“Being rational is a moral imperative. You should never be stupider than you need to be.”
It is relatively easy to describe rationality. Being rational implies clear-headedness and executing sound judgement and discipline.
In the investment world, we seek to complement rational decision making with such skills as fundamental analysis, economics and business valuation techniques. But the world is not always rational.
In recent years, Tesla has traded at greater than twenty times sales. Passive investing has skyrocketed over the past twenty years, meaning every time a passive index fund receives an inflow, that inflow must be fully invested, irrespective of price. Further, how does an investor value an asset with interest rates at zero, implying a risk-free rate of zero? How does an investor begin to apply fundamental valuations to crypto currencies?
Over-valuation and under-valuation have significant elements of subjectivity. Some assets can and do trade at premia and discounts for valid reasons. Others experience such situations only temporarily.
Given recent supply shortages in energy, food and fertilizer, structural changes in price will not necessarily reflect rationality, given the essential nature of such commodities. Supply curves in food and energy are not easily adjusted in an orderly and timely way.
With the economic emergence of China this century, structural disinflationary benefits arose from outsourcing global supply chains, until it was discovered that outsourcing can come at a cost. “Just in time” inventory management is being replaced by “just in case” inventory management. Expansionary globalisation is now in reverse, which will see many economic efficiencies become inefficiencies, which by definition will reverse the disinflationary tailwinds of the twenty-first century.
Economic decisions are being increasingly made against a backdrop of national interest, and not necessarily economic interest.
Markets always change, but human nature does not. Greed is still greed, and fear is still fear, and in such a highly connected world, changes in liquidity conditions in either direction affect asset prices in different ways that are difficult to predict. Especially when leverage is involved.
Investment rationality gets tested in times of elevated asset prices as much as during periods of depressed asset prices. The Federal Reserve cannot foresee where liquidity injections will be directed, being the blunt policy tool that it is. Equally, when such policy measures are withdrawn, it is difficult if not impossible to assess those corners of the markets that are most vulnerable.
So, today we have many thematic moving parts that make sound, rational investment extremely difficult, such as;
The massive role of passive index investing in global debt and equity markets
Trade sanctions on food and energy at a time of rising inflation
Economic policy decisions being made on grounds of national security
Economic stimulus withdrawal at a time of “de-globalisation”
Unprecedented financial leverage
Flat yield curves at the outset of an interest rate tightening cycle
Sovereign defaults in Sri Lanka and potentially Russia inter alia
Most importantly, any combination of the above issues directly impacts liquidity conditions. In times of market downturns, selling begets selling, and investors are often forced to sell good investments, as adverse investments are invariably less liquid.
This implies that the most important element of investment rationality is being able to do what you choose, rather than what you are forced to do. And seeing the world as it is, and not how it should be.
That would seem to be a moral imperative.