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Rational Logic Means Nothing in the Markets

Greenspan speaks to how irrational markets can be:

Michael, Thanks for making all of your podcasts available to the public. Please keep up the good work. I thought you might find the quote below from Alan Greenspan of interest. It’s from a 10/26/13 interview with the FT entitled “Crash Course”:

“…He [Greenspan] admits that he first saw how irrational finance could become as long ago as the 1950s and 1960s when he briefly tried, as a young New York economist, to trade commodity markets. Back then he thought he could predict cotton values ‘from the outside, looking at supply-demand forces’. But when he actually ‘bought a seat in the market and did a lot of trading’, he discovered that rational logic did not always rule. ‘There were a couple of guys in the exchange who couldn’t tell a hide from copper sheeting but they made a lot of money. Why? They weren’t trading a commodity but human nature…and there is something about human nature which is not rational‘…”

Best,
L.W.

Trend following foundational point #1,232,980.

Greenspan Wakes Up to Behavior

From The Wall Street Journal:

“I’ve always considered myself more of a mathematician than a psychologist,” says Mr. Greenspan. But after the Fed’s model failed to predict the financial crisis, he realized that there is more to forecasting than numbers. “It all fell apart, in the sense that not a single major forecaster of note or institution caught it,” he says. “The Federal Reserve has got the most elaborate econometric model, which incorporates all the newfangled models of how the world works—and it missed it completely.” He says JP Morgan had put out a forecast three days before the crisis saying the economy was on the rise. And as late as 2007, the International Monetary Fund also said that global risk was declining. “A few days [after the crisis hit], I run into an article, and it is titled, ‘Do we economists know anything?’ ” he says.

Mr. Greenspan set out to find his blind spot step by step. First he drew the conclusion that the nonfinancial sector of the economy had been healthy. The problem lay in finance, because of its vulnerability to spells of euphoria and irrational fear. Studying the results of herd behavior provided him with some surprises. “I was actually flabbergasted,” he says. “It upended my view of how the world works.”

He concluded that fear has at least three times the effect of euphoria in producing market gyrations. “I wouldn’t have dared write anything like that before,” he says.

Studying the minutiae of the events leading to the financial crisis brought to mind some lessons from his famous friendship, from the 1950s on, with the late Objectivist philosopher Ayn Rand. He says that Rand didn’t influence him politically—he was always a libertarian—but she did point out tensions in his philosophy about life. “She caught me in contradictions, which shook me, and I said, ‘My God, she is right,’ ” he says.

Mr. Greenspan then believed in analysis based mainly on hard science and empirical facts. Rand told him that unless he considered human nature and its irrational side, he would “miss a very large part of how human beings behaved.” At the time they weren’t discussing economics, but today he realizes the full impact of emotions and instincts on markets. He also has come to admire psychologist and Princeton University professor emeritus Daniel Kahneman’s work applying psychological insights to economic theory, for which he won a Nobel Prize in 2002.

Good for Greenspan. So late to the party.

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