Rational Irrationality: The real reason that capitalism is so crash-prone.
Charlie Munge stresses the importance of “being willing to kill your best ideas”. In this spirit I have to confess something, I’ve recently killed one of my favorite subjects, behavioral finance. After learning about behavioral finance, I became a victim of “the man with a hammer syndrome”- solving every financial dilemma with prospect theory or a cocktail of cognitive bias; what an inappropriate application of a mental model. Luckily, I stumbled across complex adaptive systems (which shed light on different solutions)…. Although, I haven’t completely killed behavioral finance I understand the limits of the field and subsequent theories.
My conclusion: Are markets efficient? I have no idea- and that’s a good thing. Rather than worrying about market efficiency, I focus on opportunity. Markets can (and will at times) deliver incredible opportunities. Being prepared & lucky is the most anyone can ask for…
Note: If you find this article fascinating I recommend reading Michael Mauboussin’s latest book, “Think Twice”.
Click Here To Learn About The Real Reason Capitalism Is So Crash Prone
Introduction (Via New Yorker)
What does all this have to do with financial markets? Quite a lot, as the Princeton economist Hyun Song Shin pointed out in a prescient 2005 paper. Most of the time, financial markets are pretty calm, trading is orderly, and participants can buy and sell in large quantities. Whenever a crisis hits, however, the biggest players—banks, investment banks, hedge funds—rush to reduce their exposure, buyers disappear, and liquidity dries up. Where previously there were diverse views, now there is unanimity: everybody’s moving in lockstep. “The pedestrians on the bridge are like banks adjusting their stance and the movements of the bridge itself are like price changes,” Shin wrote. And the process is self-reinforcing: once liquidity falls below a certain threshold, “all the elements that formed a virtuous circle to promote stability now will conspire to undermine it.”
Additional Excerpts (Via New Yorker)
Markus Brunnermeier, an economist at Princeton, and Stefan Nagel, an economist at Stanford, obtained data from S.E.C. filings for fifty-three hedge-fund managers during the dot-com bubble. In the third quarter of 1999, they discovered, the funds raised their portfolio weightings in technology stocks from sixteen to twenty-nine per cent. By March of 2000, when the Nasdaq peaked, the funds had invested roughly a third of their assets in tech. “From an efficient-markets perspective, these results are puzzling,” Brunnermeier and Nagel noted. “Why would some of the most sophisticated investors in the market hold these overpriced technology stocks?” We know that many such investors had no illusions about the prospects of the financial products they traded. But their strategy was to capture the upside of the bubble while avoiding most of the downside—and, with timely selling, many of them succeeded.
It won’t be as easy to deal with the bouts of instability to which our financial system is prone. But the first step is simply to recognize that they aren’t aberrations; they are the inevitable result of individuals going about their normal business in a relatively unfettered marketplace. Our system of oversight fails to account for how sensible individual choices can add up to collective disaster. Rather than blaming the pedestrians for swarming the footway, governments need to reinforce the foundations of the structure, by installing more stabilizers. “Our system failed in basic fundamental ways,” Treasury Secretary Timothy Geithner acknowledged earlier this year. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.”
Click Here To Learn About The Real Reason Capitalism Is So Crash Prone
