug. There are journal articles and sales rep visits and ads on TV -- all designed to "create a story of the new wonder drug."
Vioxx was one such wonder drug, of course. Akerlof and Shiller tell us in considerable detail how the system broke down in that specific case.
The investing industry is another ideal "phishing" hole where financial professionals drop their lines in order to take advantage of phools. One big takeaway from their research just might help ordinary investors. After analyzing numerous industries and countless case studies, the authors conclude,
In every one of the phishes, it occurred because the phisherman took advantage of the phool's wrong focus. In some cases the phisherman, like the magician and the pickpocket, himself generated that wrong focus. We also checked Cialdini's [Ed. note: Robert Cialdini, author of The Psychology of Persuasion] list of psychological biases; each one of them could be considered to be the result of an errant focus by the phool.
This insight is extremely valuable when applied to the investing world. Financial professionals very frequently exploit the tendency of ordinary investors to focus on the wrong thing. That "wrong focus" can be extraordinarily costly in fees and poor investing performance.
Just consider how much "focus" the financial media places on the inscrutable actions of the Fed or the volatile movements of commodity prices or whether or not a recession is right around the corner. And think about how much emphasis some financial professionals place on their ability to generate "alpha" by pursuing some incomprehensible strategy that requires you to pay them hefty fees, even if they're not successful.
Phishing is everywhere in the financial industry and it's designed to make you lose your focus on the right things, while you fork over your hard-earned money to the phishermen. None of us can predict where markets are going in the short term, so worrying about what the Fed will do or about how much alpha-generating ability your advisor possesses (he'll tell you it's a lot) will only distract you from your long-term investing plan. If your financial advisor is calling you with a hot tip on a can't-miss fund based on the latest investing fad, then you might be in danger of focusing on the wrong thing. In other words, you're most likely a phool.
This fine book yields another crucial insight for investors. The authors argue that phishing is one of the prime reasons behind the volatility of asset prices. Misleading accounting, media hype, investor sales pitches -- these are just some of the ways that asset prices become inflated. When the inflated assets have been purchased with borrowed money, huge losses will eventually snowball and "then credit dries up; and the economy tanks." We experienced that back in 2008 and 2009, of course. Phishing hurts investors in a variety of ways.
So, what must be done? First, remember that the authors believe strongly in the power of free markets. They're not advocating for a "people's paradise" with centrally planned outcomes.
Instead, they just want us to recognize that people don't always do what is good for them. That's why we need sensible securities regulation in our public markets. We also need more prudent and smart oversight in both the economic and political realms. Leaving everything to free markets alone, the authors argue, will result in bad outcomes. There was a time in American history when that opinion wasn't terribly controversial.
I highly recommend this book, even for those who might disagree with the authors' outlook. Their case studies are illuminating, and their insights on the way markets work are fascinating. When you consider the sorry state of the personal finances of the median working age family in the United States today, it's hard to disagree with their central thesis that our current system isn't working properly.