H/T to Simoleon Sense:
Here’s the most important lesson from this paper (via ssrn):
“This suggests another fundamental difference between rational expectations investors and trusting investors. Where the former look to “the shadow of the future,” the latter care about “the shadow of the past.” Put differently, a rational expectations investor expects others to exploit her whenever possible. Accordingly she will always be forward-looking, trying, just as a chess player might, to anticipate other players’ opportunistic future moves. In contrast, trusting investors look to the past. If someone or something has always behaved in a particular way in the past, trusting investors assume that that person or thing will continue to behave similarly in the future, without worrying too much about understanding what drives the behavior in question.”
Abstract (Via SSRN)
Evidence is accumulating that in making investment decisions, many investors do not employ a ‘rational expectations’ approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like ‘the market,’ in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.
Great Introduction (Via SSRN)
Burt Ross graduated from Harvard University in 1965. After working several years as a stockbroker, he ran for and was elected mayor of Fort Lee, New Jersey. Then Ross turned to commercial real estate. In 2003, he decided to sell some of his buildings and invest the proceeds, which amounted to more than five million dollars. Ross thought he was prepared for retirement. At least, he thought he was prepared until December 11, 2008, when he learned that his nest egg–which he had invested almost entirely in funds managed by the now-infamous Ponzi schemer Bernard Madoff– was gone. (Pulliam, 2008)