Wednesday, October 15, 2008

READ: Lessons

As I go into work every day fearful of what will happen next, I am truly envious of scholars in just about every branch of academia. Instead of worrying about the impact of this crisis on their livelihood (unless they invested their retirement savings in the stock market, oops), they benefit from the endless material that a spectacular meltdown like this provides for further study and analysis. Those in finance and economics are reconsidering how we think about risk (and some are being propelled from the outskirts of economic theory right to the forefront); political scientists are exploring the role of the government and regulation in causing, preventing and resolving situation like this; sociologists can study the impact of the decline in the housing market on communities around the country. In other words everyone worth their academic post can find something in this mess worth pondering about, at least for a few moments.

However, while we're still deep in the middle of it all, I can also see how it is incredibly demoralizing to some: Markets are supposed to be perfect.. Regulation is supposed to prevent this.. 10% drops and gains in the stock market are supposed to be extremely unlikely.. People are supposed to be rational. In other words, imagine your whole professional life is predicated on certain assumptions and overnight those assumptions turn out to be shaken, if not crumbling down. A perfect case in point is this blog entry:
We should ditch the assumption - which in a sense is mere courtesy - not only that others are rational but even the weaker assumption that they are nearly so. Perhaps we should indeed regard them merely as “empty suits.”
Apart from making that substantive point about ditching a widely-held assumption, I was quite moved by the sense of helplessness and confusion embedded in the final words of that entry:

All of which leaves me genuinely puzzled. Were banks risk managers really that bad? Are bosses an order of magnitude stupider than even I had thought? Or is something else happening? Help me.
I can relate to this sense of confusion, anger and frustration. I encounter it quite often in my job: when common sense logic and endless analytical work is telling you one thing and the market is telling you the complete opposite. When you spend days, weeks, months and sometimes years being right about something fundamentally but still lose money in the market. Problem is that quite often the market is not driven by logic or common sense, but rather by pure emotion. It can be anywhere from humbling to outright insulting to see that your analysis is correct albeit sometimes completely irrelevant.

Market fundamentalists often respond to this observation by saying that eventually, in the long run, the market gets it right - emotions give way to underlying fundamentals and the prices correct. However, that long run can be painfully long, especially for those who are evaluated on their daily, weekly, monthly, quarterly and - if they're lucky enough to be still around - annual performance. (Which is why people often find it easier - and more lucrative - to predict emotions rather than to predict fundamentals, but there I really digress.)

So how is that related to the frustration expressed in the blog post and this meltdown? Perhaps the answer to the deep questions underlying this whole crisis cannot be found in any one of the academic fields I mentioned above because all of them either simplify or altogether ignore the role of psychology and the human element in their analysis. In other words, the assumption that people are rational is not necessarily flawed; maybe people are just much more complex that we give them credit for in standard economics analysis and until we can somehow break down the artificial barrier between economics and psychology we will never quite get it.

Surely enough, this idea is not at all novel. In its origins, classical economics was indeed quite interested in understanding the link between human psychology and economic decision-making and more recently there has been a resurgence in behavioral finance and economics. However, much like the idea of a Black Swan, it sits very much on the fringes of academia. Perhaps thanks to this situation it will finally get more respect and airtime in those Econ 101 classes.

Until then, I have found myself a new interesting read which may contain some good insights applicable to this situation: Almost Certain Loss: The Psychology of Pyramid Schemes.

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