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The Death of Homo Economicus


Mass psychology necessary to understanding the market.

Beauty in the Details

The only way to teach economics in a semester or 2 is to simplify it beyond recognition. But the beauty of life is often in the details. Bennet Sedacca used to say that understanding markets didn't require an MBA, but degrees in history, psychology, sociology and macroeconomics.

The concept of a rational human who makes economic decisions with a full set of data and pursues enlightened self-interest is personified by Homo economicus. It's just such a mythical economic figure that allows us to simplify our models of the economic world.

As a model, it's enticing because it contains a hint of emotion (self-interest). And yet it completely fails to describe reality, because that emotion is masked by a false stability. Homo economicus has no way to adjust its emotions - to modulate from greed to fear and back again. But those mood swings are precisely what moves markets comprised of real humans (rather than economic models of humans) - just think of truisms like, "Buy from the fearful and sell to the greedy," or "The crowd is always wrong at extremes."

Changes in Behavior

Simple: When you were young and learning how to use a hammer, you swung with abandon at that nail until you hit your finger for the first time. Suddenly, your method of hammering changed forever.

Not so simple: When you were young, you may have been afraid of roller coasters. But then you tried them, and surprisingly, it was fun. But then roller coasters started to make you feel queasy as you got older, and your bones rattled, and your neck hurt afterwards. By now, you've probably made up your mind whether you like them or not, and changed your behavior accordingly.

Complex: Flipping that string of condos sure was sweet. Making money without doing any real work sure is fun, and thank goodness the loss you took on the last one only wiped out all of your previous profits and didn't really put you under. Now, how will you decide to take risk in the future? Are you chomping at the bit, what with all these new "cheap" prices, or have you changed forever?

Changes in behavior typically occur after consequences are revealed and absorbed. The amount of change in behavior and the permanence of the change is a function of the amount of pain felt and the length of the pain endured during the learning process.

Trying to get us to go back to our previous behavior is nearly impossible if the consequences suffered are severe enough.
No positions in stocks mentioned.
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