The myth of the rational investor

In Blog by Ian Fraser1 Comment

10 June 2011

The myths of the rational investor and the efficient market hypothesis have much to answer for. Arguably, they underpinned the folly that was Alan Greenspan-ism, fuelling the insanity and fraudulence that overcame banking and financial markets ahead of the global financial crisis.

I’ve always thought there are parallels between neoliberal economists who peddled such thinking  — and indeed managed to make it mainstream for more than two decades — and the inhabitants of the mythical floating island Laputa in Jonathan Swift’s Gulliver’s Travels (pictured above). The erudite Laputans spend their days working on obscure mathematical, astronomical, musical and technological formulae — but these are utterly detached from reality and they remain resolutely incapable of putting these to any practical use.

A new book by David Tuckett, Minding the Markets, explores some of these themes. The author, a professor at University College London who trained as an economist before turning to sociology and psychoanalysis, argues that contemporary economics is a pseudoscience. This is partly because it ignores the emotions and unconscious fantasies that drive human behaviour.

The book will make uncomfortable reading for mainstream economists who still believe in neo-classical nostrums (including that markets are efficient and that the economy as a whole is a stable and self-correcting mechanism) like shipwreck survivors clinging to flotsam and jetsam in the sea.

Writing in The Observer, Heather Stewart provides an excellent synopsis of Tuckett’s thinking (which I’ve taken the liberty of quoting  at length):

There is plenty of economic research – by George Akerlof and Robert Shiller, for example – on the psychology of market bubbles. But Tuckett’s insight, based on in-depth interviews with more than 50 investors, each managing more than $1bn, is that stocks, shares and derivatives are a special kind of asset, and decisions about whether to buy and sell them are particularly subject to stories and emotions.

For one thing, the value of financial assets is prone to extreme uncertainty: thousands of unpredictable events can affect the profitability of a company, for example, from the collapse of a key supplier to a sudden change in the cost of commodities to a natural disaster many thousands of miles away.

At the same time, the owner of a share – or a credit default swap – has nothing they can eat, drink, live in, or even hold in their hands: they have to weave a story, a narrative, even to understand why it’s worth buying the asset in the first place, let alone hanging onto it when its value has soared to once-unthinkable heights.

Given these special characteristics, Tuckett argues, financial assets tend to become what he calls ‘phantastic objects’, which their owners invest with extraordinary powers and think about in ways that are unavoidably emotional. Subconsciously, investors suppress nagging, negative thoughts (How can this firm possibly be worth that much? What if US house prices don’t go up for ever?) and plough on in what psychoanalysts call a ‘divided state’.”

Tuckett’s core argument is that the short-termist culture in today’s financial markets promotes irrational thinking amongst investors — including a proclivity to depend on self-serving fairytales instead of facts — which fatally undermines the conceit of efficient markets which still underpins neoclassical economics. In Tuckett’s view it also encourages investors to suppress negative emotions they may have about risk. The recent Groupon IPO is an illustration of the sort of groupthink that can sometimes end in disaster.

Tuckett believes investors actually fall in love with the stocks they own, to the extent that they become irrational and blind to their flaws. A collective self-delusion can arise, where nobody dares mention the emperor is wearing no clothes for fear of pricking the bubble. We saw this with tulip mania in 17th century Holland and, for example, in the Irish banking and property sectors in 2006-07, as well as in the United States mortgage market in 2003-07. In the Irish bubble, Merrill Lynch suppressed an analyst’s note because it accurately described the parlous state of the market. When their love wanes, as happened after the banking crisis, investors self-disgustedly accentuate the negatives, with their love rapidly turning to hate.

As The Observer’s Stewart says: “The traders piling into tulips, credit default swaps or gold ingots are carried along by a collective frenzy of hopes, fears and anxieties – what Tuckett calls ‘groupfeel’. As he points out, even regulators, and watchdogs such as the IMF, were caught up in the maelstrom, soothed by the idea that financial innovation had made the world a safer place – and reluctant to be the cause of the pain that would result from pricking the bubble.

A version of this article was published on QFINANCE on June 9th, 2011

Comments

  1. Having for many years in the past sold medium to long term investments myself, I have always maintained that the motivation behind any sale is how it makes the purchaser feel and rarely has anything much to do with the nuts and bolts of a product. For this reason I would agree entirely that the rational investor theory is a myth.
    The illustration of the floating island of Laputa provides a very tangible image of the detatched reality inhabited by economists who believe investing is a cerebally motivated excerise rather than an emotional one.

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