The Stock Market, Reflexivity, and the Limits of Rational Behavior
We’ve all gone mad. And we’ve all gone poor.
And the economic mess that we’re in right now shows you that going mad can make you poor. Like giving loans of a quarter of a million dollars to households with combined incomes of $50k. That’s mad. And now the household and the bank left holding the note, have gone poor.
Are we mad? Of course we are! I’m in the marketing communications business. I know mad when I see it. People are just downright crazy. And we have been for some time.
People at their core are not rational beings. We stare at grocery shelves comparing the unit price of two tubes of toothpaste to save twenty cents … then five minutes later blow six bucks on People magazine at the checkout counter. We spend money on water from a bottle when it is free from the tap. We buy off-road vehicles that never go off road. We read Perez Hilton. We’ve been through fads that have included Hula Hoops, Tiny Tim and the Marlboro Man. We do all kinds of crazy stuff every day.
Some guy got 18,000 to get naked and curl up like a fetus in a city square in Mexico. The same guy got over 6,000 people to get naked and stand on a glacier in Switzerland. On a glacier!!!! Any objective or “rational” outside observer would say we’re all insane.
So why shouldn’t markets be the same?
George Soros said so some time ago. But traditional economists were unimpressed. Backin May, David Lynch wrote an article in the USAToday on Soros and his economic theory of “reflexivity.” Christopher Neely’s reaction to Soros’ challenging the theory of rational market equilibrium:
“It is difficult to conceive of a more mistaken understanding of the profession’s research in the last 10-15 years. … The great danger of the (earlier) book is that non-economists will take seriously his ill-founded criticism of economic research,” wrote economist Christopher Neely of the Federal Reserve Bank of St. Louis.”
What Neely doesn’t understand — and Soros did — is that there is a human element to markets that make markets irrational. Indeed, the starting point of Soros’ theory is so clear … so plain … so evident in everyday life … that I am amazed that economists have the temerity to challenge it.
According to Soros … “The starting point of my theory … holds that our thinking is inherently biased.”
Duh! Soros’ observations would be a no-brainer to us marketing types so I find it fascinating that the Wall Street and banker crowds disdain it. Here are some excerpts from Soros’ speech at MIT back in 1994 !!!
The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it …
Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences …
Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory …
I don’t know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics …
In coming out of “retirement” and based largely on this theory of reflexivity, Soros made several billion over the last decade.
Who ya going to believe? Soros or your undergraduate economics teacher?
He knows we’re mad. And he ain’t poor.