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The last ‘rational economic man’ standing?

July 12th, 2008 · 2 Comments

Although economics has an air of hard science surrounding it, with often very complex mathematical models bulging out of most economic journals and even more complex mathematical models running on computers in research centers spitting out rather exact forecasts for the economy. Yet, with all their sophistication and complexity, these models are notoriously bad at forecasting, especially of important turning points.

One fundamental problem with these models is that they are build on mechanical equilibrium models which were borrowed from physics over a century ago. Whilst physics has moved on, economics hasn’t, and it has quite a bit of catch-up to do. (There are new fields, like complexity economics, behavioural economics, and experimental economics that try to move away from these constraints of the mainstream).

One of the fundamental building blocks of all mainstream economic models is the assumption of ‘rational economic man’ (which, it might surprise some of you, includes women as well). Man is reduced to a rational deductive calculator who manages instantly to arrive at his best personal solutions, given the choice constraints of the situation. (The theory is considerably more farfetched than this lame description, but we’ll spare you the details).

There is overwhelming evidence that this depicting of ‘man’ as thoroughly rational is incorrect. We are mostly hardwired with all kinds of heuristics (decision rules) that served us well in previous circumstances (in an evolutionary sense, so think of the African savanna where we originate from).

Leaving ‘rational economic man’ behind has far reaching consequences for economic science, we might go into that some other time, but for the meantime we have to note that ‘man’ is also driven by ‘sentiments’ (and this might surprise some of you but this includes.. man).

Now, one of the systematic mistakes that we’re not supposed to make according to that picture of ‘rational economic man’ economist are so fond off is the ‘availability bias‘. We will base our view of reality mostly on easily available data (in stead of digging deeper for our own data).

If we hear from all sides that we’re in deep economic trouble, it tends to become our world view. Three observations follow:

1) Mea culpa. We have, in our own small way, contributed to that..

2) On a more serious note, these notions might very well turn into a self-fulfilling prophesy. Beliefs tend to have a strong influence on actions, if we think we’re in economic trouble, many of us are likely to act upon these beliefs, for instance by cutting back expenditures, postponing big ones (new house, new car), drive less, saving more for a rainy day, etc. Actions that will aggravate the economic situation.

3) On a more humoristic note, luckily not everybody is so easily swayed. Here something we found on the DryShip message board, written by a certain ‘Karlklassner’, an antidote of sorts (whether it is the right sorts remains to be seen…)

I call it the “media terrorists“. They want to strike fear into Americans every chance they get. I have been saying this for months, even years. All you hear about in the media is stuff designed to scare people. Oil prices? Big deal. So we’re paying $1 more for gas. If the average person drives 15,000 miles per year, he uses an extra 700 gallons of gas. That’s only $700 more dollars you’re spending this year than last. Is $700 really going to kill anyone? Even if gas goes to $5, people would still be spending only an extra $1500 a year, some more, some less, depending on how much you drive.

As far as the foreclosure issue — it doesn’t affect most people. Some ,sure, but not the majority. So who cares? Also, the reason many people are getting into foreclosures is because they are spending way beyond their means. Americans are notorious for that — spending way beyond their means. So whose fault is it?

Now people are scared of stocks? BUSINESSES ARE NOT GOING TO STOP MAKING MONEY JUST BECAUSE OIL PRICES ARE HIGHER. If that was the case, then we might as well just shut down every business in existence and commit mass suicide.

I don’t need to be reminded by the media 24 hours a day what gas prices are. It’s like this sick obsession. I don’t care what gas prices are. I fill up my car and go about my business. It’s that simple. I don’t worry about the extra $20 it just cost me because $20 is chump change. It’s a couple less meals out during the week or a couple less latees at Starbucks.

But the reason the “media terrorists” get away with the garbage they do is because people enable them to. CNBC says sell, people run and sell, sell, sell. CNBC says buy, people buy, buy, buy. If you want to make money, you need to play CNBC’s game. Be one of the smart ones, not one of the suckers.

Face it, stocks no longer trade on great fundamentals — they trade on hype, like baseball cards. That’s the sad state of affairs in today’s stock market. That’s why there are so many pumpers and bashers on every message board. They think they can hype something higher or lower, make a buck, then run. CNBC is basically the same thing only on a grand scale.

Is ‘karlklassner’ the last ‘rational economic man’ standing? We’re not so sure but we thought we’d share this with you and let you enjoy the weekend on a more optimistic note :-).

One final observation. If more people think like the author of this diatribe and won’t let themselves be intimidated by higher gasoline prices, we might have to revise our oil market predictions, which were based on the assumptions that they have gone high enough for people to start changing their behaviour…

Tags: The Markets

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