In finance there is often a marked difference between theory and practice. Advisor Perspectives carried an excellent commentary from Loomis Sayles on an alternative way to think about financial markets. It points out, very clearly, that what is often lost in theory is the human element.
In an often cynical world, standard financial and macroeconomic quantitative models give people the benefit of the doubt. Fundamental economic theory assumes the best of us, supposing that human beings are perfectly rational, know all the facts of a given situation, understand the risks, and optimize our behavior and portfolios accordingly. Reality, of course, is quite different. While a significant portion of individual and market behavior can be modeled reasonably well, the human emotions that drive cycles of fear and greed are not predictable and can often defy historical precedent.
Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical financial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed. Economic historian Charles Kindleberger can offer some insight. In his book Manias, Panics, and Crashes, Kindleberger explores the anatomy of a typical financial crisis and provides a framework that considers the impact of the powerful human dynamics of fear and greed.
Kindleberger famously dubbed this sequence a “hardy perennial,” probably because the galvanizing human conditions of fear and greed are more often than not prone to overshoot fundamental values compared to the behavior of a rational individual, which exists only in macroeconomic theory.
Loomis Sayles contends that Kindleberger provides the qualitative framework for Hyman Minsky’s pioneering work on boom and bust cycles. Their graphic is remarkable in its simplicity and explanatory power—and in its distance from traditional economic equilibrium models. (You can see the image in the article.)
The cycles that Loomis Sayles discusses are driven by behavior, and often not behavior that would be considered ”rational” in the classic economic sense. Relying on precedent—the last time that happened, this happened—may or may not work. In fact, each time there is a paradigm shift, precedent will fail. Overshoots can be significant, so it’s important that an investing approach be adaptive enough to reflect changes in the environment. Most importantly, investing needs to take human behavior into account. Asset prices are a reflection of that behavior, suggesting that paying attention to prices may be far more useful than paying attention to economic theory.
