Irrational Investments and Behavioural Finance

Irrational men down rational markets

A “compromise” between the traditional and behavioral approach

Markets are efficient. This is the main underlying assumption in Economics and Finance, and it means that any asset price should reflect all the available information, stating the homonymous Efficient Market Hypothesis. Although we can have different forms of efficiency, the main concept that this theory wants to expose is that nobody can beat the market consistently, introducing the concept of “No Free Lunch”: “A free lunch refers to a situation where there is no cost incurred by the individual receiving the goods or services being provided. In the world of investing, free lunch usually refers to riskless profit, which has been proven to be unattainable for any extended period of time.”[1] The traditional approach to financial markets assumes that from the EMH we can consider asset prices on markets as “right”, so that there should be no opportunities on markets for investors: the so-called Free Lunch. As soon as such an opportunity arises, investors jump on it, leading the mismatch immediately back to the fundamental value. We can now ask, where does Behavioral Finance stand in all this? Well, the main critique of the behavioral approach comes from the objection that the absence of Free Lunch does not necessarily imply that prices are right.

After this brief (hopefully not too boring) introduction of the two main views, let’s get into the real topic of this article. The main question is, therefore, not about market efficiency and rationality, rather about people and our irrationality. Even if there is some debate about the rationality of markets, there is clear evidence that nobody is able to take “perfect” decisions, considering all available options and outcomes. I would like to focus on a word I used before, which is “consistently”.  We mentioned above the possibility of beating the market: this does not mean that no money can be gained on markets through investments; conversely, the implication that any amount of risk needs a corresponding level of return is crystal clear, otherwise, nobody would choose such a way to commit his/her own money. But this also means that by investing, especially with increasing risks, anyone can incur gains and losses: the higher the risk the bigger they will be, because there is no way to get systematically high returns without accepting an increasing level of uncertainty.

What does “consistently” mean, then? The whole market is based on expectations, which play such a protagonist role in economics. Thus, every investment decision is based on predictions, according to anyone’s expectations about the future. The point here is not believing that prices would rise or fall, but rather guessing what the others think about it, in order to take a quicker decision[2]. Let’s go back to the behavioral approach: predictions are sometimes missed because people’s judgment is not always rational. Indeed, while trying to forecast the future and deciding how to invest money, people tend to fall for predictable errors, so-called heuristics and biases, which sometimes allows even to know in advance how such predictions are inherently imprecise.

There are many biases, but regarding expectations, we surely must mention overconfidence and optimism. The difference between these biases is sometimes slight, but in both cases, they may lead to a misjudgment.

Overconfidence is the situation that implies that people are too confident in their beliefs and estimates (i.e., statistically speaking, their confidence intervals are too narrow, the variance too small). This situation has two “guises”: the fact that 98% confidence intervals include the true quantity about 60% of the time, and a more general miscalibration of probabilities, which means that events reputed as certain occur just 80% of the time, as well as that “impossible events” arise 20% of the time.

Speaking about optimism, we refer to the “overly positive views” of abilities and prospects (again, statistically the mean considered is too high, an overestimate). A classic example of this bias is that around 90% of the drivers consider themselves above average (which, I would say, should be halfway, a good 50-50 point).

Basically, we can summarize the difference between them with two short sentences: “I know what’s going to happen” for overconfidence, “Things will be fine” for optimism.  these kinds of mistakes can be conducted in expectations-making processes, not only by “normal people”, but also by professional investors, especially when speaking of overconfidence.

Now that we presented both sides of the story, the question is: Who is right then? Well, it is not wrong to admit that markets themselves are rational. Of course, rational does not always mean right. There was some occasion when the prices were not truly representing the fundamental value of the asset which they referred to. Price is what you pay, value is what you get. Transaction costs do exist in the real world, and sometimes are the underlying cause of these misalignments. But in all these situations, we must consider that prices are based on expectations, which come from people. We know that people are far from being rational when it is up to decision making. Therefore, we can speak about market “sentiment”: things can go extremely well or badly following these moods, such as for financial bubbles, as well as for financial crashes. If any sort of panic spreads among investors, we can observe that even overnight markets could collapse, which actually happened in 2008, with waves of distrust that can resolve in “bank runs”.

Financial models, though, just aim to represent a framework for getting some better understanding, but from such models, we cannot expect exact answers to be predicted, about where the market would go, and when. Problems and uncertainty lay on the inputs of such models, valuation is not an easy game, and assumptions really make the difference. Valuation is and always will be a judgment, it may help in estimating values, but is not an exact science. If any misalignment or mismatch presents, it tends to adjust itself to correct values, otherwise some could have systematically beaten the market. Truth is, this adjustment is not always as fast as it should be, because of people’s expectations[3]; some can try to get some Free Lunch, some can lose money while trying it, as happened in cases of Royal Dutch and Shell[4]. But at the end of the day, we must consider that markets are made by people, they are just a tool that can be used to help, not to solve every problem occurring in decision-making processes.

In conclusion, do not always blame markets if something does not go as planned, and at the same time do not blame people for being “irrational” with expectations and mood. After all, we are human, not computers.


[2] For further reading: “The Beauty Contest” in Keynes, John M. (1936), The General Theory of Interest, Employment and Money, London: Macmillan

[3] For further reading: Werner F. M. De Bondt, & Thaler, R. (1985). Does the Stock Market Overreact? The Journal of Finance, 40(3), 793-805. doi:10.2307/2327804

[4] For further reading: Barberis, Nicholas C., and Thaler, Richard H. (2003). Chapter 18. “A Survey of Behavioral Finance.” Handbook of the Economics of Finance, Elsevier, Volume 1, Part B,2003, Pages 1059-1061

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