Financial crashes, reward, and punishment

I was recently looking over some old books I’ve collected about financial markets. I found myself going through the 2013 Credit Suisse Global Return Yearbook. Who in their right mind goes through a book like that in their free time? This is my hobby. Anyways, I found a great chart about volatility and mean reversion.

The 2008 Credit Crunch/Lehman Brothers crisis was devastating. Many of you reading might remember that moment. That crash required the most trading days for the VIX to revert back to its mean. During the Credit Crunch, it took the VIX more than 200 days to revert. That’s nearly double the amount of time to mean revert than the shocking October 1987 Crash. Here’s the chart:

In trading and investing, mean reversion suggests that over time an asset will eventually return to its average price if it drifts or spikes too far from that average level. The behavioral economists Daniel Kahneman and Amos Tversky are mean reversion masters and made it a mainstream concept in financial markets.

But Kahneman and Tversky also apply it to other aspects of life. They tell a story about mean reversion and the Israeli Air Force: when it came to influencing and improving a pilot’s ability to fly, reward and punishment were simply an illusion. Each time the Air Force rewarded a pilot for a great flight, that pilot tended to do worse on the next attempt. And when they punished a pilot for a poor flight, that pilot tended to do better on the next attempt.

While at first glance that small anecdote might look like an insight into the effects of punishment and reward, it was in-fact nothing but reversion to the mean. The pilots who flew great were reverting back to their average on the next trial, and the pilots who flew poorly were also reverting to their mean on the next trial:

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“We normally reinforce others when their behavior is good and punish them when their behavior is bad. By regression alone, therefore, they are most likely to improve after being punished and most likely to deteriorate after being rewarded. Consequently, we are exposed to a lifetime schedule in which we are most often rewarded for punishing others, and punished for rewarding.”

– Kahneman and Tversky, On The Psychology of Prediction

I’m going to end this post right here. I think if you’re reading, you’re smart enough to see the lesson at hand in both markets and life.

Mean Reversion In Your Life and In Markets was originally published in Luchini In The Air on Medium, where people are continuing the conversation by highlighting and responding to this story.