Why Markets Are Inherently Irrational
Sceptics who have never invested, don’t intend to or even disgusted at the sound of “investing” would say that investing is no different from gambling. But is that really the case? If someone you know says that gambling is a lot easier or even better than investing, show them this article by Investopedia.
There’s a very good reason why the richest people in the world gathered their wealth from investing and not gambling. Ironically, many of those in the stock markets are speculators, commonly dubbed as gamblers as well. But the richest people and majority of those who are successful in the stock market are not speculators. They are investors.
Of course, there are success stories of speculators or rather, smart short-term traders who made it big in the stock market. The common characteristic of these successful stock market players — investors and traders — is their understanding that markets are inherently irrational. The stock markets are driven primarily by emotion and thus, are psychological phenomena.
It is, therefore, important for us — investors or traders — to understand why the markets and majority of the stock market players are irrational. With a clearer picture of what the markets are really like most of the time, hopefully, we won’t be as irrational as them and benefit from the situation.
Confidence can boost or hinder markets
Most economists and experts would say that humans are supposed to be rational, but that’s not always the case. As can be seen in the stock markets, when prices are climbing high, sometimes way higher than the stocks’ financials can hold, investors still rush in to buy.
John Maynard Keynes, an English (behavioural) economist of the early 20th century, introduced a concept in human psychology called “animal spirits“, which sought to explain why humans act the way they do and how those actions drive the economy.
In a more recent study, which drew from Keynes’s work, George A. Akerlof and Robert J. Shiller explained how humans are rational, but only most of the time. The overall market confidence can “drive” or “hamper” the economy and stock prices, and humans tend to act according to the market’s confidence, not the actual real value of assets.
Most “losing” decisions are due to lack of information
Ironically, this is also exactly how successful investors make money from the stock markets — benefitting from the irrationality of the majority. The ones who rush in to buy when prices are climbing to dangerously high levels (lack of information and thus considered irrational) contribute to asset bubbles, which eventually couldn’t hold and burst.
When the bubble bursts, stock market players rush for the exits and make huge losses as prices continue to plunge. When stock prices of excellent companies that are able to tide over financial crises fall below their real or intrinsic value, some investors enter to pick up the cheap stocks (have the right information and thus considered rational) when everyone thinks it’s suicide.
The main difference between the winners and losers are the amount of information they have. The winners tend to have more information than the losers — that’s exactly why the former end up making the better decisions.
Markets are actually quite inefficient
The “Efficient Market Hypothesis” (EMH) is a commonly disputed concept, particularly because the stock market is the biggest evidence against it. If markets are indeed that efficient and rational, there won’t be income inequality in the world.
Building on the previous point, because there is a lack of information, there is an apparent gap in the amount of information each investor has. Furthermore, each individual process that information — regardless of depth — differently.
To make things worse (or better, if you’re profiting), most investors make decisions based on their emotions as mentioned earlier and in the point about market confidence. Emotion in itself increases market inefficiency and is the main cause for irrationality.
Key takeaways
1. Stock prices are driven by confidence (or also known as market sentiment) so they are often not indicators of the actual real value of assets.
2. Winners win and losers lose because of the amount of information they have — to avoid “losing” decisions, make sure you have enough information before buying or selling stocks.
3. Because of information gaps, markets are inefficient. Individuals process information differently according to their perceptions and therefore, emotions get in the way, causing irrationality.
By understanding the market is irrational and why, hopefully, we can avoid being the same and profit from the irrationality. This might seem exploitative but that’s how the market works and there can only be winners if there are losers.
