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Why markets can be mad, bad and dangerous to know

PSI |  18 February 2014  |  Portfolio

StrategyOne of the greatest absurdities of economics is the claim that humans are rational. Clearly, they are not. In the investment markets, we constantly create bubbles and, when things go wrong, we trigger collapses. Rationally, we should buy low and sell high. In practice, most of us do the opposite.

Indeed, the very notion of "rationality" is suspect. It is the idea that ratio of value can be constructed, then people can follow that. But the ratio is just a number. It is not a mind. Minds can understand the ratio, then punt on it; their awareness of the number's meaning is nit incluyded in the ratio. So there is a whole layer above the numbers that determines the prices, which analysts typically call "sentiment". In fact, "sentiment" just means "what humans will actually do rather than what the numbers indicate they shoudl do." That is, the bit that economics and financial analysis does not, and cannot, tell you.

Behavioral economists try to adjust their analyses to take in the human element, which is only a partly convincing endeavour, although it does start out with the right question. Usually, there is far too much emphasis on brain science. The barin is not the mind. In fact, the relationship between the brain and the mind is a little like the relationship between th numbers and "sentiment".

On is Dan Ariely, who explains why humans are biologically wired to make irrational decisions when money is involved. Like many, he appeals to theories of evolution, which is dubious. But he does look at the "herding instinct", which does seem to have some biological basis and does seem to explain some of the behavioural excesses of markets. He argues that in some sectors, like the banking sector, bad decision-making has become so ingrained in our institutions that a "clean slate" approach is our best option should we have the courage to deploy it. No argument there.


It is worth a read. Especially for super investors trying to come to terms with markets that do not seem to make sense. Humility is crucial when reading the irrationalities of human behaviour:

In very general brushstrokes I think that most bankers are in fact inherently decent people. We just put them in situation in which their conflict of interest is tremendously high and their social norms are incredibly dysfunctional.

When you hear bankers talking about their customers as Muppets, for example, they are forgetting who they are serving. They are hired by the rest of us to do a particular job; and they forget this. And then they have terrible conflicts of interest.

Imagine that I give you a world in which, if you can adopt a particular perspective on life, you could get $5 Million as a bonus. Wouldn’t you start believing that world? And then everybody around you is doing the same thing, and you have some justification for it by talking about financial market theory and so on. All of a sudden you could see how you could take good people and you could put them in this distorted way -- in the same way that we talked about how global warming is probably the perfect storm for inaction -- I think Wall Street is the perfect storm for allowing people to rationalize their own selfish motivations as if they are serving other people.

It is really, really terrible because we have not done anything to change the way we pay bankers. And we have not changed anything in terms of the code of ethics and morality.

On the consumer side, there is a tremendous loss of faith. We have been screwed and we know that we have been screwed. And we know that we are not trusting other people. And I think loss of trust is a central issue for this financial crisis and sadly nobody is trying to do anything about that. Human beings are incredibly forgiving, but nobody has really stood up and said, "I am really sorry. I made all of these terrible mistakes. I want this particular bank to start fresh and caring about people," right? Nobody has admitted anything. So we as consumers feel that there are these other people on the other side who have behaved terribly, which is true, and that are smug about it, and that nothing is different. And why should we trust them? And we do not.

I don't think it is a generational thing. I think there is a tremendous feeling of lack of control, agency, and helplessness. And the sad realization -- this is one of the things that came out of financial crisis -- is that it is much harder to start a new bank now. So young people are actually quite idealistic and I think people would have started new banks where they behaved very, very differently. But what happened is that it is really, really tough to open a new bank now. But I am still hopeful: I think that this anger and frustration just needs to be channeled in a better way.

I am not a religious person but the story from the Bible is that God made the people of Israel walk around the desert for 40 years until the old generation that worshipped the golden calf passed away. I do think that we need a new generation of bankers. I think you cannot take the old generation of bankers and rehabilitate them.

Recent history is not showing us that this is something we should hope for. But there is a real question of, How do we create a new generation of bankers that are going to think of themselves as the caretakers of society, rather than the rapists?



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