Isn't the market always rational?
I always found the appeal to the market gods a bit odd. Why would the market fix mistakes instead of aggravating them? When the Chicago economists sometimes (reluctantly) admit that people make mistakes, they claim that people make different types of mistakes that will eventually cancel each other out in the market. Behavioral economics argues that, instead, people will often make the same mistake, and the individual mistakes can aggregate in the market. Let’s take the subprime mortgage crisis, which I think is a great example (but a very sad reality) of the market working to make the aggregation of mistakes worse. It is not as if some people made one kind of mistake and others made another kind. It was the fact that so many people made the same mistakes, and the market for these mistakes is what got us to where we are now.
I’ve got money in the stock market, less than I might though. I thought we were in a bubble in ’06 and ’07, and then I thought we were in a bear in ’08. So, I made a plan to slowly get into the market in spite of myself, using Value Averaging over 5 years.
I share all this because I’m noticing a weird psychological effect. I’m happy when the market goes up, because I reduce my stock market losses. I’m happy when the market goes down because it proves me right.
And sometimes, feeling right feels better than making money by being wrong.
… what a weird thing the brain is. Part of it might be that an up market increases my actual wealth but a down market increases my relative wealth (in that I am still heavily in cash) … but maybe I shouldn’t admit that.
Dan. your story is completely different when you change the word “mistake” into “crime”. Giving a loan to someone of whom you know he cannot pay back and repackage thousands of these (non – performing) loans and sell as if they were as sure as gold … i wouldn’t call that a mistake. A mistake is sth you do wrong because you “you don’t know”. You can learn from mistakes by experience. Fighting crime is a lot more difficult. Read this post of today
http://www.sciencedaily.com/releases/2008/10/081015110751.htm
Many have commented that at some point, financial market participants have a broadly distributed tolerance for risk, but as time evolves, attrition takes place at the low end. This stands in contrast to political situations involving group polarization, where there is dispositional reinforcement in two opposing directions (let’s say liberal and conservative). The same “bimodal” dispositional bias ought to exist in financial markets, as it’s a system that closely resembles the political arena (there are no provable facts about the issues under argument). What makes financial markets so much more prone to a collapse in consensus toward one of two prevailing views (bullishness or bearishness), where political systems retain a much stronger equilibrium of polarization and disagreement?
Generalization is not appropriate here. The market isn’t a single body and doesn’t have an ultimate goal, hence cannot be rational or irrational per se. The market is a set of participants with own goals, knowledge, and rules of exchange. Participants may expose the irrational behavior. But what is irrational here? They just may prefer to achieve their short term goal instead of a long term goal. But who says this is a mistake? In addition to this, Frederic Bastiat cautioned that good economic decisions can only be made by taking into account the “full picture” and continued on based on what information those decisions should be made. The definition of “mistake” is also fuzzy. I guess by “mistake” we mean some amount of regret about some action in the past, but these regrets may last for some limited time as the situation changes. So today we may think we made a mistake yesterday, but tomorrow we may think “Oh, I guess I was right then”.
The subprime mortgage crisis was the result of a combination of factors. I agree with one of the readers that “crime” or I would put it as fraud on the secondary debt market was one of the reasons. But the main reason of this crisis is that participants didn’t know the “full picture” with giant players like Freddie, Fannie, and the Fed.
I think we all need to keep in mind that depending on where one lies on the socioeconomic/credit-worthiness ladder, rational for one person may not equate to rational for another.
In the case of sub-prime borrowers, maybe they were exhibiting “rational” behavior. In normal times, they would never be considered for a $250,000 no-money-down interest-only loan. And aware of their past poor credit history and hopelessly resigned that they will only continue such bad behavior in the future, they might rightfully conclude that if they don’t accept the generous loan now, they might not get it in the future. Even if it means they can’t afford it and will foreclose within 12 months or so….at least for 12 months they can live a lifestyle that they will “never” be able to afford (assuming they plan on continuing their behavior of uncreditworthiness).