Question

What did Keynes mean when he said “Markets can stay irrational longer than you can stay solvent”? Explain how that process led to failures or near failures of such companies as Lehman Bros., Merrill Lynch, Wachovia, Bear Stearns and others.

Answer 1

When Keynes stated that market can stay irrational longer than you can stay solvent then he meant that even if the fundamentals and sentiments of the investors are triggering that market should go different ways but it is not showing that movement because markets are always irrational in nature and they are always trying to factor in different adverse moves against the will of the market participants, so contrary to the the economic policies where markets are deemed to be rational, the markets are irrational sometimes and investors should be adjusting his risk accordingly.

It can be exampled through the current coronavirus crisis in which people are expecting an impending recession and there is global growth slowdown but NASDAQ has hit 52 highs.

This process lead to failure of companies like Lehman brothers because they where compounding upon their gains even if the market was in a bad shape due to housing crisis and the market was always trying to continuously factor into their optimism and they were irrational even if it was visible in the current economy that a crisis was unfolding and they were not trying to discount those, so when the market ultimately crashed, the investors lost their money because they were invested onto those shares believing that the market will recover but markets are always irrational in nature and these shares ultimately crashed to such extent that recovery was not possible so markets were always irrational even the crisis were unfolding then, these companies shares did not drop and when the crisis were over, the share of these companies were brutally corrected.

So, an investor should not always try to predict and time the market because the markets are always irrational in nature and they can have unpredictable movements and if you are having a position in the adverse side, it is bound to make you insolvent, if risk is not managed properly.