Reflexivity vs benign equilibrium

Chatting in the soup line…

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Georgina: The market doesn’t just seek a benign equilibrium. There’s what we might call reflexivity involved. Which is…

Roberta: You put too much emphasis on behavioral finance. If you could figure more than one variable at once…

Georgina: I’m not claiming I’m great at simultaneous equations. What I am saying is that economists don’t take into account the power that people have to drive the market. Times are good, people buy stocks. They buy more stocks, companies buy other companies and sell those stocks. Optimism is everywhere. Rationality is thrown overboard, the prices are too high, it’s all unsustainable and a crash comes. Then everyone panics, they sell off wildly, the prices plunge, often way below their real value, but the investors are too scared to come back to the market for a long time. For months. Sometimes for years.

Roberta: That’s what you call reflexivity?

Georgina: People looking inward, not looking out. It’s a factor. Taking account of psychology drove the Quantum Fund up 4000 percent  between 1970 to 1980 when the market went up only 50 percent. And four weeks is all it took for people to panic and halve the value of their pension funds.

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Voice-over

At times like these are not only new crises to cope with but new ideas to explain what went wrong. But it may be small comfort even when you know why it all happened.

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