Mr Market’s capers are not so silly

4th August, 2007

Mr Market has been getting a pasting from my learned FT colleagues recently. John Authers compared him to Wile E. Coyote. John Kay warned against personifying the market – but called him a silly old fool anyway.
The criticism seems reasonable enough. Credit spreads, bond prices, equities and currencies have all been dancing an insane caper. At times like this, the idea that the market is rational and efficient falls out of fashion pretty swiftly.
Mr Market is big enough to take care of himself, but I feel obliged to offer a few words in his defence. There is a danger in writing him off too casually, a temptation (to which I know Authers and Kay would not succumb) to think that if Mr Market is so demented, it would be easy to do better. But Mr Market is not as silly as you think.
We journalists are partly to blame for the market’s crazy reputation in times like these. It seems rather limp to write that the market rose 1.9 per cent, then dropped back 0.7 per cent, and nobody really knows why. It’s far easier all round to write a story explaining that the pattern was due to bullishness about growth, followed by profit-taking. It may even be useful, because it helps us remember what happened.
But such impromptu explanations are likely to sound feeble indeed when the market has a month like July – or worse, a day like “Black Monday” in October 1987. We are left to conclude that Mr Market must have lost his mind.
That is why it is irresponsible of me to be talking about “Mr Market” at all. It is an irresistible but misleading metaphor. Market moves that would surely be irrational if made by a single decision-maker can make perfect sense when made by a large group of investors. The economists Jeremy Bulow and Paul Klemperer have shown that even a market full of hyper-rational investors would suffer frenzies and crashes. The intuition behind their model is simple enough to grasp: smart investors pay attention to what other investors may know. When the market moves on no news, that move is the news: it is information about what everybody else is thinking.
This is not to say that all investors – or even most investors – are rational. It would be very surprising if they were. The field of behavioural finance, populated by a potent alliance of financial economists and psychologists, is revealing all sorts of evidence of irrational behaviour. An important example is a reluctance to sell loss-making stocks, because that would crystallise a loss.
This sort of psychological research deserves the serious attention it is getting. But it would be a mistake to believe that behavioural finance offers us an opportunity to put Mr Market on the psychiatrist’s couch. Just because some investors make these mistakes does not mean that the market as a whole will do so: there is too much incentive for the smart money to learn about the biases and try to do exactly the opposite.
Another difficulty for behavioural finance is that some of the behavioural economists’ discoveries have a tendency to evaporate when real money and real experience is on the line. John List, an economist at the University of Chicago, has shown that a well-known psychological bias against trading is not shared by experienced traders in real-life trading situations. (I’ll admit that the traders were dealing in Mickey Mouse badges and baseball memorabilia, but the discovery is instructive.) The experienced, rational traders tend to have more cash than the eager naïf, and so while many traders are irrational, Mr Market may well be sane enough.
It is, in any case, frustratingly hard to turn either psychological research or good solid common sense into a market-beating strategy. Psychologists point to “the endowment effect”, a natural and irrational urge to hold on to what we have rather than trade to something better. Yet wise heads caution against the foolishness of day trading. We can’t both be irrationally eager to trade and irrationally reluctant to do so – unless a split personality is to be added to the list of market traders’ psychological flaws.
Another example has been made famous by Nassim Nicholas Taleb, with his talk of the “black swan”.
Mr Taleb believes we should resign ourselves to the occurrence of dramatic, unexpected events. He claims to profit by betting that these black swans will arrive from time to time. That sounds wise indeed.
And yet the psychologist Philip Tetlock, who has made a life’s work out of studying the forecasting record of political experts, concludes that they have a natural tendency to imagine unlikely events and convince themselves that those unlikely events are, in fact, all too plausible. Mind-broadening techniques such as scenario planning or reading the Financial Times turn out to be embraced too readily by those who are already spotting black swans behind every clump of reeds. Are we too eager to imagine black swans, or too eager to dismiss them?
So I am convinced that human rationality is imperfect; I am far less convinced that those imperfections yet tell us anything profitable about the financial markets. If I am wrong, I urge any behavioural economists who have parlayed their ground-breaking research into stock-market millions and early retirement to get in touch.
Until then, I’ll invest in good old tracker funds and pay little attention to what happens to them in the short term. I’ll admit that Mr Market isn’t perfectly rational. But if I thought I could do better, I’d be crazy.

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