Rational or irrational? Investors can be both

Understanding how narratives work could resolve the gap between classical and modern views of investing

Rational or irrational? Investors can be both

Classical theories of the markets hold that participants behave rationally, acting on information that they have to collectively determine prices. But because of developments in behavioural economics, we now recognize people’s tendency to behave irrationally because of biases and blind spots.

But does that mean people are always irrational? Not necessarily. In an attempt to resolve the contradiction between the classical and newly recognized models, US financial economist Andrew Lo advanced a theory called the Adaptive Markets Hypothesis (AMH).

“Lo reasoned that in times of continuous market developments, people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model,” wrote Thomas Mayer, CFA, PhD, in a blog post published by the CFA Institute.

“But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join the stampede, either rushing into the markets out of fear of missing out (FOMO) or fleeing from them from fear of going broke,” Mayer said.

Taking the thinking further, Mayer proposed an extended theory he developed with a colleague, Marius Kleinheyer, called the Discovering Markets Hypothesis (DMH). Rather than taking the different shifts — from rational to irrational investor behaviour, and from continuous to disrupted markets — as given, it attempts to explain them by taking into account people’s ability to exchange information and form new narratives.

“We begin with three central assumptions: That information does not exist as an object, that subjective receptions of complex inputs are communicated through narratives, and that shared narratives shape prices and are shaped by them,” Mayer said.

Citing classical economist Friedrich Hayek, he explained that the knowledge each person holds is unique, as it reflects their specific and unique ability to gather and process information. By acting or watching action in the market, investors can improve their knowledge by seeing how it compares with others.

Investors may also communicate with each other directly to crosscheck their subjective knowledge, he added. “But complex knowledge is difficult to communicate,” Mayer said, which is why people often reduce them to narratives that are easier to share. As market participants share narratives and act on them, prices move; the movement of prices feeds back into the narratives.

As different groups of participants coalesce around different narratives, those narratives end up competing. Comparing it to Thomas Kuhn’s and Imre Lakatos’s insights on how new scientific knowledge is created, Mayer said that the competition may be intense with an absolute victor — Kuhn’s view — or it could be more like Lakatos’s theory, which would mean a long-drawn battle with a gradual displacement of the old paradigm.

“All this implies that we should not expect to be able to predict market outcome,” Mayer said. “[But] by identifying narratives shared among many people and by determining whether these narratives are ascending or descending, we can assess the persistence of market price movements. In some cases, we may even identify narratives that precede price movements.”


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