February 24, 2009, 6:00 am

The Danger of Rationality

by: The Financial Blogger    Category: Investment, Market and Risk
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When I was in college, I took a lot of psychology classes since I wanted to understand what people think and what lead them to think this way. Later on, I did my bachelor degree in finance and marketing because I really enjoyed marketing classes such as consumer behaviours (yup, marketing is as evil as to make research to know what you really think in order to sell more 😉 hehehe).

While I’m now working in the finance industry, I still believe that my psychology classes apply to my job. I actually found something very interesting while reading the business newspapers for the past two years:

2 years ago, every business journalists were listing all the good reason why oil would reach $200, why China will lift the global economy on their shoulders for the next 100 years and why stock options and other derivatives were created to protect investments and were not more dangerous than any other financial products.

I remember reading tons well written articles on the fact that we will lack of oil in no time as the economic growth will become astronomical.

What happen to all of this? How come we are not missing oil anymore? How come the barrel dropped to $40 while it was at $150 last summer? Where all the Chinese go?

Nothing really happened. All of this was the curious creation of what we call human rationality. Human beings have a tendency to explain things that are going on based on what they know and making links where there are none. We now know that the barrel of oil increase that much because of highly speculative hedge funds more than anything else.

We also know that Chinese economy still depends on the North America and Europe spending habits. Nothing has changed, really. It is just that we now see the real cause of our economic boom and why this couldn’t last forever.

So now that we have found out that our economy wouldn’t outperform for ever (remember, the very same thing happened during the techno bubble; internet was the source of a new, more powerful and indestructible economy), we are turning back and we are looking to find reasons why this crisis would be the worst ever, that we all going to lose our job and that the Dow Jones will hit the mark of 1,000 points by the end of 2009.

Is it really going to happen or are we just using our brain to make “rationale” links between events and facts that are not necessarily connected?

Unfortunately, I don’t have the answer. I just make this observation thinking that history always repeats itself as human beings make the very same mistake each time…

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Put it that way: I would qualify this as the danger of irrationality. Human beings are not infallible. Because good information is scarce and not evenly distributed, there are some errors in perception and some errors in the process of formulation. With so important drops in financial markets, it is hard to understand what it is happening right now. Even if economists try to put financial explanations to irrational stock markets, psychology is taking over. There’s no more rationality!

This reminds me of Bernstein’s Four Pillars of Investing… once all the articles were written about oil or China being the next big thing, you know it’s time to get out.

That’s right! It also reminds me of an old Wall Street saying from the Great Depression: “when everybody’s getting into the market and even the shoeshine boy is giving stock tips, then it’s time to sell.”

I prefer the following quotes:
“the time to buy is when there’s blood in the streets.”
– Baron Rothschild, an 18th-century British nobleman

Actually, my father used to tell me that story haha it can be a nice story for your kids!!!

You have to put yourself into context of the late 1920s. It was in a period of great economic growth (introduction of automobile, radio, telephone, electricity boom, skyscrapers sprang up like mushrooms …). Everybody was getting into the financial market, Everybody was talking about stocks, and that stockbroker knew it was time to sell, cause even the shoeshine boy was giving him some stock tips….

and now the shoeshine boy is probably telling you to sell:)

hahaha it would probably be my hair dresser… 1 year ago was probably the best time to sell

[…] Financial Blogger has an interesting take on predictions in The Danger of Rationality. […]

I don’t think there was any rationality behind what most analysts and the business media peddles. More often than not, they grab the most plausible story and try to string everything together in a way that’s supposedly easily understood. The forces that propel the market are most likely too multi-faceted, unpredictable, and maybe even unscrupulous to spin on network TV.

But in the case of oil, most people were wrong, including Warren Buffett. And that says something.