How is it possible to understand the market? I have been thinking about this question this week.

What are human beings able to understand? The most obvious and natural thing is other people. We have evolved in social groups and one of our most developed mental skills is the ability to navigate within them. We are able to use subtle cues to infer the thoughts and emotions of members of a group and to create a map of how they fit together.

We are also able to understand theory. We can take a set of principles and apply them to a particular case. If it is combined with a good method of building a theory — science — we can gain a robust understanding of natural phenomena by this method.

Understanding through theory is much harder than understanding people in our social groups. One needs to spend many years training to be a scientist, or priest, or astrologer, for example. One must spend many years immersed in a theoretical framework to apply it accurately and consistently. Consequently, people who have not spent this time and effort often attempt to understand in a personal way things that are best understood in a theoretical way. Here are some examples:

  • Dogs. Expert dog handlers have learnt to act in ways that will, generally, get dogs to do what they want. The fundamental elements of this knowledge can be transmitted theoretically relatively easily to intelligent participants in dog training classes or in books. But many new pet owners fail to seek out the theory, treat their dogs as people and reap a harvest of bad behaviour.
  • Nature. Primitive cultures tend to personalise natural events and objects — volcanic eruptions, winds, trees, even rocks. Children fear not the dark, but malicious creatures that they imagine to be hidden by it. Christians cannot help believing in a personal explanation for the origin of the universe.
  • Economics. The recent trend towards fiscal austerity has a moral element. Bankrupts recover from economic and social ruin by wearing a hair shirt and living within their means. People think, wrongly, that this must also be true of firms and of countries (more from Paul Krugman).
There are many more examples.
We understand members of our own culture much better than members of other cultures, so there must be an element of learning involved in personal understanding. This learning is best undertaken in childhood, but clearly it is possible to gain a personal understanding of certain subjects. One may come, after long exposure, to understand dogs or foreign cultures almost as well as one understands one’s own family. But that does not necessarily happen: dog owners can spend a lifetime treating their pets like people, and expats can become cynical about their foreign hosts.
I have seen the tendency towards cynicism in people who try to understand the markets. “This is bad news so obviously the freakin’ [sic] market will go up” is not an unusual comment on blog posts. These people are like the expat who spends all his time drinking in the Colonial Club — they have tried to understand the market using their preconceptions about how a person should behave, found that it sometimes does, and sometimes does not, and concluded that it is at best capricious and at worst out to get them. A small number of people, however, manage to develop a sufficiently good personal understanding of the market to trade it successfully — pit traders being the classic example. These people are like the expat who builds a circle of local friends by getting to know their mores. He may always be a foreigner, but he will be good enough at predicting his hosts’ behaviour to live among them successfully.