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In a bid to modernise Vietnam, the French undertook the development of a vast sewer infrastructure to improve hygiene and Sanitation. However, over time, the 14-kilometre tunnel designed for modern flushing toilets in colonial houses became a breeding ground for rodents. To curb this problem, the French Governor-General appointed a team of Vietnamese labourers as rat hunters, who were paid a bounty for each rat killed. The tail of the dead rat had to be shown as evidence. Vietnamese labourers, yielding to their capitalistic pursuits, found ways to earn money out of this. On several occasions, they would just cut the tails and let the rats breed. Some of them have even started raising rats. Their numbers grew unabated.

When the administration came to know about this practice, it scrapped the programme with immediate effect. The solution to the problem in turn created another problem. In economics, this is known as “government/administrative failure.

This conveys a good example of how the world works. It works in a random manner. Actions driving desired results are a probability, not a certainty. In fact, every action has consequences, sometimes unintended, even in the wildest of dreams.

We live in a COMPLEX ADAPTIVE SYSTEM. Even the car, telephone, and elevator that you use are complex systems with several components interacting with each other to make things happen.

This is true in the socio-economic context as well. Consider this: when one buys a smart-phone from a US-based company, which has been manufactured in Vietnam, using metals derived from African soil and using software written by Indian engineers, one basically interacts with this complex system, which has got a number of autonomous firms, individuals, and countries involved.

Such a way of thinking can be of great benefit in the stock markets as well. This is because the stock market in itself is a complex adaptive system. Consider the stock market to be a massive weighing machine based on the heuristics and biases of several investors. More importantly, it constantly adapts to new knowledge in the face of ambiguity. Thus, an analysis of individual investors yields limited insight since market direction emerges at a higher, aggregate level.

The famed Efficient Market Hypothesis, which says that markets adapt to any new information or stimulus instantaneously and that it is almost impossible to beat the overall market, also draws from this idea.

As complex as the system is, forecasting, especially in the short term, is next to impossible as “past performance is not an indicator of future success.” In addition to that, humans tend to make errors in judgements even though they try to make educated judgements. Even the most successful investors are cognisant of this fact. In his book “One Up on Wall Street,” Peter Lynch makes an interesting observation: “There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d be millionaires by now… As far as I know, most of them are still gainfully employed, which ought to tell us something. “

Some people claim they have cracked the market and can time the market cycles. They also present their hypothesis to justify this. The problem with their hypothesis is that it is based on hindsight and may not play out in the future.

All those claiming to have cracked the market and are being called “market gurus” due to their ability to foresee the unforeseen are lying. Nobody can time the markets. The more widely publicised a forecast is, the less reliable it is. The stock market is like a school of fish. Though highly organised and efficient, it has no clear leader or winner. This problem gets particularly magnified in bull markets since everyone believes that they are the best stock-picker that has ever existed. It is only when the tide turns that their grit, patience, and skill can be put to test effectively.

One should be humbled by the power of markets and not consider themselves above it. Globally, passive investing has made more money for investors than active investing has over the past 20 years. This is because fees for passively managed funds can be as low as 0.1% of the assets as compared to more than 1% for the actively traded funds. In fact, active fund managers weren’t even able to beat the S&P 500. Additionally, over 99% of all traders yield returns that are less than the average fixed deposit returns.

This idea is also applicable in the field of business and economics. In this age of fast consumption, most businesses- small and big, actively give huge discounts and perks to drive revenues. But there are times when this strategy might go wrong. Consumers conceive the price to be equal to the value they get. So, when they come across a heavily discounted product, they perceive their satisfaction as equivalent to the price they pay, instead of the actual price, thereby manifesting relatively lesser satisfaction. Thus, businesses should consider all factors before setting their prices. For example- research from Vanderbilt University, published in the Journal of Consumer Research suggests that low prices can backfire the retailers because consumers sometimes equate less price with less quality/ volume. It is due to this very reason that one may never find a ‘Redbull’ being sold at a discount as compared to soft drinks.

So, after reading all this behavioral analysis, how can one avoid the mistakes?

Apply second-order thinking. Most successful risk-takers that the world has seen based their decisions and actions on second-order effects, not known to many. It is only when that becomes evident, that the world follows them and it becomes a precedent. We should not merely perceive information as it is. Rather critically evaluate all our options and choices, before making a decision. We should try to not be ‘fooled by randomness’.

By Krishiv Agrawal


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