Today is the 20th Anniversary of Black Monday. Joe Nocera had some interesting thoughts on this here, including this:
Having watched the way investors have behaved since the Crash of ’87, I’ve come to believe that most human beings are simply not hard-wired to be good investors. In the 1990s, a new kind of economics arose, called behavioral economics, which tried to show that investors weren’t so rational after all. So I can’t deny that one of the reasons I like Mr. Zweig’s book so much is he provides, at last, a scientific basis for this theory. It turns out that there is a new discipline called neuroeconomics, which combines biology, psychology and economics and tries to understand why we make the often foolish financial decisions we make.
The central finding, as Mr. Zweig put it, is that ”the brain is not an optimal tool for making financial decisions.” The part of our brain that tells us to act like rational investors tends to be completely overtaken by much more powerful emotional impulses — impulses, Mr. Zweig writes, ”that make us human.”
He’s got a million examples. ”Humans,” he writes, ”have a phenomenal ability to detect and interpret simple patterns. That’s what helped our ancestors survive the hazardous primeval world, enabling them to evade predators, find food and shelter and eventually to plant crops in the right place at the right time of year.” But, he adds, ”when it comes to investing, our incorrigible search for patterns leads us to assume that order exists where it often doesn’t.”
Perhaps he could have said, ”when it comes to TEC, our incorrigible search for patterns leads us to assume that order exists where it often doesn’t.”
In my opinion, it helps you to be rational about investing and a whole lot of things if you remember that you really don’t own things, but are a steward of them for a time, and that in any event you need not worry but can depend upon your father in heaven.
The essence of the challenge (at a deeper level) is that economic events are quite probably distributed according to some sort of a power-law, rather (here’s the important bit) than according to the much more familiar ‘bell’ (Gaussian) curve.
Freakish events are [i]much[/i] more common in power-law distributions than in Gaussian ones. Since the probability of, say, three necessary sub-events coalescing to trigger a major problem is the product of their individual probabilities, the greater probabilities associated with power-law distribution make for a substantially greater risk of the freakish event than most people suppose.
If the Gaussian probability of those sub-events is 0.001 (one in a thousand) then the probability of all three occurring simultaneously to trigger the freakish event is 0.001 x 0.001 x 0.001 = 0.000000001 (one in a billion). However, if within the power-law distribution the (unexpected) actual probability is 0.02 (one in fifty) then the probability of a trigger event is 0.02 x 0.02 x 0.02 = 0.000008 (one in 125,000) — [b][i]eight thousand times more likely than believed.[/i][/b]
The mistaken assumption of Gaussian distribution for economic events is a profound error of approach, and it’s why even institutional investors are surprised repeatedly by nasty, freakish events they believed could never happen.
Don’t trust your money to somebody whose hair isn’t mostly grey. They simply haven’t been beaten up enough by freakish events to be appropriately cautious with your money.