Decisions led by emotions can cost one dearly. That is what happened to many investors when, owing to overwhelmingly positive sentiments, they invested in the Pakistan Stock Exchange (PSX).

Those who entered a little late must be regretting their decision. And those who borrowed money in order to expand their businesses must be experiencing pangs of regret as interest rates inch up yet again.

In their last book titled A Crisis of Beliefs, Andrei Shleifer and Nicola Gennaioli help us understand the reasons for such disappointments and the resultant bank runs or stock market sell-offs. Their theory of expectation — called diagnostic expectation — relates to what has been happening in our country over the last two months.

They state that in times when good economic news runs rife, investors and analysts mistakenly fall victim to the over-representativeness of only one brighter aspect of the news while ignoring tail-risks.

When the tail-risks surface, as the euphoria dies down, the negative side becomes over-represented, resulting in market sell-offs and, in extreme cases like the financial crisis of 2008, bank runs.

Keeping this theory in context, consider the following: Prime Minister Imran Khan goes to Saudi Arabia and returns home with big news — a $6 billion package out of which $3bn would be placed in foreign exchange reserves while the rest would be in the form of deferred oil payments. The stock market welcomed the news by rallying around 1,500 points in a single session. Triumphant times.

Here is where the over-representativeness of good news overshadowed the tail-risks, such as the deal’s exact value, the time it would take to materialise and the inherent and expected twists.

Then came the prime minister’s visit to the United Arab Emirates where Pakistan entered into a “long-term strategic economic partnership”. Another cause for celebration.

This jubilant reverie was broken when the prime minister returned empty handed from China with only assurances of future promises and further ‘investments’.

The China trip was the first jolt that opened our eyes to reality.

Moving on, we again saw tail-risks resurfacing when the rupee experienced a historic devaluation in a single day, touching Rs144 against the dollar from Rs134.

The increase in the key interest rate from 8.5pc to 10pc cleared any lingering doubts about the country’s need to turn to the International Monetary Fund. Tail-risks continued to take a toll and misplaced expectations were duly corrected. The PSX plunged a precipitous 1,335 points.

“Over-exuberance can be precarious. Pakistan, while on the right path, will still need almost two years before it can make an economic turnaround. Before that we need to put many things in place — to set the machinery that is going to steer us away from an economic straitjacket that we are still managing to fight against, to stability and progress,” said Shan Saeed, chief economist of IQI Global Malaysia.

The theory of expectations relates aptly to the events in Pakistan. But there is also a takeaway.

Embracing optimism is a virtue. But Panglossian belief is rarely a good option. Social and economic circumstances will get better, but the change will require time. We are moving in the right direction. We will need help diplomatically and economically in the shape of loans from countries and institutions. But this is not going to happen ‘in a jiffy’.

The government should have avoided issuing grandiose statements. Ordinary people and capital markets build expectations on the basis of such announcements. The government should take a cautious as hundreds of millions of rupees are at stake. It is always useful to synchronise expectations with reality.

osama.rizvi@moderndiplomacy.eu

Published in Dawn, The Business and Finance Weekly, December 17th, 2018