Saturday, January 21, 2006

Rational & Efficient Markets - Tain't No Such Thing

You may have learned about rational markets & efficient markets in college.

You poor thing.

They probably taught you all sorts of fancy economic models to describe markets and market participants. If you took graduate economics courses you learned how to destroy existing models and build others.

They told you markets are efficient because investors will rationally weigh the knowledge available and that knowledge will be reflected in investment prices. Basically they said a price in an open and free market is
always the right price.

In reality an open market price is an agreement between two people that both think or feel they got the better of the other. If they did not perceive an advantage for themselves they would not trade. That perception does not have to be rational.

Markets are made of people. There were once bull markets for elmo, cabbage patch dolls, beanie babies, and pogs. We are just off new highs in a bull poker market.

In that great
financial training film Men In Black two of the characters have some Dialog that goes something like this:

Will Smith as MIB: "Why don't we tell the people? People are smart, they can handle it."

Tommy Lee Jones as MIB II: "You know better than that. Individually people can be smart, as a group they are irrational, screaming, idiots."

( Governments actually do follow this thought process regarding citizens. As a group bureaucrats, voters, movie stars, elected officials, media - they are also irrational, screaming, idiots)

We are people, you and I, and we know that individually we can be irrational and / or make serious errors in judgment. Markets are made of people like us. Together as "the market" we can be irrational, screaming idiots.

Markets are moved by group or mass psychology.

Is your house really worth twice what it cost three years ago? Are increased uses for silver and a decreasing supply of silver a rational reason for years of prices drifting lower?

Keynes, the father of modern silly economics did get this one right. He said something to the effect:
"The markets can stay irrational longer than you can stay solvent."

This means rational investments recommended by wise and studious analysts can go very wrong for a very long time. They will have a great excuse, and eventually they may make some money. In the meantime you could go broke.

You can be right on your speculation - but wrong on your timing - and still lose money.

The key to speculation is to
cut loses short, and let profits run.

Here is another Speculation Rule:

Never, ever - even consider adding money to a losing position - never, ever!

If it is losing, you were wrong. If not in fact - than in timing. Get out of the speculation and look for an entry point where you have a chance to be right.

Markets are irrational, there is no reason for us to be irrational also.



Blogger xianfu said...

hmmm..still a young kid about market stuffs.... :p

7:55 PM  
Anonymous Anonymous said...

Thanks for dropping by anyway.

When you decide to learn, come back and visit.

8:42 PM  

Post a Comment

<< Home