Mad, bad and dangerous but possibly rewarding

This Green and Strangely Pleasant Land ventures into the world of investment

It is entirely possible that you have not come to this space to read about investment matters, indeed you may regard discussion of finance as being somewhat less compelling than synchronised nail clipping. However your disinterest will not spare you from experiencing the consequence of what happens in the rarified world of investment.

The recent death of Daniel Kahneman prompts me to write about this subject because he had one of the most compelling insights that helps makes sense of financial markets. These insights are part of  Prospect Theory co-authored by Amos Tversky who predeceased him. The theory is simple but its simplicity only became evident with hindsight.

Kahneman and Tversky had a background in psychology rather than economics, which annoyed finance specialists, not least because they cut through much of the nonsense written by economists and correctly identified how markets are detached from the economic reality they are supposed to reflect.

They did so by challenging the widely accepted idea of market rationality and showed that investors are more influenced by the prospect of potential gains rather than potential losses. This is why markets are prone to repeated cycles of dangerous euphoria fuelled by tales of untold riches exerting a lure infinitely more powerful than awareness of risk and the prospect of loss.

Investors make decisions based on systematic bias, disregarding information that contradicts their bias. Crucially they ignore the simple fact that every boom has been followed by a bust. Instead of paying attention to the consistent pattern of market behaviour they eagerly jump onto the bandwagon of rising prices fearing that they will miss out if they do not do so. These hapless buyers push markets up to dizzying levels well beyond any form of rational valuation.

What inevitably follows are spectacular market crashes which have occurred ever since stock markets became such a pivotal part of developed economies. The global crash of 1929, arguably the best known, led to a devastating depression lasting over a decade, other crashes have followed a remarkably similar trajectory.

What changed in the middle of the twentieth century was that markets became more volatile and crashes more frequent, albeit often localised as was the case in 1990s Japan. And things have become even more complicated in a world where margin trading and shorting have exploded giving  investors a vested interest in prices falling because betting on failure can be very lucrative.

The wild swings of today’s crypto markets point towards another bout of madness which will not end well. That is unless you believe that pouring vast sums of money into various schemes that have zero intrinsic value and are based on thin air is a solid investment.

Were it the case that these periods of financial market excitement only affected the direct participants, a case could be made for saying that anyone not dabbling in the markets is immune from the fallout. However there is not a single example of a market crash that has not had a profound impact on the wider economy.

As a graduate of that well known kindergarten for novice finance journalists, the Investors Chronicle, discovering Prospect Theory was a revelation allowing me to understand that despite claims to the contrary heavily cloaked in complexity, financial markets are not propelled by logicality. 

True believers in the wonder of free markets maintain, correctly, that despite the occasional outbreak of exuberance, markets will always return to logical valuation and therefore should not be undermined by excessive regulation preventing what they see as the ability of the forces of nature to reassert themselves.

The problem with this line of thinking is two-fold. First, it pays far too little attention to the carnage wrought before these ‘magical’ forces of nature reassert themselves. Secondly, it underestimates the continued damage caused by obsession with markets. Companies that should be focusing on improving what they do and how they do it are all too frequently distracted by their share price (a distraction also explained because a company’s share price is often linked to the remuneration of the bosses). Then there is the problem of reconciling the interests of shareholders with those of consumers and employees. The perils of this are very much in the news because of the great scandal of the British water companies preoccupied by giving shareholders generous dividends at the expensive of investment in water supply and non-harmful sewage disposal.

Capital or equity markets are supposed to be a way of raising funds for companies where the risk is shared by investors. They are not supposed to be casino-like exchanges, where risks are multiplied by the nature of trading.