Guest Post: Rational Decisions In Closed Systems

Submitted by Alexander Gloy of Lighthouse Investment Management

Rational Decisions In Closed Systems

In closed systems, rational decisions lead to irrational outcomes. Take a crowded stadium. A fight or fire breaks out. Panic ensues, and everybody scrambles to get out as fast as possible (rational). In the process, people are hurt or trampled to death (irrational).

The same applies to the stock market. Rational behavior demands you buy stocks when they are presumably cheap (April 2012), and sell when they are apparently expensive (March 2009).

Rational decisions will likely lead to mediocre investment results. Does this imply you have to become irrational?

Yes and no. It is very difficult for the human brain to constantly make irrational decisions. Apart from this, it would also be a hard-to-swallow pill for clients if you told them your investment philosophy was “I am trying to make you money by trying to lose money”. I have never come across a portfolio manager or fund with the stated loss of doing so (apart from some leveraged or commodity ETF’s where it is pretty clear from the beginning they will lose money over time).

You have to train yourself to constantly challenge prevailing opinions (the “consensus”). You can be as far away from consensus as you want, but you eventually have to be right.

I consider my investment views as pretty far away from consensus.  In my view, there are no positive outcomes or solutions to the Euro-zone crisis or over-indebted governments. At times, financial markets tend to ignore those issues (Q2 2011, Q1 2012). At other times, they matter (Q3 2011, now).

Trying to be “outside” of consensus is difficult, as it requires “mental capital”. You have to be able to withstand the daily barrage of tainted news, opinions and stock price movements. Going against the stream does not “feel” good and consumes more energy than simply floating with the tides. No pain, no gain.

It is not easy to maintain your views given the unhelpful mainstream media (concerned about advertising dollars from financial services firms). Politicians and central bankers are nothing but bubbling fountains of propaganda (they somehow make it easier to read the truth between the lines, since they always seem to lie; for example, if the Spanish Prime Minister says “Spain has not asked the IMF for a bailout” you can safely assume that he if just off the phone with Christine Lagarde, begging the IMF for help).

Unfortunately, some bloggers seem to be paid stooges, trying to make the public believe they shouldn’t sell their stocks, shouldn’t buy gold and, sacrilege, should not take their money out of their bank. I have seen instances where a blogger marvels at the “great snow”, pretending to ski on the slopes in Utah, while at the same time managing to post favorable comments on various macro-economic indicators coming out over the course of the day, complete with perfectly formatted and updated charts.

Back to the stock market: even IF everyone was smart enough to buy stocks in the darkest days of a recession it wouldn’t work – every buyer needs a seller. The structure of the market – relatively constant supply of shares and relatively constant amount of money available for stock market investments (= demand) require any changes in investor preferences (cash or shares) to be resolved via the price.

Humans are hard-wired to behave rationally. This makes it so hard for us to escape the “rationality-trap” of the stock market.