Limits of Rationality: Timely Reminders from Daniel Kahneman

When I graduated from college in 1996, the Nasdaq hovered around 1,200.  As I started my career, the index as well as many asset classes and other economic indicators already showed signs of exponential growth that inspired Alan Greenspan’s “irrational exuberance” meme in a 1996 speech.  That prescient remark rocked currency and equity markets, but the shock soon yielded to defiance and counter-arguments, and Greenspan’s warning receded into history as another example of the Fed chairman’s ordinary-course-of-business stewardship of the market.  But, in the years that followed, the growth accelerated to hyperbolic rates; the market and the economy convulsed through a historic cycle of boom and bust.

In hindsight, the meaning of the cycle seems perfectly clear: the big, long-necked “head-and-shoulders” spike on this chart tracks a rapid transformation of tentative economic optimism into manic economic psychosis, followed by a painful descent in search of renewed rationality.  The chart – along with other measures of increasing market volatility — suggests that this quest will not end victoriously anytime soon, if ever.  The gyrations of the past decade or two have humbled many market theorists and strategists who still cannot claim to have identified the precise coordinates of rationality in financial markets.  Every trading day brings fresh evidence that markets (and the human beings behind the charts) refuse to conform neatly to classical economic theories.  We still cannot feel confident in our ability to calculate the present risk-adjusted value of our bright and prosperous future.

Daniel Kahneman’s latest book “Thinking, Fast and Slow” reminds us about many of these humbling lessons.  As in the earlier works that earned him a Nobel Prize in 2002, Kahneman continues to deconstruct the fiction of the perfectly rational Homo Economicus and the perfectly efficient financial markets.  He also reminds us not to seek false comfort in the confident assurances of “experts” who claim to have tamed the beasts of uncertainty.  As expected, some of the book takes us into a familiar terrain well-trodden by major contributors to behavioral economics.  Still, the perspective is refreshing, and it reveals new depths and new implications of this still-unorthodox school of thought.

In a way, Fast and Slow is also a self-help book in that it opens our eyes to the broad potential for breakdowns of rationality in our daily lives.  For people so powerfully conditioned to follow trends and trust experts, the book is an invitation to the pleasures and practical benefits of thoughtful skepticism and fearless self-awareness.

Most importantly, the book’s cautionary message acquires special resonance and urgency as we see clear signs of renewed exuberance in many markets around the world, including the U.S.  Less than three years after the post-crisis lows reached in March 2009, the Nasdaq has more than doubled, and Dow 13,000 became a reality again last week.  Looking at these trends, one might think that the U.S. and other governments have fixed everything that caused the Great Recession.

In reality, the global economy’s many ailments have not even been reliably diagnosed; they certainly haven’t been healed.  We still don’t know the full magnitude of the “toxic asset” challenge.  We still haven’t brought to justice many of the wrongdoers and profiteers.  We still haven’t reformed many of the toxic business practices that sustained market-wrecking illusions.  Public trust in the integrity of the U.S. financial system remains abysmal.  And Americans simply don’t trust Congress.  In fact, higher percentages of Americans hold favorable views of pornography, Nixon during Watergate, BP during the Gulf of Mexico oil spill, and even the idea of America switching to Communism.  The list of problems seems endless.  Why is the Nasdaq soaring to new highs?

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