Defending Rational Markets

Liberals like to assume markets and individuals are irrational, in agreement with their denial of individual cognitive exceptionalism. After all, if everyone is an irrational blank slate, how can anyone be intrinsically better than anyone else?

It’s then not surprising to see Michael Lewis – the inveterate liberal anti-banker journalist – be in favor of ‘irrational markets’ view, in a Bloomberg view article: The Economist Who Realized How Crazy We Are. A commenter quickly refutes the premise of the article, correctly arguing that choices that seem irrational in retrospect or to outside observers may not be irrational to the person carrying them out:

I disagree that people are irrational. What seems to be irrational to someone is simply behavior we don’t understand or agree with the reasoning behind it.

Everything makes ‘sense’ to the person doing it at the time they’re doing it for reasons they and they alone determine to be worthwhile. An observer may not be able detect the reason for that action. At other times, the observer might understand the reasoning, but disagrees with it. In neither case, does this mean the action doesn’t make perfect sense to the person making the decision.

I’ll cite the example of the guy faced with mowing his yard. I too don’t like paying someone to do things that I could do myself (up to a point), but that doesn’t mean I want to do the same thing for someone else. So I too might not want to pay someone $10 to mow my yard while I would turn down $20 to mow someone else’s yard.

When economists talk about ‘rationality’, it’s not how lay-people use the word, who typically use it mean a ‘level-headed’ person. In ‘econ-speak’ it means:

A decision-making process that is based on making choices that result in the most optimal level of benefit or utility for the individual. Most conventional economic theories are created and used under the assumption that all individuals taking part in an action/activity are behaving rationally

So all else being equal, choosing a $4 quart of milk is the rational choice over spending $10 for the same milk. This pertains to investing because some economists, especially those on the left like Robert Shiller, argue that individuals who buy stocks at inflated prices (or bubbles) are not rational because in retrospect the valuations exceeded even the rosiest projections of fundamentals. Therefore, investor behavior is irrational, defying the EMH, which stipulates rationality. But are the investors/speculators really irrational?

In an earlier article, Irrational Investors Don’t Exist, I delineate between ‘real time’ rationality and ‘long term’ irrationality, as well as explaining how trying to short ‘irrational’ bubbles for financial gain is a futile endeavor for most contrarians. Suppose in the past hour you see a stock rising from $60 to $90 for no apparent reason. Is it so irrational to assume it will go up another, say, $10 within the next hour? Maybe not. That is ‘real time’ rationality. But let’s assume the the stock implodes because the run-up was all hype and had no fundamentals behind it. In retrospect, those individuals who chased the gains were irrational. But what if the company becomes the next Facebook? Then they may have been rational. The ‘real time’ rationality reconciles long-term irrationality. Even if the speculators know the company has no fundamentals, seeing the sudden, great rise in price behooves chasing it since it’s ‘free money’ on the sidewalk and to not pick it up would be irrational. Betting against this rise by taking the opposite side (short the stock) can lead to huge losses due to ‘real time’ rationality, even if your original thesis that investors are behaving irrationally is correct in the long-term. The ‘real time’ is what trips up people like Shiller and Lewis, as well as everyone who thinks they are being ‘smart’ by shorting what appears to be a bubble.

The bubble-deniers and bubble-riders both have victories and defeats, ultimately resulting in a long-term stable return for both sides. Such a return could be ‘fundamental drift’, the risk-free rate, or some other benchmark/drift, which agrees with random walk theory, as I explain here. The aggregate of speculators cannot get a long-term ‘edge’ with either strategy.

Back to the EMH, the subject of a heated debate on Seeking Alpha. Prospect thoery, as orignated by Amos Tversky and Daniel Kahneman, is a popular alternative to the EMH; however, prospect theory/loss aversion may work in small, well-controlled lab experiments involving paid subjects, but it doesn’t always apply to the markets, which still exhibit great efficiency. The EMH has flaws, but it’s the better than the alternatives. The EMH underpins option pricing, and attempting to create option pricing formulas on an inefficient market would not only fail to work, but fail to agree with empirical results. Furthermore as shown below, the diminishing alpha, especially in the past decade, lends further credence to the EMH:

Fund returns are becoming increasingly correlated not only with each other, but the market, suggesting increasing efficiency of the market:

Comments are closed.