09 Feb Finance Series – Exploring Investor Rationality
The Efficient Market Hypothesis has been under fire since Eugene Fame of the University Of Chicago Graduate School Of Business first suggested it back in the early 1960s. The central idea behind the Efficient Market Hypothesis is the theory that investors are completely rational in interpreting and acting on market news and information (which, ostensibly, is fully revealed public knowledge).
It has since come to be known as the Theory of Rational Expectations. This rational investor behavior is factored into the value of all news and information the moment it becomes available. And it happens to the extent that “beating the market” becomes an impossible task.
The idea of investor rationality has been under fire by the few “gurus” who have consistently beaten the market since its inception. Nobel Laureate and father of Behavioral Finance, Daniel Kahneman, pointed out that the failure of the rational model is not inherent in the logic of the theory, but rather in the human psyche. He posited that nobody has the ability to simultaneously process all incoming stimuli and attain a complete understanding and mastery of that stimuli.
From the many arguments for and against the theory of rational expectations, I observed that many of the arguments stemmed from a difference in the understanding of what rationality means in the first place (indeed, that is further proof that “rational” people can look at ideas and apply their own bias and still be regarded as “rational”). If the world is made up of blistering imbeciles making irrational decisions, like those who argued against the theory suggest, wouldn’t the world more closely resemble an assembly of monkeys? Yet, if the world is made up of rational humans the way the theory postulates, wouldn’t the world be more robotic than human?
For too long, academia has debated the theory by taking sides with either the monkeys or the robots without a clear understanding of what constitutes rationality in the first place. Is the investor who rushes blindly into the stock market during market bubbles irrational? Are investors rational beings if they buy undervalued and sell overvalued stocks? Essentially, all reasonable human beings are rational! Rationality is the consistency of action based upon a set of logical variables. The issue here is that the difference in one’s level of knowledge and life experiences is the determining factor that allows for the installation of a distinct set of logical parameters and values in every human being!
This means that two human beings looking at and interpreting the same information can come to two separate conclusions and resulting actions! The result of which is a two-sided market. An investor who has lost a significant amount of money in the stock market may prefer to stay out of an overextended stock regardless of how fantastic the news. On the other hand, investors who have never been through that same life experience would simply continue to buy on the news. Both investors, in this case, are rational in regard to their own level of knowledge and experience. This explanation of rationality effectively consolidates all the differing views on the Theory of Rational Expectation. Because investors are rational, two-sided markets are created, making the overall market more and more efficient. Because investors are rational, they rush after price bubbles on the expectation of profits only to be defeated by the Law of Regression to the Mean.
Being greedy is a rational response to one’s needs and wants and being fearful is a rational response to one’s past sufferings. The driving factors of Greed and Fear are also rational expressions! Contrarians who take positions against the market are rationally expressing their expectations that markets eventually turn against the prevailing trend. Trend followers who take positions along with market trends are rationally expressing their belief in that trend continuing into the foreseeable future. Both create a two-sided market for each other, driving the overall market towards more and more efficiency.
However, this explanation of rationality completely nullifies the part in the theory that states that “rational investors should act in a similar fashion in response to the same news”. Because there is no way of measuring or predicting whether or not there will be more decisions of rational buying or rational selling in response to new information, nobody can predict market movement with any moral certainty. Although not attributed to random behavior, the unpredictable nature of the market has more cause and effects than the theory itself can explain.
In summation, any argument to explain market behavior through the notion of rationality has limited application in reality. As investors in the stock markets, our understanding that the markets cannot be predicted and the set-up of realistic stop loss points in preparation for worst-case outcomes and hedging portfolios using stock options, are the most rational actions that can be taken. As behavioral finance suggests, everyone makes the best of a bad situation and the situation in the stock market has never been ideal for anyone.