Friday, May 1, 2009

Irrational Behavior in the Markets

Prof. Daniel Kahneman received a Nobel Prize in Economics for his work on irrational decision making. I have seen him in interviews tell his often repeated story of the 'map':

"But the story Kahneman recalls when asked about the economic models at the root of the current financial crisis is actually taken from history, not an experiment. It concerns a group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

According to Kahneman, the moral of the story is that some of our economic models, perhaps those of the investment world, are worthless. But individual investors need security - maps of the Pyrenees - even if they are, in effect, worthless."

Ok, fine. but there must be some way to measure the relative worthlessness of a economic model.... If there was you would think that a Nobel prize winner would know how to do so.

You can read a very good interview with Kahneman at: