The Rhyme of Irrationality

"Man has the power to act as his own destroyer -- and that is the way he has acted through most of history." ~ Ayn Rand

I recently ran across a few articles that got me thinking about irrational behavior, especially with regard to the key players (politicians, the federal reserve, big business, and the investor herd) in financial markets.  Each article is worth a read; however, I will provide the key takeaways and then follow with a few of my own thoughts, which will hopefully provoke your own:

Predictably Irrational: How Investors Frame Decisions:

• Author of the popular book, Dan Ariely, shares some of his observations from research in the field of behavioral finance at a recent industry conference for investment advisers.
• Ariely says, "Your brains are fooling you in a repeated, systematic way, and they are doing the same for everybody."
• The abundance of choices increases complexity and decreases the brain's ability to make good decisions -- the process of investing (selection, monitoring, buy/sell decisions) is rarely simple, yet decisions are made quickly.
• When decisions affect events further in the future, people act more rationally.  As time frames shorten, temptation plays a greater role and decisions become more irrational.  Ariely calls this "hyperbolic discounting," which explains why people don't save, diet or exercise -- the rewards of immediate temptations are valued too greatly.
• To overcome temptation and other related and irrational behavior, investors (and their advisers) should create binding contracts that anticipate temptation and provide details for rational reactions, such as re-balancing a portfolio in the midst of large swings (up or down) in stock prices.

Can Irrationality Be Rational?:

• Blog author, Barry Ritholtz, of The Big Picture, comments on a recent New Yorker article, titled Rational Irrationality, which discusses "the real reason that capitalism is so crash-prone."
• Mr. Ritholtz's take on the New Yorker article is that the author rationalizes irrationality, for example, on the part of big financial firms having little choice but to participate in financial bubbles or suffer by comparison to others who are profiting.
• This appears to Mr. Ritholtz as overlooking the consequences of a narrow short-term view.  In other words, how can one rationalize irrational behavior simply because others are participating (and profiting at the moment)? 
• Prudent risk management requires that a money manager or CEO go against the crowd at times of irrational exuberance and to exhibit objective judgment rather than herd behavior.

Why Capitalism Fails:

• The article observes recent interest in a somewhat obscure macro-economist, Hyman Minsky, who died over a decade ago, and whose studies predicted exactly the kind of financial meltdown we are experiencing today.
• In true bubble (and human) fashion, Minsky noted that periods of economic stability, as we experienced over the past few decades, would set the stage for monumental crises.  As Minsky observed, "Success breeds a disregard of the possibility of failure."  That success, of course, encourages borrowers and lenders to take on more risk and eventually a "euphoric economy" would develop.  Once this kind of economy develops, any panic, such as the failure of a large firm, would create a sudden economy-wide attempt to shed debt.
• This moment of panic, the watershed moment, would later become known as "The Minsky Moment."  Speculators and Ponzi borrowers would collapse first, followed by the remainder of market participants, even the more stable players.
• Minsky aptly named his idea "The Instability Hypothesis."  In the wake of a depression, he noted, consumers, businesses and financial institutions are all extraordinarily conservative.
• So, what now?  Minsky's solution, put briefly, was for extended programs from the federal government, even more than is currently being implemented.  Understandably, there is much concern today of socialism creeping into our governments so Minsky's solution will not likely be fully implemented.

With regard to these articles, especially the latter, I will avoid the temptation to cast judgment on any particular political view.  What I will opine, however, is that capitalism does not "fail" -- it simply follows a natural cycle that reflects human behavior that happens to go largely unchecked in a free society.

In a free society, individuals, businesses and institutions have an almost limitless capacity to fail, just as they have equal capacity to succeed.

The events in financial markets developing over the past few decades and unfolding within recent years simply speak to my consistent argument that human behavior, which is part of nature, has not fundamentally changed in thousands of years.  Only the environment has changed.

All of these observations underscore my belief that a great understanding of human behavior, combined with a significant degree of self-knowledge, allows for an understanding of all things touched by human behavior, including and especially financial markets.  In other words, knowledge of financial markets and financial instruments is less critical to understanding their cycles than the knowledge of human nature itself.

The only real certainty is that irrationality of participants in financial markets will return again, although it will manifest itself in a different form -- not a "repeat" but a rhyme of irrationality, if you will, that will continue to occur as long as humans populate the earth.

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Link to Don Ariely's book: Predictably Irrational: The Hidden Forces That Shape Our Decisions

Additional Reading on the subject of capitalism and human behavior: Atlas Shrugged by Ayn Rand.

Comments

[Alex G]

Leverage doesn't kill people, high leverage does :) Thanks for calling Barry out. He's such a walmart of blogging making such huge blunders regularly.

As far as being "self aware" (of your own human weaknesses) and philosophical implications:
http://emergentfool.com/2009/09/20/discovery-and-being-self-aware/

Less philosphy and more specifically on financial innovation. an FDA is needed:
http://emergentfool.com/2009/10/01/how-viagra-is-like-your-mortgage/

[Kent @ The Financial Philosopher]

Thanks for the comment, Alex:

I was not necessarily "calling Barry out" but rather reflecting his doubt that irrational behavior can ever be justified as rational, simply because the herd is irrational.

Personally, I believe that rational behavior sometimes looks irrational when it looks like a contrarian or rare dissenting view.

"Before the beginning of great brilliance, there must be chaos. Before a brilliant person begins something great, they must look foolish in the crowd." ~ The I Ching

Thanks again for the comment. I'll be sure to check out those links!

Cheers...

[Ramanji]

Greed is the biggest driver of irrational behaviour in human beings. It has deep influence in especially financial decisions.You may be a manager,politician or an investor,speculator or trader.It is very difficult to evade greed in such key decisions.