In economics and investment 101 classes, students are taught theories underpinned by a sacrosanct assumption that investors are rational. On first hearing, this appears logical and difficult to argue with; it’d be a brave student that stands up to interrupt a professor imbuing foundations that underpin much of what follows. How could people not be rational? Move on, right?
After nearly 25 years in the market, I feel less and less confident that the investing world operates in the way that is often taught and question the validity of some key underlying assumptions. Part of the issue is that market innovations develop far more rapidly than textbooks can be updated – this is a function on how quickly academics keep abreast of such developments, can agree on what they mean, and sometimes admit if they were either wrong or the world has moved on.
To be clear, the point isn’t that investors are irrational altogether but rather that in the real messy world, rationality is not binary. Instead, it should be thought of as a spectrum. Investors and market participants lie at different points, depending on their environment and era. Of course, what is rational in one era may be different to another.
Richard Thaler, winner of the 2017 Nobel Prize in Economics, has “The List” of ways in which even the most sophisticated investors will act irrationally. Some examples are:
- Playing with the house’s money: all money should be treated equally, but investors tend to take larger risks after making a big profit.
- The Endowment Effect: people hugely overvalue the things they own, yet classical theory tells us that owning a stock should have no bearing on the value you place on it.
- Narrow framing: investors are unwilling to make individual bets with good, risk-adjusted outcomes, but high variance, even though over the course of a career they are almost guaranteed to have a positive outcome.
In the stock market if everyone understands and acts rationally on all information, then the volatility and trading volumes would be far lower. Overtrading based on the noise of short-term earnings releases and fluctuating market conditions must be irrational when viewed in a longer-term context and considering trading costs.
