Bottom Line Up Front: Before you ask another man how to invest your money, ask him how he makes his money. If he makes his money investing or because he owns a business, listen to him. If not, be skeptical.

Behavioral Economics 101: Women’s high-heeled shoes

Behavioral economics is the soft science of why we spend, how we spend, what we spend. Good science is predictive. Economics, sometimes called The Dismal Science, tries to be predictive. The thinking is that if we understand why people spend, we can predict how their behavior will affect the economy and then write good economic policy, laws and regulations.

A fun example is the one about women’s high heeled shoes. One school of thought is that when women buy more high heeled shoes it’s an indicator of troubled economic times. The reason? Women’s spending represents a big segment of the economy. They buy high heeled shoes to make themselves feel better. If lots of women are buying high heeled shoes it indicates anxiety about the economy. I’m not sure I agree with it, but it’s an interesting suggestion and a good example of behavioral economics.

In troubled times people buy more alcohol. Car buying indicates a variety of things. Magazine sales, too. Fast food sales. What does it mean when different kinds of purchases rise or fall?

“It’s a fool who goes looking for logic in the chambers of the human heart.”

– O Brother, Where art thou?

Money and emotion are linked and we rarely do anything for just one reason. We are complicated creatures and who can tell why we do the crazy things we do?

I remember standing by Baltimore’s Inner Harbor early in 2007 with a good friend who worked on Wall Street. It was the first time I heard the term Collateralized Debt Obligations, or CDOs. He told me CDOs  had become so complicated that only a few people understood them and they were not the guys buying and selling them like lunatics. The guys buying and selling them like lunatics were salesmen. Employees. Men whose commissions rode on sales. Not investors.

“I can pack up and mail in my keys.” – Bartender’s Blues

Between 2007 and 2009 many people found their financial lives turned upside down. Mine certainly was. The US economy is still feeling the results of those three years. Real estate and real estate speculation played a disproportionately large role in the financial turbulence of those times and we can still feel the effects of that, too. As the markets began to slide and the economy registered stress, economic policy makers in congress made decisions on how they thought people would spend money. As the real estate market inflated and became a bubble, homeowners discovered refinancing and started pulling equity out of their houses. Like crazy. At the time I owned some investment properties and we used to refinance very rarely, but I knew homeowners who did it over and over again. It all came crashing down when the law of supply and demand reasserted itself.

Here’s the (not so) funny thing: As congress came to grips with the situation they made a big assumption that was fundamentally wrong. They assumed nobody would walk away from their mortgage. But that’s what happened. People got in over their heads and just walked away. Mailed in the keys. They said to their lenders, “Well, the house is collateral on the loan and you lent me the money. I don’t have the money so take the house.” Contractual thinking and it happened in droves.

Supply times Velocity or, how currency really works.

Another interesting aspect of Behavioral Economics is why people spend money at all. If I have $5 in my pocket and I use it to buy shoelaces I am saying I have faith in the future. If you think it through you’ll see what I mean. There are variations but you get the idea. What makes a currency powerful is how much (or how little) of it there is, but also how fast people exchange it. Exchanging currency is an act of faith. The US dollar is in crazy demand all over the world and people exchange it with extremely high confidence. One of the mysteries of the global economy is why. Why do so many people believe the US dollar has value? Their belief and confidence indicates their faith in the US way of doing business.

What does an Investor really do?

An investor makes money by finding hidden value. An investor makes money by knowing on which side of the table to sit. When someone buys, someone else is selling. Where you sit on the transaction makes all the difference in the world.  Likewise, the different kinds of hidden value are endless. How can investors make money when the stock market tanks? They’re on the right side of the table. The next time you hear crazy bad financial news, ask yourself, “Who’s making money, here?” I assure you someone is always winning.

Call to Action: Today, go on YouTube and search the term, “Supply times velocity” and watch a video on it. Then, do the same with “Behavioral economics.” After you have watched those two videos, buy yourself a beer. Congratulations, you are starting to think like an investor.