In this section, we free ourselves from the constraints of standard finance theory for the purpose of exploring a possible way of illustrating CFS. We do not pretend that the results hold true; rather, this is a conceptual exercise embedded in the regular dynamics of scholarly research. We go through several deployments of the spinning framework to explain its various parts. One should keep in mind that spinning being a process, all graphs are quintessentially under the pressure of a time horizon.
4.1. The CFS-Markowitz-Modified CAPM Framework
Our first step is to assume that dysfunctional consumers detach from the reasoned CML and form a line of their own, which we call the Exuberant Life Stage Line (ELSL), to use parallelism and hence assume that the latter is a portion of a larger vertical quadratic function, because we also consider that the efficient frontier is a quadratic function (a horizontal one). The ELSL has the format
f(x) = ax2 + bx + c, where
x = the standard deviation
σ and the coordinate of the vertex of the horizontal axis of symmetry of the parabola,
y = the expected return on the investment portfolio
E(Rp), where
a and
b contract (large
a and/or
b) or widen (small
a and/or
b) the parabola and are >0 (if <0, then the parabola would deploy downward), and
c moves the curve up or down along the Y-axis (Y-intercept)—
Figure 1.
Note: Because the Exuberant Life Stage Line (ELSL) is assumed to be a parabola, it implies the use of the left quadrant, which we name the “too-good-to-be-true domain”. A time horizon is added to the Y-axis as this is where the borrowers (future buyers of high-stakes financial products) act: they change their expectations over their time horizon depending on perceived risk. The latter replaces σ, because under the principles of symmetry and parallelism, all constructs pertaining to the two market agents—lender and borrower—must be psychological in nature.
Figure 1 reads as follows (from left to right). The too-good-to-be-true domain is illusional: technically, there is no such thing as negative risk. To read it properly, one must think in psychological terms: to the right is the domain where the market imposes its conditions, hence the perceived risk. In the left domain, the consumer is led to think the market can be beaten. For a short while, between the risk-free rate
rf and the point where the CML touches the Efficient Frontier, the ELSL espouses the regular CML as a quasi-straight line (both curves are reflective of the life stage of the customers: as income rises with advancement in career, they can borrow more and invest more). Note that the assumption that the ELSL is a parabolic function that tends to narrow means that its
a and
b increase overall. Note that the parabola and its extension into the left quadrant, which is an imaginary one, also represents reality. Many financial scams build on this too-good-to-be-true domain. Bernard Madoff and his immense Ponzi scheme provides a perfect example, among many others (Enron, Bre-X Minerals, Norbourg, etc.): his clients were led to believe he could systematically beat the market no matter how volatile it was, promising (abnormal) rates of return of some 15% year after year, without any interruption, regardless of economic conditions. Note also that risk
σ is listed as perceived risk, as all constructs must be psychological in nature, and that time horizon has been added to the expected return variable
E(Rp)time, because this system is predatory: time horizon is of the essence.
Our second step is to examine in more detail what happens to the various elements that are included in the framework (
Figure 2).
Note: Because the ELSL is assumed to be a parabola, it implies the use of the left (unrealistic) quadrant; also, rf shifts down to spinning rf (valued at 0).
Figure 2 reads as follows (from left to right). We added wording in the too-good-to-be-true (irrational), “Madoff”, domain indicating that there are two vertical spreads: the normal one, and the spinning one, characterized by an inflated expected return
E(Rp)’ of the portfolio and a deflated risk-free rate of return
rf’. One can see that while the expected returns reach new highs (↑), the alleged risk-free rate diminishes to the point of absence of risk (→0). This is emblematic of predatory behaviors, just like promising a too-go-to-be-true outcome. All financial scammers try to convince their prey that their financial system is risk-free (otherwise, why would anyone venture to buy into it), or else they try to hide risk through incomprehensible contracts (or websites) and complex financial instruments. The widening, net effect of the spread between expected return and the risk-free rate is because ELSL replaces the CML for the greedy consumers as can be seen in the right quadrant. Financial predators bet on their prey’s risk aversion and offer them “heaven” by promising (abnormal) high returns and low risk, often claiming they have the ultimate, privileged (if not secret) recipe for success. The ELSL narrows when moving to the left, while the borrowers are traveling backward on the EF function, which is possible because their time horizon shrinks. While the expected return
E(
Rp) is boosted (↑
E[
Rp])’, the borrowers’ perceived risk is moving backward (←
σ’), towards the point of origin (
rf’ and
σ = 0). Eventually, the borrowers will move to the right along the perceived risk X-axis (
σ’→) as they become disconnected and because they follow what others do, and what others do is to take on more risks in a booming market. The net graphical result is that the market risk
σm then moves right (
σm→) and borrowers’ risk
σ’ moves right as well, but always trailing the market (
σ’ < σm).
Our third step is to incorporate the three components of the dark financial triangle in the spinning model. For the same level of risk (
σ), the borrowers think they can beat the market and make themselves believe they can reach higher standards of living quasi instantly, like a lottery (abnormally high
E[
Rp]). This corresponds to overconfidence. We make this association because when overconfident, borrowers skip rungs along their ladder of needs. The idea behind this is that, as any financial advisor knows, people go through a certain hierarchy of financial needs as they engage more fully in the fabric of society, starting with saving accounts, life insurance, retirement savings, and then purchases of bonds and eventually, risky stocks. When overconfident, borrowers skip over some of the basics and invest blindly into high-risk products, as is the case in about every other financial crisis. R-rationality finds an expression by the fact that instead of satisfying themselves with a diversified portfolio, the borrowers focus all their attention on a very limited range of financial products (lower part of the EF curve)―(
Mani et al. 2013). In the case of tulipomania in Holland in the 17th century, it was tulip bulbs; in the case of the GFC, it was houses. Thus, borrowers let go of their preferences and buy whatever single product is out there that they think will make them rich fast. R-rationality is hence associated with preferences. Deceit occurs when the borrowers erroneously think that they can earn more than what the market has to offer (abnormally high
E[
Rp]) while benefiting from a lower risk-free rate of return than the established rate (lower than normal
rf); however, they are fooling themselves and others and let the predator-sellers mislead them too. The spinning spread tells the story of a lie that all scams rely upon: “Make money fast, there is no risk and the deal is much better than what is out there, believe you me!” Disconnection from needs is fostered by overconfidence (rendered by rung skipping), of preferences by r-rationality (betrayed by portfolio shrinking), and of goals by deceit (revealed by increased spreads), all without due consideration to risk. Our fourth step is to confirm that the ELSL is riskier than the normal MCL, despite what the shrewd predatory lender-sellers would have the borrower-customers believe. To affirm this, we resort to standard indifference curves, commonly found in finance theory: as these curves deploy, they are known to become riskier, so that in our framework, the upward curvature of the ELSL signifies higher risks. Again, this framework suggests that the borrowers will not take on more risk than the market: their
σp’ will not surpass
σm set by the market (at all times,
σp’ <
σm). The only way to increase
σp’ is if the market first sees an increase in its
σm. Thus, there has to be a contagion effect. As one of the borrowers follows the market and takes on more risk, so do numerous other borrowers who also compose the market: all borrowers caught in spinning imitate each other. This eventually leads them all to spin out of control.
4.2. CAPM Revisited
We have resorted to the tenets of the DPM and selected some observations from past research—such as data showing that the beta
β tends to be higher than predicted by the standard CAPM formula and that markets display substantial volatility that cannot be explained using standard economic assumptions (
Cochrane 2005). The CAPM formula assumes that there is no emotional involvement on the part of investors (it is thus a perfect instrument for financial analysts but an incomplete one for the “household” investors), and thus that transaction costs and taxes do not affect decisions (hence, they are considered null), and neither do contagion effects. In particular, CAPM is insensitive to budgetary considerations: the investors have no monetary concerns, they can borrow and invest infinite amounts, in subdivisible parcels if they wish, and the markets exhibit consistency. However, observations from the reality of markets call for a multi-factor approach to the CAPM formula (
Nicholson and Snyder 2017), which would explore the risk contribution of influencers other than the ones treated. Beside the CCAPM and the three-factor model we discussed previously, the Arbitrage Pricing Theory (APT—
Ross 1976) has been significant; it does not assume a fully efficient market. However, it rests on assumptions that clash with the conditions set for the spinning model, namely: (1) existence of perfect competition (so that there is no asymmetry of information and no predator–prey dynamics); (2) investors are rational; (3) investors immediately react to undervalued assets and sell them when relatively overvalued (in the case of spinning, recall that consumers of financial products have lost track of their initial goals, so that they do not necessarily engage in arbitrage). In summary, the original CAPM, CCAMP, and APT assume that the borrowers are and remain sensitive to their initial needs, goals, and preferences, behave rationally and ethically, and that the market is safe and sound (economistic paradigm). All three assumptions go against the description of a predatory paradigm where CFS is likely to surface. Behavioral finance has expressed limitations over arbitrage and emphasized the recourse to psychology (
Barberis and Thaler 2002), but it does not treat disconnection from reality, even though this is a phenomenon well studied in that field in its more technical term of disassociation.
Since we worked based on the assumption that all curves are quadratic, we temporarily reformulate the CAPM into a bi-explanatory-factor function, as follows:
The square of the market risk premium (Ω
2) allows us to turn the original CAPM formula into a quadratic function. The added variable (
ψ⋅Ω) acts as an amplification mechanism (
Brunnermeier and Oehmke 2012) that betrays excessive speculation and, assuming that beta
β and psi
ψ do not differ wildly from another, has theoretically less impact on the expected return on the portfolio with respect to the market risk premium than the first variable (
β⋅Ω
2), which by essence was conceived in the context of purely rational investors. Psi (
ψ), being parallel to beta
β, must therefore measure sensitivity. Because spinning occurs in the context of indebtedness, and because we assume emotionality is related to money matters (people fear missing out on the opportunity to enter a booming market—where total income is increasing, but fear the risk of getting caught in a crashing market—where an unsustainable debt looms), we consider that the added variable (
ψ⋅Ω) is a measure of emotionality in the context of spinning and propose to measure psi
ψ as follows:
We view psi (
ψ) as the expression of some of the assumptions made in behavioral finance: it discloses the impact that emotions, resulting from the fear of the debt trap, can have on decision-making (on choosing the illusory, abnormal
E[
Rp]
’). At 100%, the fear is the most “household” investors can endure; at zero, there would be no fear at all (the marketers of risky financial products have done a great convincing job). Equation (4) does not tell the whole story, however. Recall that the predator-sellers are trying to move the prey-customers into the “Madoff” domain. To do this, they have to make extravagant promises (expressed by a boosted
E[
Rp]
→ E[
Rp]
’) while making customers believe that the risk-free rate of return is close to nil (
→ 0). Hence, they have to maximize the spread between the two variables
E(
Rp)
’ and
. We finalize our spinning function as follows:
with
rf > ≥ 0 and
lim → 0. By dividing the market risk premium
Ω by the risk-free rate of return
rf, which in the context of spinning tends toward zero (→0), we express the fact that the inherent dynamic of the entire system is inflationary: predator-sellers sell a wild dream and buyer-prey buy into it. Recall that since we are dealing with psychological constructs, all scales are from 0 to 100, as previously indicated. In case of Equation (4),
rf and
are valued at 1, meaning that this equation reflects the most the “household” investors are willing or capable of conceiving: at that point, it would not be worth investing at all, because no spread would be achievable between the market
rf and the spinning
rf, as it is this spread that, in part, feeds the wealth appetite of these investors.
Equation (5) highlights the fact that the expectations of return on a portfolio (necessarily little diversified in the context of spinning) are artificially boosted (irrational) and that decisions are based on both cognitive and emotional considerations (expressed by debt). At beta
β > 1, the portfolio is more volatile than the market; at 1, it matches the market; at 0, it is often interpreted as a cash market; at < 0, it is a counter-market, with gold often being a sample case of this occurrence. At psi
ψ > 1, the borrowers may change opinion often. Looking at the interaction between beta
β and psi
ψ, one can derive that it might help to anticipate systemic risk (risks that pertain to the financial system but that are not necessarily systematic, that is, whose occurrence is not
de facto predictable)
1 and that are at the heart of financial crises (
De Bandt and Hartmann 2000). Systemic risks include phenomena like bank runs, contagion, and liquidity crushes (
Benoît et al. 2015). When both beta
β and psi
ψ are high, this points to market and individual volatility, and substantial unpredictability. This will inflate the irrational (abnormal) expected returns
E(Rp)’, which call for aggressive borrowing (greed). It is probably in that combination that the debt trap is the most treacherous. Note that because psi
ψ is measured by two types of account—the ins (revenues) and the outs (debt)—it is very sensitive to such things as fees, taxes, income tax, black market revenues, and so forth. It is therefore much better positioned to reflect the reality of the market than the original CAPM formula. This signifies that consumers, before disengaging from their initial financial needs, goals, and preferences, work hard not only to maximize the positive outlooks—
E(Rp)’ and total income, but also to minimize whatever jeopardizes them—fees, taxes, and so forth. In short, it is to their best selfish advantage to cheat the system, as long as the risks of being caught remain inconsequential. This is truly a predatory paradigm. This also holds true for unscrupulous lenders, as they will benefit handsomely from spinning clients who spend without counting.
Equation (5) may permit portfolio managers to evaluate their clients’ desired returns, based not only on the assumption that they are rational, as should be the case, but also that they may be irrational at times (see
Appendix A). It offers a way of measuring the potential for irrationality based in part on known variables—income and debt; we are not arguing here that Equation (5) gauges irrationality for certain. For this proposed equation to make sense in the market, it should be tested on a vast number of consumers of financial products to set its baseline. At what level does psi
ψ become irrational? The advantage of Equation (5) is that it calls for hard data rather than for subjective assessments of irrationality or the DFT. It is highly contextualized because it relies on the spinning
rf, which is an abnormal occurrence. We suppose that many studies will be necessary in the future to come up with a table of acceptable levels of psi
ψ given
rf’. However, in the meantime, and as part of an exploratory effort, we can determine whether the ELSL may indeed curve upwards, away from the CPL, and under what conditions. This is what we discuss in the next section, which details the research we conducted, keeping in mind again that the measuring tools for CFS are still being developed and that our effort tackles an emerging concept.