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Stockmarkets: Think rational...

Mar 29, 2005

'How many economists does it take to change a light bulb? Eight. One to change the bulb, and seven to hold everything constant.' Thus goes the joke, mocking one of the most basic principles of economic theory - ceteris paribus, meaning all other things remaining constant. Using the 'ceteris paribus' assumption is important because, with it, we can clearly designate what we believe is the correct relationship between two variables. An economist, for example, might say: "If a price of a good decreases, the quantity demanded or consumed of that good increases, ceteris paribus." This means if the price of Pepsi decreases, people will consume more of it, assuming that nothing else changes. Now arise some interesting questions - Why would economists want to assume that when the price of Pepsi falls, nothing else changes? Don't other things change in the real world? Why assume things that we know are not true? Economists argue that they do not specify ceteris paribus because they want to say something false about the world. They want to (they say) clearly define what they believe to be the real-world relationship between two variables.

This 'contradictory' assumption of ceteris paribus, thus, gives rise to another underlying assumption of 'rationality in economic thinking'. People (economics assume) religiously follow the assumption of ceteris paribus to make rational decisions and hold rational expectations. Believing that things would not change in the future, they decide the course of action for their present based on what had happened in the past.

People often have misconceptions of chance. Investors, for example, may extrapolate from a stock's or a mutual fund's two successful years of beating the market to assume that it is the 'hottest' story around, or the next big thing! What they ignore here is the possibility of regression to the mean. A flagrant example of this flaw in rational thinking has been the dotcom bubble (need we explain it again?). Based on Moore's Law, till the middle of 2000, IT firms and their customers thought that everything in the IT industry would continue to grow exponentially - be it the scope of IT and the number of clients. And this 'doubling' actually started to happen - eyeballs doubled, so did venture capital, so did bandwidth and, of course, so did share prices of IT stocks.

Warren Buffett once remarked, "It is only when the tide goes out that you can see who is swimming naked." And this has been proved time and again by companies that have grown despite tough economic situations surrounding them. When industries grow, benefits accrue to both good and bad companies. But as times get tough, and as the real test of companies' strength begins, grain can easily be differentiated from the chaff. While investors have behaved irrationally (sad, but that is true!) at more times than one, those who have set their faith in fortunes of quality companies have seen their investments multiply, and would continue to do so. And if enough investors form their expectations rationally, the effect may be the same as if everyone does. And nothing can be better than that for investors and markets. But till the time this becomes a reality, rationality will continue to be an issue to contradict.


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