Mental Mistakes

Chapter 14
Expectations

Want to see a falling market? Go to the flea market on a rainy day, if you can find one that's open. The diehard sellers are there, with others who forgot to check the forecast. But buyers are few. If you are selling, you ask yourself: should I pack up and go home and waste the day, or should I try lowering what I ask in trade? People who brought stuff because they wanted it out of the house, still want it out of the house. So prices get lower. Value is contextual, so in this rainy day context, objective values, as determined by trading, are lower.

All markets have their equivalent of rainy days. An optimistic climate makes for good expectations, and solid prices. A threatening climate makes for bad expectations, and volatile prices. Expectations are important in the market. They are part of trading. That is because they are part of thinking.

The ability to make comparisons gives us the ability to stay alive by checking to see if what we are doing has worked, is working, and is likely to keep working. That is, we can compare the present with past and future. We form an expectation of the future, so we can see a goal and check progress. Checking progress is such a powerful tool of survival that it is learned early and never lost. You would find it difficult to put aside the habit of expectation—and dangerous. How would you drive a car without anticipating what other drivers might do? How would you have a conversation without expectation of how your words will be understood?

The indispensable use of expectation is checking your methods. When you compare the present to the future, you are projecting the result of your method. If it turns out right, your method is working. If it turns out wrong, your method needs adjustment. That is the way you steer your car. It is also the way you steer your life.

Expectation is such a big part of mental activity that even passive minds do it. To a passive mind, the comparison of present to past seems like a voice inside the head narrating life, as children sometimes refer to themselves in the third person. The comparison of present to future seems like a warning. "Somehow I knew that was not going to work! I just knew it!" That is why passive minds suffer so much: they turn expectation into dread.

Subjective minds turn expectation into demand. What is expected is supposed to come about. It is not method that needs adjustment; it is reality that needs adjustment. When what is supposed to happen does not happen, subjectivity produces its own dread, mixed with resentment. "Alas! I expected better of reality."

Voluntary trades are the result of expectation. Each trader expects what he is getting in trade to do him more good than what he is giving in trade. If money is used in the trade, that is because of the expectation that others will accept it, and that its trading value will hold steady long enough to complete the trade.

A trader can put his money where his expectation is. He can trade money now for money in the future. To do that, he finds another trader whose expectation is the opposite. One thinks money will retain its value; the other thinks it will not. Both expect to benefit from the trade. Only one will turn out to be right in the future, but both benefit now, or else they would not voluntarily trade.

A trader can trade expectations by buying a painting which he expects will appreciate in value. If that is a safe bet, the trade is called an investment. If it is a risky bet, the trade is called a speculation. To trade expectations, he can buy anything he expects to appreciate, or sell anything he expects to decline. The market says he can go long, or he can go short.

Most traders hate risk. They are willing to pay to be rid of it. Speculators love risk, because they are paid to take it. Risky loans pay more interest. Risky investments give bigger returns—or no returns. Speculators take the risk, and hope bigger gains will outbalance bigger losses. Without speculators, the market would be a riskier place. Since they make risky trades at higher prices, you can be warned by those higher prices, and avoid risk. You can stick to investment. You can buy a business.

If an entire business is beyond your means, you can still trade expectation by going into the stock market and buying a piece of a business. You might wonder why a businessman would want to sell his business in little pieces.

Imagine that you want to run a business, but you don't have the money to start a business. You can sell your idea to one buyer, but then you won't be in charge. Or you could sell shares in your idea to lots of buyers. That would give you the money to start the business. True, you would not own the business, but you could still run the business. Your business would be publicly owned, but run by you. Your entire stock of shares, or any part of them, could be traded in a stock market.

Since trading is voluntary, the price of your stock will give you vital information about what traders think of how you are doing. The expectations of traders will act as a check on your own expectations. Do traders demand a cut of your profits, or will they buy the stock without that? Do they disagree wildly on what your stock is worth, or keep the price steady over time? When you announce a new product, does your stock shoot up, or does it fall?

If you are making money and have high expectations, then you might want to buy your own stock. If traders agree, you will have to pay a price. If traders do not agree, then your stock is a bargain to you. Either way, you can end up owning your own business, if you want. The fact that traders disagree does not make trading harder; it makes trading easier. It is not agreement that makes trading possible, but disagreement.

Two kinds of expectations are being traded: expectations for your business, and expectations for your stock. If traders think that your business will stay even, but your stock will be in demand, they bid the price up. If they think that your business will stay even, but your stock will not be in demand, then they will want you to pay a dividend, which is a share of your profits. If instead of paying a dividend, you use the money to expand your business, then your stock price will tell you if traders endorse that, or object to that.

Can the market get it wrong? Everybody talks about booms and busts and market hysteria. Markets do fall sometimes. How do you know that this is not one of those times?

When stock prices go up, calling that a "boom", or a "bubble", adds no new information. It adds an evaluation. It is a way of saying that prices are high enough, or that prices are too high. Calling a fall a "crash", is saying that the trend of prices scares you. It is based on the subjective idea that the results of voluntary trading are not a given, but something to be measured against the standard of the wish list.

Prices are not the result of computer programs, or the result of government fiat, or the result of academic theories. They are a range within which voluntary trades take place. Declaring that prices are too high is like declaring that a tree is too green or a rose too red. It is stating a preference.

Subjectivists tend to reify the market—to think of it not as organized activity but as an organism with likes and dislikes. "The market hates uncertainty," they say. "The market loves stability." Fine as a figure of speech, but when this figurative organism is accused of failure, of irrationality, of avarice, and of disobedience, what could that mean? The only thing it can mean is personal dislike for what traders are doing.

When traders have such high expectations that they bid stock prices up to "impossible" heights, subjectivists claim that "the market is irrational," and "the crash is inevitable." If they have power, they raise interest rates, or lower the creation of play money. They change the conditions, which changes the expectations of traders, which makes prices go down. Then they say, "See? The market got greedy, and the crash was inevitable." What really happened was that traders traded expectations of what the previous conditions would cause, and of what the present conditions will cause. If there was a "buying panic", and then a "selling panic", that was because traders know that you must be nimble to keep ahead of the vagaries of should committees.

Does this mean that the market has a "collective wisdom", which traders try to divine? No, it means that prices are not subjective desires, but objective results of voluntary actions. Prices do not give orders. They do not tell you what you must decide, but what others are deciding. If you know something before other traders do, you may buy what they are selling. This will make the price fall less than they expected. They will be alerted that they have missed something. By making money, you informed others. Since all traders try to make money, all traders get informed.

When prices fail to meet your expectations, that does not tell you what you got wrong, but that you got something wrong. You can passively shrug, or you can subjectively demand that prices be set right, or you can actively look for the gap in your knowledge. That is, you can trust to luck, try to destroy the market, or try to get smarter.

Trying to get smarter is the only thing that works, so regular traders in any market tend to get smarter. The market tends to be efficient. Prices reflect real expectations based on facts. They tell the truth. If prices for internet stocks shoot to the sky, it shows that traders have seen facts that raise expectations sky high. If, before these expectations can be realized, internet stocks fall, it shows not that a bubble burst, but that prospects changed. The first trader to notice made the most money. The last trader to notice lost the most money. Market discipline keeps traders alert.

After the crash, Subjectiman declares that anybody should have known that the market was too high, and government must ban irresponsible speculation. He wants to kill the messenger. He could also claim that the tide is too high and the rain is too wet, but that would sound silly. High expectations can be frustrated by government action, or a change in conditions; but criticizing them as "irrational exuberance", or "an explosion of greed", makes as much sense as ordering the volcano to spare your village.

A moment of introspection will confirm this. When was the last time you told yourself to stop expecting so much? High expectations of a meeting or a movie will only lead to disappointment, so you tell yourself to stop feeling them. Did this make you stop feeling the expectations, or did it simply express the fear that the expectations would not be realized?

Expectations are not a sure thing. But Subjectivists think they should be. They say, "boom", "crash", and "panic" to deny that prices result from voluntary trading. Passive traders make excuses for their inattention by saying, "I got caught up in the frenzy! Stock market trading is nothing but gambling!"

To gamble is to trade expectations of your luck. A bet is a speculation based on a guess. Anyone is free to try that in any market. If results disappoint, one is free to try a better method.

Free markets produce prosperity by making possible the division of labor that so multiplies efficiency. They produce prosperity by turning violent disagreements into cooperative trading. They produce prosperity by discovering prices, so that economic calculation is possible. They produce prosperity by allowing active thinkers to trade more profitably than sluggish or subjective thinkers, which encourages objective thinking. Subjective thinkers are enraged when others trade more profitably, so they hate the market—even when they realize that it is making them more prosperous by far than they could be without it. Since they hate it, but want to keep it, they try endlessly to tinker with it, so that it comes closer to what they think it should be.

To see how disastrous are the results of their tinkering, look around the world. "The sense of crisis is now receding," says an Economist survey (1/30/99). "...Yet it is widely agreed that this was a narrow escape, and that 'something must be done'...." Turmoil in Brazil, Russia, and all Asia is mentioned. The fact that crises recur regularly is acknowledged. Many examples of harmful tinkering are given. The conclusion of the survey is that tinkering should be improved.

Another possibility is to stop tinkering.

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