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Naive Science and the Nature of Financial Markets

Posted By Kent Thune On February 2, 2011 @ 11:02 am In Philosophy,Psychology | Comments Disabled

The post was originally published at The Financial Philosopher [1].

It’s quite true what philosophy says, that life must be understood backwards.  But one then forgets the other principle, that it must be lived forwards.  A principle which, the more one thinks it through, precisely leads to the conclusion that life in time can never be properly understood, just because no moment can acquire the complete stillness needed to orient oneself backward. ~ Soren Kierkegaard

Man is a perpetual naive scientist: Formal scientific methodologies generally involve Describing, Explaining, Predicting and Controlling, which are all extensions of everyday human behavior.  The naivety in this regard, as associated with financial markets, is financial market participants believe that by describing and explaining the past with empirical evidence, they will be given the capacity to predict and control the future.

Additionally, this empirical evidence is often compiled haplessly and contained within a certain bias to a desired result.  Although completely within in the bounds of human nature, this naivety is surely among the greatest of man’s arrogance and foolish behavior.  This is not to say that science is required for financial success but rather a suggestion that a good scientist is almost always preferable to a bad one.

Describing and explaining is integral to understanding or, at a minimum, a means of satisfying simple curiosity; and predicting is often perilous but can be done prudently; however the controlling aspect is almost always tragic.  Because man is so engulfed with the desire for knowledge (of things past and of things future) there is no ability to see himself as he is now.

Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof. ~ John Kenneth Galbraith

Last week’s 662-page Financial Crisis Inquiry Report [2], for example, is almost useless; however it is one of the only predictable aspects of the entire financial crisis: Humans, to satisfy their desire for control and for narcissistic display of knowledge, will perpetually look to the past and wonder how things could have gone so wrong, then will proceed to rationalizing the event into a means of controlling (preventing) a similar event in the future.

Studying the past, for the purpose of preventing the tragedies from reoccurring again in the future, may be responsible and even noble but it is inevitable that other similar tragedies will occur. Just as sure as one can be that there will be more hurricanes, famines and wars in the world, there will be another market meltdown in the not-too-distant future.  How might we prevent it? We cannot and we must not; because the nature of financial markets is a part of nature itself–human nature–and there is no prevention:  There is only observation, postulation and acceptance.

Reason or Rhyme?

As Mark Twain said, “History does not repeat itself, but it does rhyme.” I suppose one may argue that studying a problem of history, and understanding it, is a prudent means of preventing the event from occurring again; however the moment the study of a problem begins, the same problem is manifesting itself into a different form, destined to reoccur. Because we naively search for the reasons, and even if we find them, we miss the rhymes.  In fact, we have quite the paradox: It is a mistake to say that a natural occurrence is a mistake. Nothing attributed to nature is a mistake; it may be random; but randomness and chaos are natural parts of order and therefore should be accepted and even embraced. Fires replenish the forest; death is necessary for the continuance of life; and great recessions are necessary for great progressions.

‘I have done that’, says my memory. ‘I cannot have done that’, says my pride, and remains inexorable. Eventually–memory yields. ~ Friedrich Nietzsche

The foolishness of man is a part of the nature of man; therefore foolishness is a necessary function of the overall social organism that is our financial markets.  We can describe and explain what has already occurred; but thinking we can predict and control nature in the future is no different than thinking there is only one word that rhymes with blue.  The Financial Crisis Inquiry Report, and the thousands of books, periodical articles and Internet postings describing and explaining the causes of the recent financial meltdown, go a long way to satisfy our curiosity and desire for knowledge; however they will not provide a meaningful degree of prediction and control capacity, in my humble opinion, to make the intentions truly worthy.

Your humble author, however, will not suggest that the attempt of describing, explaining, predicting and controlling is wrong, no matter how foolish it may appear. Alas, it is natural. Let men be fools because that is part of their (our) nature.

Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes. ~ Jesse Livermore

I will end by stating that the observations in this post point to a conclusion that is one part humorous, one part frustration and two parts cynicism: All of the complaining we do about the “idiots in Washington” or “the fools at the Fed” or the “folly of herd behavior” is simply a complaint about the human race itself.  Complaining about human nature yesterday and today, and expecting a different outcome tomorrow, is no more wise than banging one’s figurative head against the metaphorical wall of human nature.  It is a naive view of man to expect man not to be naive.

Shrugs and Dogs

As difficult as it may be, let the federal government and mass media do what they do, which is to spend a ridiculous amount of time and energy attempting to justify their respective existence by providing information for the consumption of the knowledge-hungry masses.  If one wishes to be wise, however, one will acknowledge one’s own ignorance, observe the herd from a distance, and perhaps shrug in amusement.

In summary, the cause of the financial crisis was not Wall Street, Congress, the Community Reinvestment Act, George W. Bush, Fannie Mae, Freddie Mac, or Alan Greenspan.  It was all of them and all of us collectively. It was the social organism that is the financial markets; it was human nature.  Good judgment and wise men do exist; but all humans will continue to make self-serving and foolish choices; it has been this way since the beginning of time; and human nature will never change.

I think I’ll stop writing now and go spend the afternoon with my dog.

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Kent Thune, blog author of The Financial Philosopher [3],  is Certified Financial Planner and free-lance writer.


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2011/02/naive-science-and-the-nature-of-financial-markets/

URLs in this post:

[1] The Financial Philosopher: http://www.thefinancialphilosopher.com/2011/02/understanding-markets-nature-not-naivety-or-narcissism.html

[2] Financial Crisis Inquiry Report: http://www.ritholtz.com/blog/2011/01/the-financial-crisis-inquiry-report/

[3] The Financial Philosopher: http://www.thefinancialphilosopher.com/

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