Market rationality is a central point of contention among economists, investment professionals and politicians. Some argue that markets (including financial ones) make everyone better off; they are the ultimate generator of win-win situations. Narratives here range from the reasonable to the quasi-religious. Their detractors point out the many instances where markets fail to generate these win-win situations, with narratives ranging from the reasonable to the dystopic “corporations are evil” rant.
As the recent events pitting retail investors against hedge fund managers showed us, there is a pressing need to understand the nature of market rationality – lest we misunderstand it. Indeed, our understanding of market rationality will stem from an understanding of rationality itself.
Aristotle summarised humans as rational animals viz. animals which act in accordance with reason or logic. Although the average man is rational most of the time, he who is rational all of the time is not the average man (he is more Spock than Kirk). Some of us smoke, or drive too fast, or believe QAnon is real, or invest in a stock they know nothing of simply because its price is soaring. Show me someone who is not guilty of acting irrationally occasionally and I will show you a liar.
Emotions strongly influence our expectations and expectations shape our economic future. They can make billionaires out of fraudsters (Bernie Madoff), send prices spiralling up (tulips in 1637) and prolong economic pain indefinitely (the Great Depression in the US). Emotions also make us lash out, as we just witnessed Redditors from r/wallstreetbets inflict losses worth billions upon hedge funds. Schadenfreude (pleasure in another’s distress) dressed up as justice, with no consideration for the common folk invested in these funds indirectly (where do they think institutional investors get their funds from?).
Perhaps regulators could contain these animalistic impulses, and they can to some extent. Yet they too are humans facing powerful incentives (a point Nobel laureate James Buchanan made) and their knowledge is more limited than that distributed across all actors within a market. Hence their ability to act in accordance with reason is compromised (as fellow Nobel laurate FA Hayek argued).
Rationality is not a state, but a process. It is the process of learning from our actions, of trying to minimise mistakes while generating success: it is the inverse of Einstein’s definition of insanity. This holds for market rationality: the same bubble rarely occurs twice, and we learn to respond to crises better over time.
There is intrinsic value to waxing poetic on market rationality as there is in savouring good wine. Nevertheless, we may distil the esoteric into something pragmatic: take a moment and reflect on your actions. How is the bond issuer going to pay us back? Are the company’s prospects good enough to be worth the exorbitant stock price, or am I buying because it is rising? If cryptocurrency is so valuable as a currency, why do we measure its value in dollars and not in bitcoin? What would happen if hedge funds failed and institutional investors lost their money? Would it really be funny?
From the outside in, market rationality appears automatic – but it is not. It depends on us, and thinking for ourselves and trying to make the best of the resources, knowledge and time we have. It is incumbent on each one of us to take responsibility for our actions and to accept and learn from our mistakes – and if we did that, we would surely wake up to a different world, financial or otherwise.
This article is not and nothing in it should be construed as a recommendation in respect of investment products or services offered by the BOV Group. Any views, assumptions or opinions expressed in this article are those of the author.
Matthew Farrugia, Investment Analyst, BOV Wealth Management Unit