Wrong. Not just wrong, but WRONG. This is one question that everyone and I mean everyone gets wrong. People are rational. Period. Full Stop. (No, I’m not Milton Friedman writing from the grave).
11 thoughts on “Even if markets are efficient then surely a boom or subsequent bust proves that market participants are irrational, right?”
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Your answer (“everyone”) is misleading. Read Mises or Rothbard about business cycle theory, the adverse influences of governmental meddling in commerce, and the liquidation of malinvestment during a bust.
Paul, thanks for commenting but I don’t understand your point and how it relates to mine. Can you elaborate?
I’m sorry Andrew, but despite your great website this one is a real stinker. People are CLEARLY not all rational; numerous examples of investor irrationality exist in the asset pricing literature (momentum effect, disposition effect, etc. etc.). Even in the world of corporate finance several well known anomalies exist – merger arbitrage, stock splits and so on. If we imagine for a second that markets are indeed efficient (which they’re not, semi-strong at best)then the existence of booms and busts does provide a pretty convincing case for investor irrationality.
Come on, who gives a **** about the “stinker”. Just read the great stuff here about IB. Either go argue about trivial things for years or use the site to get an IB job.
Already have a job at a top 3 bank and feel desperately sorry for you ABC. It is very disconcerting that people like you – “who don’t give a **** about” fundamental questions in modern finance – want to or already work at IBs. Fortunately, I am surrounded by far more intelligent people who can ponder about important questions as well as make a few bucks.
Ally, as you have probably realized already, most bankers (or HF,PE professionals) don’t care about such intellectual topics. That’s just the nature of the finance industry.
ABC, thanks for defending 🙂 but a little intellectual discourse is okay too, especially on this topic since it is (a) controversial and (b) has nothing to do with IB jobs. I actually meant to start a new site with this kind of content but I never got around to it so I stuck it here.
Ally,
First, thanks for the comment. I don’t think anyone believes markets are perfectly efficient, just very highly efficient. See this post: https://ibankingfaq.com/markets-and-investing/are-markets-efficient/. Even the anomalies you mention (I am very familiar with the behavioral finance literature) tend to provide only a very small advantage after trading costs are taken into account. Plus, one could make a reasonably strong argument that the excess return provided by such anomalies is due to risk (or other factors) that aren’t being properly measured by standard risk metrics (i.e. volatility/standard deviation).
Having said all that, even taking the fact that the market is not perfectly efficient does not imply that investors are irrational. This is the mistake that nearly everyone makes that I try to explain here: https://ibankingfaq.com/markets-and-investing/how-can-you-say-that-people-are-rational-given-all-of-the-research-that-seems-to-show-otherwise-in-addition-to-all-of-the-booms-and-busts-throughout-history/.
Take, for example, a mutual fund manager (hedge fund investors act similarly). Nearly all mutual fund managers will chase performance (i.e. buy winners) so as to protect AUM and there own jobs. It is better to underperform along with everyone else than to be a contrarian and risk losing one’s job. Of course, this attitude leads to momentum investing and perphaps even a bubble. However, there is nothing irrational whatsoever about the investment decision. One of the points I try to explain on the other post I linked to is that you cannot measure irrationality by simple economic outcomes (i.e. investment return). Rational incentives cause bubbles not investor irrationality.
Andrew, what you’ve really done is express a tautology in an illuminating way. Internet, if you disagree with his analysis, than you don’t understand it.
Thanks Sam. I’d explain what I’ve said slightly differently. What I am essentially doing is defining the word “rational” with its (in my opinion) correct and traditional meaning. That is, a rational decision is a decision in which the actor believes he/she is maximizing his/her utility. I believe that the academic community defines “rational” incorrectly. As I mention/allude to in this post (https://ibankingfaq.com/markets-and-investing/who-cares-if-investors-are-rational-or-irrational/), essentially this is a purely semantic and academic discussion. However, I do believe (as I also discuss in that same post) that the academic community does the world a significant disservice in using the word “rational” incorrectly, especially when irrationality is used to support (erroneous) arguments about the inherent and inevitable failures of the market. At the risk of being repetitive (and for the benefit of other readers since I think you already understand my points), markets fail because incentives are messed up, not because economic actors are irrational. Why incentives are messed up, and how to fix them, are the vastly more interesting and important questions.
Dear Andrew,
Coming from a hard-core Economics background, I could not resist the temptation of commenting here. I totally agree with you in inferring that “we cannot imply individual rationality/ irrationality from the market performance, although market is a collection of individuals”. In Macroeconomics, such phenomenon is termed as a micro-macro mismatch. Individuals take decision to maximize their own utility, which may be different from the market return. So individual equilibrium (Pareto efficiency) varies widely from a market equilibrium (market efficiency). There is a lot to say here from macroeconomics and microeconomics literature to explain the discrepancies between individual rationality and market efficiency, but I believe it is clear to what I am hinting to. We cannot judge individual rationality by market performance solely, and especially not judging by only financial market which is just one of the many macroeconomic markets an individual participates in (e.g. labor market)!
The individual irrationality referred by behavioral economics is not implied by their market performance but by their randomness in incentive structure (in loose words, messed up incentive!). So they suggest to utilize random utility function instead of a typical utility function when analyzing individual behavior, but has nothing to do with market performance per se. The causality does not run from market level to individual level at all.
I hope this gives a more comprehensive view to the topic in discussion.