Basic Capital Flow Analysis: The Irrationality Axiom

Basic Capital Flow Analysis: The Irrationality Axiom Basic Capital Flow Analysis: The Irrationality Axiom

The Irrationality Axiom

Security prices are sometimes too expensive or too cheap. When investors continue to buy into an over-priced market, they act irrationally.

Similarly, when issuers buy back their own stocks when costs of capital are extremely low, their actions defy economic good sense.

Some economists pretend to believe that market players behave in predictable ways based on economic self-interest.

We cannot assume that market players behave in predictable ways based on economic self-interest.

In Capital Flow Analysis, we must ignore this assumption — seeking instead the real explanation for behavior.

Some economists postulate that market players — in the long run — behave rationally and that self-interest acts like an Invisible Hand that guides players along a predictable path like clockwork automata.

In analyzing flow of funds accounts, we must reject this idea, favoring instead those sociologists who reach conclusions from observation and measurement of behavior of actual people.

In this respect, Capital Flow Analysis is similar to business market research.

Renouncing Economic Orthodoxy

The second rule of Capital Flow Analysis is The Irrationality Axiom.

In order to make sense of flow of funds accounts, we must cast off unscientific fetters of orthodox economics and renounce that figment of the theoretical economist’s imagination, Rational Man.

Market players sometimes act unwisely for generations.

In Capital Flow Analysis, we embrace the commonsense notion that market players do not always act wisely or in their own interests — often for long periods — even generations.

Having repudiated the idea of Rational Man, we no longer can sit in our offices and presume to know human behavior from the theoretical assumptions of economic texts.

Instead, we must venture into the world and notice how people actually behave.

The Irrationality Axiom

The second rule of Capital Flow Analysis is as follows:

brace: Irrationality axiom


Market Players are Often Irrational

Market players have reasons for buying and selling investment assets, but these reasons are not always ‘economically rational’ and change from time to time.

People have many motives for trading in the capital markets that are not related to maximization of financial wealth, the choice between consumption and spending, or logical expectations of future returns.

brace: Irrationality axiom

Reasons for Irrational Behavior

People have reasons for behavior other than enlightened self-interest. These reasons make sense if we accept players as they are, not as they would be if they were prudent.

Here are a few common explanations of divergence from rational behavior:

Imperfect Knowledge:

Most market participants do not have the time, inclination, or capacity to exercise due diligence on all available information before making trading decisions.

Trusting the judgment of others, following the crowd, and making snap decisions based on scanty information are common habits of investors.

Conflicting Interests:

Owners of financial assets often do not manage their own affairs. Fiduciaries often behave in ways that are not consistent with the interests of their clients or employers.

Stockbrokers and investment bankers have built-in conflicts of interest. Some brokers act professionally to the benefit of their clients, while others do not.

The honest broker does not always earn the highest commissions.

Emotion and Weakness:

Fear, greed, superstition, laziness, undue haste, panic, carelessness, negligence, and stupidity are often important in financial decisions.

Deliberations of boards of directors more often follow the behavioral pattern described by Cyril Northcote Parkinson, the historian, than Adam Smith, the economist.

Manipulative Aims:

Some important market participants enter the arena primarily to manipulate the price of financial assets.

The Federal Reserve Open Market Committee exists to manipulate the price of U.S. Treasury securities.

American corporations have purposely driven up the price of their own equities by repurchasing stock.

The SEC grants safe harbor for issuers to manipulate prices.

Investment bankers regularly manipulate the price of securities during public offerings.

The Securities and Exchange Commission grants safe harbor so that players may ramp prices in certain instances.

After the destruction of the World Trade Center on September 11, 2020, the SEC relaxed rules on corporate buybacks, hoping that companies would enter the market and support security prices.

Since reduction in capital could only make companies weaker and less able to withstand a recession, while not improving the prospects of long-term investors, the action of the SEC stemmed from political rather than economic motives.

False Information:

Many powerful market participants are engaged in disseminating biased, false, or misleading information.

An ordinary person without special training has difficulty in reaching correct conclusions, even if inclined to make the analytical effort.

Ministers of Finance routinely issue misleading statements about the state of the economy.

Ministers of Finance and Secretaries of the Treasury throughout the world regularly issue misleading statements about the state of the economy.

The announcements of the International Monetary Fund regarding the economic health of countries are tempered by the need to avoid harsh truths that may frighten investors.

The Fund’s appraisal of the Indonesian economy in the years leading up to the collapse of 1997 encouraged many institutional investors to include Indonesian securities in their portfolios.

The IMF had connections to the government in Jakarta and should have known that things were not as rosy as reported.

After the economy had collapsed, the IMF painted a black picture to force the government to follow their dictates.

Once the government fell in line, the IMF pronouncements again turned optimistic.

Custom and Long-Held Belief:

American mutual fund investors have come to believe that investments in common stock growth funds will always be in their long-term interests.

They also believe that they should continue to invest, whether market prices are high or low.

In the 1990s, even when price-earnings ratios reached historic peaks and cash dividends become almost irrelevant, they continued to invest.

Rational Explanations For Irrationality

To say that market participants behave irrationally is not the same as saying that there is no rational explanation for market movements.

The Irrationality Axiom says that we should not assume that rational economic behavior controls markets.

It is best to approach the market without a notion of why people act, relying instead on unbiased observation.


Before proceeding, check your progress:


The Irrationality Axiom states that:
Choice 1Market players are always irrational.
Choice 2Players are not always economically rational.
Choice 3Investors are always 'rational men'.
Choice 4Issuers are never rational.
Reasons for the irrational behavior of investors include:
Choice 1 Imperfect knowledge.
Choice 3 Custom and long-held belief.
Choice 2 Emotion and weakness.
Choice 4 Cost benefit analysis.
Legalized manipulation of security prices include:
Choice 1 Operations of the Open Market Committee.
Choice 2 Stock buybacks.
Choice 3 Pump and dump schemes.
Choice 4 Price stablization for new issuers.

Basic Capital Flow Analysis: The Irrationality Axiom  learning module : continued>

Lesson: 1 | 2| 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10

Suggested Reading

"Secrets of the Temple: How the Federal Reserve Runs the Country", Paperback, William Greider

The economists at the Federal Reserve are master manipulators of securities markets and are not outside the system.

"Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron", Hardcover, Bethany McLean, Peter Elkind

These clients of McKinsey & Company were a band of MBAs and PhDs that acted with profound irrationality and fooled the market while they did so.

"Pathologies of Rational Choice Theories: A Critique of Applications in Political Science", Paperback, Donald Green, Ian Shapiro

When sociologists attempt to copy economists and postulate "rational man", they get into trouble.

"The Winner's Curse", Paperback, Richard H. Thaler

An economist challenges the economic dogma of "Rational Man", using the economists' own weapons.

A Treasury of Wall Street Wisdom", Hardcover, Harry D. Schultz, Samson Coslow, Teresa Alligood

A useful compendium of the writings of famous Wall Street players over the last century.

"Struggling With the Demon: Perspectives on Individual and Organizational Irrationality", Hardcover,
Manfred F. R. de Vries

Psychology of the entrepreneur and irrational behavior.

"Technology as Magic: The Triumph of the Irrational", Hardcover, Richard Stivers

A sociologists warns against our current veneration of technology.

External Links

Cyril Northcote Parkinson : "Brainy Quotes" from books by this famous British humorist and observer of bureaucratic behavior. [Return]

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