30 second reviews
Our goal is to reconnect you with useful things you might have already read and help connect those ideas to investor behaviour.
Why Nations Fail by Daron Acemoglu and James A. Robinson
This is the second of our special two-part edition :30 Second Reviews with Emerging Markets Portfolio Manager Christine Tan. In July, we discussed the 1943 classic, The Little Prince, by Antoine de Saint-Exupéry. Here, we discuss a 2012 economic bestseller, Why Nations Fail.
Seven years ago, an M.I.T. economist and a University of Chicago political scientist published Why Nations Fail: The origins of power, prosperity, and poverty. Daron Acemoglu and James A. Robinson had an ambitious project: figuring out why some countries achieved solid economic growth and others seemed perennially stuck in neutral. Using numerous current and past examples, and testing various theories, they examined the conditions necessary for innovation, which drives productivity. They determined that innovation happens in places where there are incentives to be innovative, and this is often tied to political institutions. Countries that are “extractive” don’t innovate, since the fruits of innovation are taxed away or benefit only a few. A small, powerful leadership group tends to extract and distribute wealth to their family and personal connections, and are highly motivated to keep doing so. Or, a lack of central authority leads to disorder, and this inhibits investment. On the other hand, in inclusive economies, leaders are periodically voted out of power, so there are limits on self-dealing networks becoming entrenched. Innovators in such countries know that they can have an idea, take out a loan, start a business and make a profit.
Question: Your specialty is emerging markets. One of the exciting things about emerging economies is that institutional reforms can unleash a lot of untapped potential. And moving from low productivity to even middling productivity can be very lucrative for the country and investors. Keeping in mind the “inclusive” versus “extractive” classification of Why Nations Fail, have you seen improvements in emerging markets over the past 10 years, where institutional changes increase productivity?
Christine Tan: In the past, when people looked at countries that achieved economic success, the reasoning was often simple. For example, some believe that in Canada, we have a lot of oil, water and other resources, so that must be why we’ve done well. But Argentina, Venezuela and South Africa have more resources in the ground, and at one point Venezuela was one of the wealthier countries in the world. But today, all these countries are still emerging, and Venezuela is still fighting the cycle of hyperinflation, high interest rates and high debt levels. Contrast that with a little country like Norway, which also has a lot of oil, but with prudent inclusive policies has accrued the world’s largest sovereign wealth fund – at over U.S.$1-trillion, that represents around C$260,000 per citizen.
EM countries with inclusive policies are achieving better and more sustainable growth. One key development in recent years is that the democratic system is working in several EM countries to bring in reform oriented governments. This may be related to the powerful combination of younger demographics and technology. Through technology providing access to information, people have a better understanding of what they want. They see how their peers live in other countries, and they press for those structures. They vote for governments that are willing and able to enact those reforms. For example, if you look within the ASEAN region, the government of Thailand, Philippines and the Indonesia are opening up their economies, improving their education systems and are in the early stages of providing better health care coverage. Similarly, when you look at the corporate sector in those countries, companies are more focused on the incentive structure: employees are promoted, given wage increases and in some cases, getting stock options based on merit – simply put, these governments and companies are implementing inclusive policies.
On the other side of the coin, let’s consider two countries that have slowed. My birth country, Malaysia, was at one time one of the most developed of the ASEAN countries. We have often observed that having the same party in power for a long time can lead to stagnation. Malaysia had the same party for almost 45 years. That means they had slower policy reforms than other countries in the region and as a result, Malaysia has been falling behind. Recently, because of this, the younger generation in Malaysia voted a new party in the recent 2018 election.
South Africa has had the same ruling party since 1994, and there has been both corruption and a lack of reform and progress. In the recent May election, the ANC again won, under a different leader Ramaphosa – and even with this change in leadership, we have seen a change in sentiment. So, that’s how important government is in EM – even the expectation that a leader will make reforms and improve an emerging economy’s ability to tap into its young demographics, can drive investor interest. And the resulting increase in wealth creation can drive that virtuous cyrcle of greater domestic growth.
Q: In India, there has been a definite policy shift to make the economy more inclusive. The national identity program seemed to be following the authors’ advice, since the creation of a biometric identity database, which enabled wide adoption of electronic payments is an important structural improvement to include more of the population in the formal financial system. Can you comment on these types of structural moves in emerging economies? And as a related question, let’s talk about the EM category a bit in light of structural improvements. Canada and the U.S. still have home bias, but are you seeing any change in attitude?
CT: I’ll tackle the second part first. Ten years ago, the discussion was about “why emerging markets?” Today, advisors are asking about particular countries or sectors within emerging markets. Questions are more “Why India?” or “Why technology within EM?” So that is a sign that there is more comfort with EM, and that the conversation has progressed to differentiated positioning.
I’ve also noticed that with greater focus on ESG, advisors are more sensitive to these factors when they choose a manager for their EM exposure. So they are looking at the countries and companies that are following good practices.
One good example is Brazil. It’s a resource-intensive economy, with a lot of oil. And one of its most important companies is Petrobras – also a key employer. When oil prices were reaching peaks in 2008 and other commodities were expensive, Brazil had the capacity to implement very generous social policies. At that time, their pension was set so that a man who has worked for 35 years can retire at any time. So, someone who started work at 20 could retire at 55. And a woman can retire after 30 years of contribution. Today, oil prices are significantly down from the peak, and Brazil still has a lot of its fiscal budget going to pensions. As a result, even though Brazil is a relatively young country, relatively little spending is being allocated to education or health care, which are key “inclusive” policies for future growth. The government has been debating pension reform for two years, but now looks on track for final approval in October. It has been a very painful thing to negotiate, but the message was clear to the government that if they don’t act on this, the government could be bankrupt within a decade. In emerging markets, we have noticed that in Latin America, it often takes a lot more pain to compel change. In the ASEAN countries, the reform process has been more gradual.
Returning to your first question. Over the last 5 years, India had implemented tremendous reform that has created serious dislocation in the economy, and still, the government won a second significant majority in May 2019. Modi’s first majority, in 2014, was India’s first in over 30 years. Now with a stronger majority, with a bigger turnout of the electorate, that is positive. It’s not just that the change is happening; it is happening through democracy.
Q: Speaking of India and structural reform, India’s national biometric-based identity program has been linked to electronic payments. So there has been greater likelihood that benefit payments actually reach intended recipients.
CT: Exactly. It leads to a more inclusive economy, and more efficient distribution of government spending. Technology can provide information, but it can also enable governments to achieve meaningful reforms. And it can lead to leapfrogging of development. For example, in continental Africa, M-Pesa, a mobile payment system, was created by a telecom company – Vodafone, in 2007 – for the two largest mobile companies in Kenya and Tanzania. Mobile payments is really upending the concept of the financial company, because here we think of banks as financial companies. But, where the banking systems don’t have the same reach, the telecom system has that reach.
India’s biometric ID – Aadhaar, is the most extensive biometric program in the world – 1.1 billion people are registered. And one of the drivers of this change is that a portion of the population, for example among the elderly in rural areas, might not be literate. So now this does not limit their ability to access the financial system, they can just use their biometrics.
Q: Why Nations Fail co-author Dr. Daron Acemoglu contends that China is still an extractive economy, and that its growth will eventually top out, since innovation happens when new winners are able to emerge in economies. What is your view?
CT: Time will tell. Although China has a socialist republic structure with one party, the government has been successful in generating strong economic growth while improving the lives of its people because of its focus on inclusive policies. China publishes 5-year economic and policy plans, in part to inform, but also to involve its people. More importantly, these plans have evolved as the economy grew. The initial phase was focused on urbanization and infrastructure. Within that phase, there was a strong focus on affordable housing, access to schools and road/rail transportation.
Now that China has built out its infrastructure, the current phase is focused on shifting to value-added manufacturing and supporting growth of knowledge-based industries such as robotics, environmental protection and artificial intelligence. As these sectors grow, higher quality and higher wage jobs are naturally resulting in higher consumption, hence shifting the economy away from fixed asset investments to consumption, similar to developed economies such as the U.S. and Canada. An improving legal system, which includes more property rights and intellectual property rights, combined with the ability to finance at reasonable interest rates have also translated significant wealth creation within a generation for many Chinese. Today, reflecting this evolution, several of the world’s largest financial, technology and consumer companies are domiciled in China.
The Little Prince by Antoine de Saint-Exupéry
In this two-part edition, we have Emerging Markets Portfolio Manager Christine Tan with us to discuss two very different bestsellers: The Little Prince and Why Nations Fail. We will start this month with the former, and post our Q&A about Why Nations Fail in September.
Antoine de Saint-Exupéry’s The Little Prince was first published in 1943, in French. According to the New York Times, the 84-page novella has been translated into 250 languages and dialects, and sells approximately 2 million copies a year. It has a little prince, of course, and the very small planet he lives on. The setting is the Sahara, where a pilot (perhaps a version of the real-life pilot, Saint-Exupéry himself) has crashed his plane, and where he meets the traveling prince.
Question: This is an unusual book. When it was first released, people didn’t know what to make of it, and then its sales took off. Why do you think people find it important? Why did you choose this book for discussion?
Christine Tan: My English teacher (my all-time favourite high school teacher) gave me this book when she retired. She simply told me that it’s a book I should read from time to time over the years. And I have. Surprisingly, The Little Prince is very relevant to me as a portfolio manager, because one of its messages is to not make assumptions. Whether I’m meeting a CEO or assessing a new country, like investing in Vietnam – now that it’s becoming an emerging market as opposed to a frontier market – it’s important to approach it with a curious mind, and not let my previous assumptions bias me to quick conclusions.
The simple example in the book is that, as a child, the author draws a picture of a boa constrictor swallowing an elephant. And, in his child’s mind, that’s what his drawing represented. But, when he shows it to adults, they all tell him that it looks like a hat. That is a message I try to keep in mind. The more great companies you meet, the more you form an idea of what the key success factors are and what you should be looking for. While the knowledge gained from analyzing strong companies is valuable, it’s also important to be open and curious. By trying to prevent myself from jumping to conclusions too quickly, I will ask myself, for example, is there something different about the dairy industry in Vietnam compared to the dairy industry in Canada?
In that light, the book is using the observations of a child – the prince – to look critically at how adults behave and think. The child is outside of the day-to-day adult world, so he asks a lot of “why” questions. The prince visits six different, tiny planets and meets six different characters – adults, as he calls them. But each adult is a caricature of a different trait. There is an arrogant king who has no subjects, but he still believes he rules everything he sees. Most of the things he says are issued as orders. Another character is the businessman who is always busy counting the stars so that he can own them. These caricatures remind me to be aware of certain “adult” personality traits that, taken to the extreme, could become flaws. For example, am I really are too busy for my hobbies or to see friends, or am I behaving like the businessman, constantly counting stars that never change.
Another unique aspect of The Little Prince is that although the prince is a child, he goes through a lot of introspection – thinking about his relationship with the rose, and his home planet. So I find it’s a book that can be read at many ages. For example, I read it to my young godson and he loves the simple story of the little child prince who travels to various tiny planets. And he isn’t even aware of the life-and-death ending of the story. For me, each time I’ve re-read this simple book over the years, a different aspect impacts me….and it is a timely reminder to never stop being curious.
Thinking, Fast and Slow by Daniel Kahneman (2011)
1. Behavioural economics: Cognitive ease as a force for good
The description of cognitive ease comes early in Daniel Kahneman’s book, Thinking, Fast and Slow. It refers to the fact that we like it when our assessments are made easier. For example, a sentence printed in a clear font is easier to understand than one in an ornate font. A side effect is that, other things being equal, we are more likely to believe a sentence in a clear font.
If you were to put together a chain of connections, it might look like the following:
Clear font – easier to read – more relaxed – more receptive – more likely to believe.
Here are a few more factors associated with cognitive ease:
Simpler writing – easier to understand
Primed idea* – familiar feeling
Repeated experience – familiar feeling
Good mood – feels good
*Priming refers to the unconscious effect of the context in which something is presented. Here is an experiment described in Thinking, Fast and Slow that illustrates its surprising influence: Young adults were asked to write a paragraph using words associated with old age (e.g., “Florida, wrinkle”). After the exercise, they were asked to perform another task in a room down the hall. Compared to matched participants who hadn’t had the “old age” priming, they walked significantly slower to the next exercise. “Old” words made them act older. Interestingly, using money as a primer tends to encourage selfish behaviour.
Why cognitive ease is a key concept
Kahneman uses cognitive ease to show how System 1 – our uncontrolled, effortless, associative, unconscious judgments – can be influenced by certain techniques. Recall that Kahneman’s key observation is that System 1 has mixed results in terms of accuracy, but it is powerful. In fact, it often overshadows our more analytical System 2 work, because the latter takes significant effort. Sometimes, System 2 gets co-opted into devising complex explanations to back up our initial System 1 snap judgments. Refer to every political discussion in the last 2,000 years as evidence.
Cognitive ease as a force for good
Consider this statement, which few advisors would disagree with:
“I want my Clients to do things that increase their chances of reaching their financial goals, such as
- Being aware of their timelines;
- Saving early, consistently and enough;
- Living within their means; and
- Taking a holistic view of family finances.”
If there is a Client-success behaviour you are hoping to encourage, how might you use repetition, simplicity and clarity to get there?
2. Behavioural economics: Buying, selling and the endowment effect
The CBOE Volatility Index had two spikes above 36 in 2018, one in February and one in late December –roughly double the long-term average. Canadian investors had positive flows into money market funds, a departure from previous years.
Money market fund flows in Canada, 2018: $2.44 billion1
Average annual money market fund flows, 2015-2017: -$381 million2
We have a sense that loss aversion is important in many areas of life, especially investing. This is the tendency to overweight losses, psychologically. As documented by Nobel laureate Daniel Kahneman in his 2011 bestseller, Thinking, Fast and Slow, in experiments, subjects experienced around twice as much emotional pain from loss as they experienced joy from an equivalent gain.
Here are some questions that tie to loss aversion, which are more thought-starters than prescriptions:
- How might loss aversion affect investor behaviour during and after periods of market volatility, and what is the role of the advisor?
- Is loss aversion necessarily a negative thing?
- Are there investment strategies that seek to minimize the sting of loss aversion but leave room for potential growth? What is the role of guaranteed products? Asset class diversification? Low-volatility strategies?
- How might Clients react to a service they had previously enjoyed being removed?
Fellow Nobel laureate Richard Thaler related loss aversion to the endowment effect, where people often “demand much more to give up an object than they would be willing to pay to acquire it.3” The basic interpretation of the endowment effect is that once we own something, we have a hard time parting with it. In Thinking, Fast and Slow, Kahneman points out cases where the endowment effect isn’t universal. For example, compare these two situations:
- A professor purchased several bottles of wine for $10 that had risen in value to $100. She was unwilling to sell one of her bottles for $100, yet she would not consider buying more bottles for herself for $100.
- A shoe store owner had no problem selling his last pair of a popular line of shoes.
The difference between the two situations is that the professor owned goods that were held for use, while the shopkeeper had goods that were held for exchange. This is an important difference, and has implications in various transactional settings. Here are some thought-starters related to the endowment effect:
- The same financial holdings can be seen differently, depending on the person’s vantage point. For example, an employee participating in ABCD Company’s share purchase plan may be reluctant to sell any of their company shares, even though diversifying proceeds into other investments may improve their risk-adjusted returns. A second investor who has experience buying and selling shares also holds ABCD. They have no qualms about selling. Is it possible to reframe the first situation so the share purchase plan member thinks like a trader?
- A house owner recently purchased a condominium. Their house is up for sale but they “can’t sell” because offers are coming in below the house’s peak value of a year ago. How is the endowment effect making it difficult to sell, even though they need the money?
When interviewed, Kahneman is humble about the success rate in applying behavioural research insights to produce actual behavioural change. There have been wins, but they often come from building guardrails around predictable errors rather than eliminating them through logic or willpower. Advisors who go back to Kahneman’s bestseller today will be in a better position to understand Clients’ varied, human responses to financial situations.
1 Strategic Insights, Investor Economics, January 2019, p. 19.
3 Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias by Daniel Kahneman, Jack L. Knetsch, Richard H. Thaler The Journal of Economic Perspectives, 5(1), pp. 193-206, Winter 1991.
3. Behavioural economics: Interesting, but what do you do with it?
Behavioural economics has inspired several good books over the past two decades, and people keep buying them. Thinking, Fast and Slow, Blink, Predictably Irrational, Nudge, The Undoing Project, The Power of Habit, Freakonomics and Outliers are all bestsellers. So, the secret is out: research shows that we often stray from the model of homo economicus, which assumes we make rational assessments to maximize utility. The question is, what are we doing with that knowledge?
System 1 and System 2
The old saying, “You can’t judge a book by its cover,” needs a postscript: “But you will anyway.”
Psychologist and Nobel laureate Daniel Kahneman, author of Thinking, Fast and Slow, spent five decades studying the way we interpret events and make decisions. His conclusion: people can be trained to make more thoughtful decisions but, ultimately, we are biased to making quick, intuitive judgments. Our more reflective processes, in many cases, align to support these judgments.
Through measurements of brain activity, researchers have evidence of fundamentally different processes at work, which Kahneman calls System 1 and System 2. System 1 is uncontrolled, effortless, associative, unconscious and skilled. It comes into play when we respond automatically to a photo of an angry person’s face. Similarly, tasks that have been practiced over and over can become a System 1 response. System 2, by contrast, is controlled, effortful, deductive and slow. It goes to work when people are asked, “What is 17 times 14?”
System 1 responses are powerful. From an evolutionary perspective, this makes sense. Snap judgments help us keep out of harm’s way and they conserve energy. Unfortunately, System 1 responses are also error-prone. This combination, of making errors but being powerful, means we have cognitive biases.
One of the most common patterns is that we substitute an easy question for a hard one. When asked what we think of a politician, we substitute the question “Does he look like a leader?” System 1 comes up with a quick answer: “He’s too young/old!” System 2 would entail time-consuming analysis to provide a more accurate answer: “What are his policies? How do they compare to the other candidate’s?” Since System 2 consumes energy, System 1 substitution takes place, and then System 2’s supporting points are brought in after the fact.
Practical tidbit: Have you ever walked out of a client meeting and thought, “Wow, we didn’t even get to (name the important issue)!” The “halo effect” in meetings is one example of System 1 taking over: issues that are introduced first and most forcefully tend to dominate the entire proceedings. One way to lessen this effect is to have meeting participants write down their ideas before anyone speaks.
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