Common Sense for the Market

I’ve been working in financial markets for a couple of years now, and for me it is quite intriguing why so many brilliant people fail so hard in investing, or generally in understanding economic events. Charlie Munger, the right-arm of Warren Buffet, defends that there are lots of facts that contribute for this phenomena. Among them is the academic interpretation of the economic variables.

The academics use lots of statistical-based information to estimate the impact of variables and understand how these variables have an influence on each other. This seems pretty logic, right? Well it is not! This fails so hard simply because most of the time the models specification is wrong. We always use many variables to explain one main variable, however we forget lots of interactions between variables, and more than that, we forget that the economy, like biology, is not contained in a rigid model. The organisms tend to adapt, many times breaking their past and expected behavior so does the human being, and since the economy is constituted by humans, most likely it will be an ever evolving organism.

I believe that the first economists, like Adam Smith, saw things like this, and most of all I believe in simple solid logic, not in complex almost incomprehensible economic models. As more complex is a model, more probably it will fail. Therefore models like CAPM (Capital Asset Pricing Model) are Frankensteins waiting to fall.

The same applies to politics, thinking that just because some model tells you that for each € you save you will get less 0.5 € of growth, you should follow that policy because you are saving more than you are losing, might lead to results like the Portuguese, where for each 1 € the government saves, the Portuguese people lose 1.6 €. This is the road for catastrophe, but the most surprising fact is that it wasn’t a monkey that chose this way, it was chosen by brilliant academics.

In the end of the day remember: if your investment decisions needs lots of sophisticated calculus, it will probably fail!

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