Why markets are irrational
Why markets are irrational?
Because individuals are not rational.
Following studies have shown that people are not rational and suffer from various lapses of logic
Extrapolating the present into the future. People tend to downplay uncertainty and assume recent trends, whether good or bad, will continue. Markets can go higher than your wildest dreams & they can also go down beyond your nightmare.
Giving more weight to recent spectacular or personal experiences in assessing the probability of events occurring. This results in an emotional involvement with an investment strategy. If an investor has experienced a winning investment lately, they are likely to expect that will continue. Once a bubble gets underway, investors’ emotional commitment to it continuing steadily rises, thus helping to perpetuate it.
Overconfidence. People tend to be overconfident in their own investment abilities.
Too slow in adjusting expectations. A tendency to be overly conservative in adjusting expectations to new information, doing so slowly over time. This partly explains why bubbles and crashes in sharemarkets normally unfold over long periods.
Selective use of information. Ignoring information that conflicts with current views. People tend to make their own reality, which helps to perpetuate a bubble once it gets underway.
Wishful thinking. People tend to require less information to predict a desirable event than an undesirable one, which may partly explain why asset price bubbles normally precede crashes.
Myopic loss aversion. People dislike losing money more than they like gaining it. Various experiments have found that a potential gain must be twice the potential loss before an investor will consider accepting the risk. An aversion to any loss, particularly in the short term, probably explains why shares traditionally are able to provide a relatively high return (or risk premium) compared with “safer” assets such as cash or government bonds.
The madness of crowds
As if individual irrationality is not enough, it is magnified and reinforced by “crowd psychology”, and investment markets have long been seen as providing examples. Collective behaviour in investment markets requires the presence of several things:
A means by which behaviour can be contagious. Mass communication, with the proliferation of financial media in print and electronic form, is a perfect example. More than ever, investors are drawing their information from the same sources, which in turn results in an ever-increasing correlation of views among investors, thus reinforcing trends.
Pressure for conformity. Interaction with friends, monthly performance charts, industry standards and benchmarking, all contribute to herding among investors.
A precipitating event or displacement giving rise to a general belief that motivates investor behaviour. The IT revolution of the late 1990s or the growth in China and emerging markets are classic examples on the positive side. The demise of Lehman Brothers and related events setting off investor panic is an example on the negative side.
A general belief that grows and spreads. For example, share prices can only go up, or shares are a poor investment. This helps to reinforce the trend set off by the initial displacement.
Just reminding myself about the above studies have saved me a lot of money & time.
Paying attention to the market is important but finding rational in market behaviour is plainly irrational.
Admitting the fact that you do not know what markets will do tomorrow is the best thing you can do as an investor.