Advertisement

Book of the week: irrational markets and investor psychology

A Crisis of BeliefsAcademic economists Nicola Gennaioli and Andrei Shleifer argue that financial markets can, behave in irrational ways.

A-Crisis-of-Beliefs-100

Investor Psychology and Financial Fragility

Princeton University Press, £24

Buy on Amazon

Financial economists tend to believe in what is known as the "rational expectations hypothesis" (REH). Put simply, they assume that people automatically make optimal decisions after taking into account all available information. Such a simplification may be useful when building an economic model, and indeed it has a kernel of truth, but it flies in the face of the evidence that people can behave in quite irrational ways. In this book, academic economists Nicola Gennaioli and Andrei Shleifer examine the financial crisis of 2008-2009 to assess the REH's shortcomings and to look at alternatives.

Advertisement - Article continues below

They consider two questions. First, why did apparently intelligent and well-educated people overlook the problems with the financial system, even after credit conditions started to tighten from the summer of 2007? Second, why did investors' sentiment shift so dramatically following the collapse of Lehman Brothers? In their view, the second question is as important as the first, since there are several plausible explanations for the emergence and persistence of the subprime bubble, but fewer explanations for why it suddenly collapsed.

Their view, backed up by evidence from surveys of investors' sentiment taken immediately before and after the crisis, is that it stemmed from our tendency to use our recent experiences to temper our expectations about the future (or what they call the "diagnostic expectations hypothesis"). This generally enables us to strike a balance between looking at what's happened in the past and thinking about the future.

But it can lead us to swing from complacency to panic in our perception of improbable, but catastrophic, events.

Advertisement - Article continues below

In other words, just because things are going well, people begin to assume that they will always go well. Even in the early stages of the crisis (the so-called "credit crunch"), the fact that the financial system seemed to be coping meant that people remained complacent. When Lehman collapsed, people overgeneralised in the other direction, assuming the risks were greater than they were, causing a panic.

Gennaioli and Shleifer seek to straddle a middle ground between the REH and models that are more backward looking. But it is also a bit simplistic, as it ignores the other reasons for the wild market swings during this period, such as monetary conditions, moral hazard and groupthink, as well as all the other psychological biases investors suffer from.

The book isn't helped by the fact that the authors succumb to the obsession in modern economics with complicated equations. Still, it's nice to see academic economists acknowledging that financial markets can, indeed, behave in irrational ways.

Advertisement
Advertisement

Recommended

Visit/spending-it/films/600911/theatre-review-the-visit
Films

Theatre review: The Visit

Friedrich Dürrenmatt's Swiss classic The Visit, transported to 1950s America, poses the question: how much would you kill for?
28 Feb 2020
Visit/519325/six-contrarian-books-for-christmas
Films

Six contrarian books for Christmas

Merryn Somerset Webb picks six of her favourite contrarian books to help you look clever and perhaps win a few arguments over the Christmas dinner tab…
9 Dec 2019
Visit/513323/coming-to-terms-with-anna-sorokin
Films

Coming to terms with Anna Sorokin

My Friend Anna: The true story of the fake heiress of New York CityWilliams is a solid writer who does a good job of explaining how she, and other int…
21 Aug 2019
Visit/513324/book-in-the-news-the-inside-story-of-spains-tumultuous-crisis
Films

Book in the news… the inside story of Spain’s tumultuous crisis

After the Fall Crisis, Recovery and the Making of a New SpainA book that goes beyond politics to offer a deeply sympathetic portrayal of a country.
21 Aug 2019

Most Popular

Visit/investments/property/601606/house-prices-crash-uk-property-prices-falling-where-next
Property

House price crash: UK property prices are falling – so where next?

With UK property prices falling for the first time in eight years, are we about to see a house price crash? John Stepek looks at what’s behind the sli…
2 Jul 2020
Visit/investments/stockmarkets/601611/nasdaq-all-time-high-markets-and-the-real-economy
Stockmarkets

How can markets hit new record highs when the economy is in such a mess?

Despite the world being in the midst of a global pandemic, America's Nasdaq stock index just hit an all-time high. And it's not the only index on a bu…
3 Jul 2020
Visit/economy/inflation/601584/the-end-of-the-bond-bull-market-and-the-return-of-inflation
Inflation

The end of the bond bull market and the return of inflation

Central bank stimulus, surging post-lockdown demand and the end of the 40-year bond bull market. It all points to inflation, says John Stepek. Here’s …
30 Jun 2020