Individual rationality can mean collective irrationality & An Institutional Theory of Momentum and Reversal

I like this article because it brings up an interesting issue- while individual participants in markets can be rational (or irrational) markets as a whole can behave differently than expected. In essence markets are not always the sum of their parts.

The only criticism I have  is the lack of a multidisciplinary presepective. It seems like (often times) economists, investors, & behavioral scientist  tweak existing theories  in order to reconcile the differences between individual (or agent) behavior and collective behavior.  I think there is a much better way of looking at this problem but it would require a different mental model. If you look at markets as complex adaptive systems (an idea which Michael Mauboussin addresses extensively in his upcoming book Think Twice) then you could reason that  diversity, interconnectedness, and adaptability act via positive and negative feedback to create emergence.  This emergence would result in very different properties than found at individual levels.  Think about water when the temperature hits a certain point (aka critical threshold or tipping point) it becomes ice. That is to say the property emerges as a result of the molecules adapting to a changing environment (and being connected).

Lets apply this model to the article – individual investors (who hand their money to money managers and the like) act on incomplete information. As markets change they adapt (this happens regardless of the accuracy of their calculations of ultiliy or expected value). In the case of a panic, individual investors have less diversity as a collective (that is to say there are more sellers than buyers and thus less diversity). Because these  individual investors are  interconnected you get irrational pricing and (later on) momentum.

I’m just presenting an alternative model. The paper is pretty solid and infact the author use to work with GMO. Enjoy!

Introduction (via FT)

Some economists insist that markets must be efficient because they are rational. And if they are not rational, the whole of economic theory collapses.

So be it, we might reply. Better no theory than a dud one. And other theories, based on behaviour rather than rationality, do a better job.

But when it comes to the big stuff, our actions belie that. When we are grappling with the subprime debacle or Chinese economic policy, we ask ourselves what people are up to – not how they behave, but how they are reasoning.

In fact, the theory of rational behaviour is a model – a schematic attempt to portray the big picture. Any such model, in or out of economics, contains anomalies. To dwell on those anomalies, as we all now enjoy doing, risks missing the point. It is only when there are enough of them that the model is more hindrance than help and must be dumped.

Excerpts (Via FT)

The information gap between them and their agents means they are making the best of the knowledge available to them. So it turns out that individually rational actions add up to a collectively irrational outcome. That might seem odd to mainstream economists, but not to the rest of us. Mutually destructive wars have been fought on the same basis.

Click Here To Learn About How Individual rationality can mean collective irrationality

Click Here to Read The Original Paper The Article Was Based On

About Miguel Barbosa

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02. September 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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