Friday, February 18, 2011

Retrofitting explanations - Don't listen to Finance news channels!

Why are food prices soaring? Why did the markets rise? Why did they tank? We get decisive answers to these question on news channels on daily basis. But almost everyone of them uses explanation retrofitting.

For example, take rising food prices. In such a context, discussing prices only in relation to demand supply seems inadequate. It may still be dominant variable influencing prices but the recent changes to prices cannot be explained by demand supply alone. For one, the change in consumption of emerging economies and change in prices over 5 year period does not tally the thesis. To infer demand supply realities from prices, i.e. doing reverse, is like retrofitting explanation to fit the thesis. Investors and talking heads are guilty of this en masse. The problem with retrofitting explanation is that it checks all the boxes, every cause-effect link seems strong. Except, there is often no link in reality.

Imagine what would happen if we started a school science experiment to produce oxygen only there won't be a test tube to collect the oxygen we have isolated. That would be released into the air. Thereafter, the teacher will ignite a match near the place where oxygen should have been collected and it will burn - a test that confirms oxygen. Now did the match burn from the oxygen we isolated from the experiment or did it burn using oxygen from the ambient air itself? In science this is a flawed experiment. But if a finance channel would definitely report it as success and, in all probability, markets will rise 1-2% because of such discovery!

To be fair to economics scientists, social systems are difficult to model because of this problem. The economists and social scientists know this and thus are always tentative in their evaluations. Famously, they are two-handed, they always propose an alternative explanation starting with "on the other hand...". Market analysts, on the other hand, are forceful in their views and exude confidence where there is none to be found in the foundations itself.

Investors, thus, must be vary of making mental models based on the forceful arguments of the market analysts. Such mental models are often just assumptions because of the flawed fundamentals. And these are the most difficult assumptions to challenge.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle