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

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

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
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.

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

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/601065/what-does-the-coronavirus-crisis-mean-for-uk-house-prices
Property

What does the coronavirus crisis mean for UK house prices?

With the whole country in lockdown, the UK property market is closed for business. John Stepek looks at what that means for UK house prices, housebuil…
27 Mar 2020
Visit/economy/uk-economy/601063/the-uks-bailout-of-the-self-employed-comes-with-a-hidden-catch
UK Economy

The UK’s bailout of the self employed comes with a hidden catch

The chancellor’s £6.5bn bailout of the self employed is welcome. But it has hidden benefits for the taxman, says Merryn Somerset Webb.
27 Mar 2020
Visit/investments/commodities/gold/601037/gold-is-on-a-wild-ride-so-should-you-be-buying
Gold

Gold is hard to find right now – so should you be buying?

With demand through the roof and the physical metal hard to find, it's not the best time to buy gold. But right now, says Dominic Frisby, you want to …
25 Mar 2020
Visit/investments/stocks-and-shares/share-tips/601035/share-tips-of-the-week
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
27 Mar 2020