Reasonable Reasoning

dreamstime_xl_85454226Reasoning is the process of thinking about a subject matter through rational, level-headed reflection.  Many people draw inferences from complex situations following thoughtful deliberations. Others couldn’t be bothered and simply accept what life throws out. Here are examples of drawing reasonable inferences. Every chicken we have encountered crosses the road; therefore, all chickens cross the road! But you can see where this might lead. All cars in this country drive on the left, therefore, cars drive on the left in all countries. It is no exaggeration to suggest that fact is stranger than fiction. As Nassim Nicholas Taleb famously remarked; if every swan you’ve ever seen is white then there is no reason to doubt that all swans are white – until you see a black one!

Some people make a habit of being contrarian – working out the logical, sensible conclusion and then taking the opposite viewpoint. We’ve all met someone who takes the opposing view every time; someone who simply excels at arguing and contradicting. But a true contrarian is one who gauges what others will consider rational and determines that it’s beneficial to follow a different direction. Many of the great thinkers in history have been contrarians and it is reasonable to conclude (Ha! – Ed) that many current contrarians are similarly great thinkers.

One of the greatest insights from reasoned, rational thinking was Darwin’s observations on the origin of species. However, at the time (and perhaps since) he was accused of a strange inversion of reasoning. Critics could not intuitively conclude how nature could be so beautifully perfect without the absolute requirement for intelligent intervention. Therefore, Darwin’s ideas, in critics’ eyes, were counterintuitive and contrarian. Darwin demonstrated, admittedly not to everybody’s satisfaction, that the process of evolution did not understand what it was doing – it just plodded along regardless. Much the same way that a piece of mathematical software doesn’t understand arithmetic logarithms – it simply does the calculation and provides the correct answer. And otters build dams without understanding what dams are! And chickens cross the road!

Naturally, movements in financial markets are not immune to reasoning – being, after all, simply expressions of the decisions of multitudes of individuals and weird computing machines designed by other-worldly humans. One would hope that much rational thought goes into every investment decision and, consequently, the price movements are the results of these balanced and cogent decisions. But we intuitively know that this is not the case! Markets are irrational and are influenced by a host of factors; the most important being that many of the decision-makers don’t understand what’s going on. Many spot that markets are currently rising and deduce, therefore, that markets will always rise.

As we demonstrated in our piece in February on Mean Reversion, financial markets do not rise in a straight line – stuff usually happens. It is therefore wrong to conclude that an upward trend will be observed forever. It seems that many investors are ignoring this and are currently taking contrarian viewpoints. Black swan anybody?