Tuesday, October 18, 2016

Learning from experience and the "should" versus "will" of behavior

What experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it.
- Georg Hegel  1832 

This is a quote heard before; however, many have not given it specific operational meaning. This is especially true for financial analysts. What is learned in history can be varied, but what is critical is accepting that what people and governments will do is often mistaken. Current motivations for action will differ from should be done if there is a close reading of history. There is a strong distinction between what people and government "should" do if they internalize history and "will" do.

If people and government learn from history, they should behave in a way to minimize errors. They will learn from mistakes so that past failures do not occur again. Learned behavior suggests that mistakes will be made, so caution with action is appropriate.

Now some history can be learned through quantitative methods if there is enough sampling. The problem is that many events that have a strong market impact do not often happen. Crashes are rare. Large policy changes and possible mistakes do not often occur. The link between a policy choice and the market impact may not be immediate.

In reality, many often do not act in a way that would suggest that they have learned lessons from experiences. Overleverage still hurts. Euphoria is eventually offset with large corrections. Policies that have not worked in the past are tried again because they are easy to implement. This is tied together with trying to determine how behavior will change when faced with new circumstances. Learning often does not happen.

Why focus on the distinction between "should" versus "will"? Too often analysts will talk about what, for example, the Fed "should" do. The "should" is based on their learning from experience, but this is irrelevant. The focus has to be on what "will" the Fed do based on current knowledge and behavior. Mistakes will be repeated. We may know that governments should not engage in austerity and should finance debt at low rates to boost the economy, but this is very different from what they will do. Actual behavior is often not rooted in experience and history. 

The lessons from history or experiences are not singular. History can be interpreted in many ways. Clearly, there are still arguments about the causes and effects with many historical events. The causes of the Financial Crisis are still being debated, but understanding differences in learned behavior will make money for investors. History is not learned and analysts should behave accordingly.

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