Sometimes the normal laws of supply and demand get forgotten.
One of the greatest American Presidents, Harry Truman, got so annoyed with his economic advisors who would always add the caveat "on the one hand, on the other…" that he asked for a one-armed economist! Unfortunately the complex nature of the modern economy means that economists cannot provide the degree of certainty that Truman demanded.
One of the "iron laws of economics" is the law of supply and demand. Almost everyone knows of this law, particularly when they're doing the weekly shopping, even though they may have never explicitly thought of it as such.
In a nutshell if the price of a good increases then people change their purchasing habits by buying less of that good, typically switching to a cheaper alternative. Similarly producers respond to rising prices by producing more goods whilst cutting back production at times of falling prices. When prices fall, consumers buy more and producers supply less.
The trouble is that occasionally the law of supply and demand fails and when this happens it can cause some investors to make poor decisions.
Meet Mr Veblen
Behavioural economics has a rabbit to pull out of its hat; a very contentious bunny that contradicts the classical economists' law of supply and demand. For a few items, whenever they rise in price consumers buy more, not less as classical theory predicts.
These peculiar goods are known as "Veblen goods", after the Norwegian-American economist Thorstein Veblen, and sometimes investors appear to treat their investments as if they were Veblen goods which can wreak havoc with their portfolios.
Veblen goods tend to be status items; the most common of which are luxury goods such as expensive jewellery, designer clothes, foreign holidays and high performance sports cars. Most Veblen goods are bought to flaunt wealth, to induce feelings of envy in others and to "keep up with the Joneses."
Of course there are limits to what people can pay so a sports car which was on sale for £50 billion would attract zero buyers but within certain price ranges the Veblen effect can clearly be observed.
This research from Caltech and the Stanford Business School shows that people will derive more pleasure from drinking wine that cost $45 a bottle than if they drink the exact same wine having been told that it really cost $5. These drinkers are not just consuming the wine; they are consuming the price difference.
Unfortunately many private investors treat the stock market as a Veblen good; this is nicely summarised by the cynical city adage which defines a private investor as someone who buys at the top and sells at the bottom. Invariably after a period of sustained market highs reports will emerge confirming that private investors have recently invested record amount in unit trusts (and likewise, net sales will increase strongly after market falls). All too often investors buy simply because the price has gone up.
Hamsters and Houses
This year's must-have Christmas toy, the Go Go Hamster, sold for just under £10 when it was introduced back in August. Many shops have run out of stock and Go Go Hamsters are currently selling online for upwards of for £40, not just because of a supply shortage but also because of increasing demand.
As Christmas approaches it is likely that Go Go Hamsters will temporarily become Veblen goods. Whilst some parents will become indifferent to price rises because they must buy Go Go Hamsters for their children, other parents will buy because the price has gone up and this enables them to make a conspicuous display of wealth to other parents and children.
Residential property, particularly buy-to-lets, frequently displays the characteristics of Veblen good, especially when desperate buyers start gazumping following a period of sharp price rises. All too often it is the rise in price which drives an increase in demand, not the other way round, which is a clear case of the tail wagging the dog. However, much of the change in demand for residential property is closely related to the availability of mortgage financing given that most potential buyers cannot buy without using borrowed money.
Cash For Gold. Cause Or Effect?
In recent months adverts offering to buy and sell gold have started to appear everywhere, particularly on daytime TV.
Ask yourself this question; is the increasing interest in investing in gold because investors are switching to gold to provide some protection against inflation or are people buying more gold simply because the price of gold has increased? I suspect that the situation regarding gold is a bit of both; some investors have recently bought gold as a hedge whilst others bought because the price has risen.
An understanding of Veblen's theory should be part of every investor's toolkit because human nature can cause people to buy something merely because its price has increased.
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