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

Markets can remain irrational longer than you can remain solvent"

• markets can remain irrational - this implies contrary to old school economics that markets are sometimes irrational. Old school economics asserts that markets are always rational because they are stable and self correcting due to the fact the participants are rational. Unfortunely with masses of people there are manias of optimistic greed and pessimistic fear. This is because people observe their peers, both optimists and fear are contagious. Often times this contagion becomes universal. Old school economics fails to account for this human reality.
• longer than you can remain solvent - old school economics assumes that an economic collapse cannot exist were supply and demand relentlessly spiral downwards to zero. That is because when everyone cuts back on consumption in response to uncertainty the paradox of thrift begins. Demand falls which induces further cuts in consumption. This was most recently evidenced in the depression of the 30's and for brief period in late 2008 / early 2009. The modern policy response is to stimulate demand by government stimulus. What is logical for a single person, a cutback in consumption is fatal when implemented by all people. The key factor here is confidence. The economy cannot survive without the rational assurance of confidence which has to be guaranteed by the government as a last resort if the market fails to create it.

The main conclusions are that
You can't time the market.
You should be very careful about using leverage.

That is, even if you are right that the market should go up (or down), the weight of opinion can keep that from happening for an unpredictable length of time. And during that time the market may go opposite to the 'right' direction.

If you use borrowed money to buy or to sell short, your loan may have to be paid back, with interest, while the market still irrationally refuses to move your way.

Therefore, the smart investments are semi-long-term. That is, you should buy a stock you think will go up and be able to hold it until your prediction is fulfilled. Or until you realize you were wrong. But continuing to hold the stock after that is a new investment. You should sell the stock unless you have a new reason to expect it to go up.