According to efficient market theory, people are only interested in one thing - making money.
They will only buy an asset if they think there's a decent chance of making a good future return. They'll only sell when this stops being the case.
Because investors are rational', they won't buy overvalued stuff. And they won't sell undervalued stuff. So prices will almost always be about right.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
This is utter nonsense, of course. But not for the reasons you might think. People aren't always rational, but they generally try to invest to make a profit.
The real reason that markets get things so badly wrong is because the people investing on your behalf, don't always care about your profits. And that's yet another good reason to take charge of your own finances rather than handing the job to a fund manager.
Let me explain
People are rational but markets aren't
Efficient market theory has never made much sense.
Recent history proves that. Two catastrophic stock market crashes inside 10 years. A devastating global property bubble. Today's burgeoning bond bubble. None of this is evidence of an efficient market.
And it's hard to believe that anyone beyond the most isolated ivory towers in academia takes it seriously these days.
The reason the theory has survived so long is because it provides a convenient, clever-sounding rationale to excuse the self-serving behaviour of everyone involved in investment markets.
Central bankers, for example, argued that if markets were efficient, then bubbles couldn't exist (because prices would always be correct). So who were they to puncture them?
They ignored the fact that the very existence of a central bank, which sets the most important price of all (the price of money), destroys the idea of an efficient market. Especially if the central bank only ever acts to prop up falling asset prices.
But it's not just central bankers who are the problem. It's the people we pay to manage our money for us. The FT's John Plender has written an interesting piece on a new paper by Paul Woolley and Dimitri Vayanos of the London School of Economics.
The problem, say Woolley and Vayanos, is "information asymmetry". What this boils down to is that when you give your money to an intermediary to invest on your behalf, the incentives change.
These intermediaries "act rationally in the pursuit of profit but not necessarily the profit of the ultimate beneficiaries [the actual investors]".
To understand how this works, let's take the process of selling a house. You take on an estate agent who reckons he can sell your house for £325,000. You agree a fee of 1.5%.
You might think that the agent will be just as motivated as you are to get the best price possible. But think about it. 1.5% of £325,000 is £4,875. 1.5% of £300,00 is £4,500.
That extra £25,000 on the price makes a massive difference to you. But for the agent? Sure, he'll take the extra £375 if he can get it. But if push comes to shove, he'd almost certainly rather have a sale in the bag at £300,000 than stick it out for £325,000.
In effect, by delegating the sales process, what's rational' has changed. It is rational for you to seek the best price you can get. For the agent, it might be more rational to put in enough effort to get a reasonable price, then convince you to settle for it.
The City is more rapacious than a pack of estate agents
To be fair to estate agents (that's a phrase I don't use very often), the skewed incentives in the financial markets can be far worse.
Fund managers make money by increasing their assets under management. The more money they manage, the more money they make. Being able to demonstrate a decent track record is only one small aspect of attracting new money.
More importantly, to avoid losing clients, you don't have to be the best manager. You just have to avoid being the worst. So there's a huge incentive to stick "close to the fund management herd", as Plender puts it. It doesn't matter if you lose money for a client, as long as everyone else is losing at least as much.
Throw all this into the mix, and it's no wonder that markets are anything but efficient. You have an entire group of intermediaries who control the majority of the money in the market, investing on the basis of what all the others are doing. Notes Plender: "it seems probably a majority of equity investment is carried out without regard to the value of the equities being traded."
In other words, the irrational' behaviour in markets is nothing to do with people as a whole being irrational. The real problem is that we hand the job to a financial industry which is more interested in its own profits, than in our returns.
This is why it's worth taking charge of your own money. Because not only do you get to cut out the middlemen. You can also take advantage of their herding behaviour, by buying the assets that they are neglecting, and avoiding the ones that they are piling into.
If you want to learn more about investing for yourself, sign up for our MoneyWeek Basics email. It's a free twice-weekly series of around 50 emails that will clearly explain all the investment concepts you need to know to take charge of your own money. You can sign up for it here.
PS Still searching for the perfect Christmas present? How about lunch with MoneyWeek editor-in-chief Merryn Somerset Webb? And better yet, the money raised all goes to a good cause. But hurry you've only a few hours left to bid click here to find out more.
-
British Airways revamps Avios scheme bringing down flight prices to £1With the new Avios part-payments scheme you can now bag a British Airways flight for as little as £1
-
RBS to close a fifth of branchesRoyal Bank of Scotland plans to shut 18 branches across Scotland, resulting in the loss of 105 jobs. We have the full list of closures.
-
As global powers fight it out, commodity prices are set to rocketAnalysis Commodity prices have been held down by globalisation. This trend is now rapidly reversing.
-
Is gold cheap relative to equities?Analysis Dominic Frisby looks at the Dow-gold ratio and explains why gold is starting to appear inexpensive compared to equities.
-
Are UK house prices set to fall? It’s not so simpleAnalysis Figures suggest UK house prices are starting to slide, but we shouldn’t take these numbers at face value, explains Rupert Hargreaves.
-
Are we heading for a commercial property crash?Analysis The pandemic has reduced the demand for office spaces and permanently changed the office environment. But John Stepek says rising interest rates are a bigger threat to commercial property right now.
-
Tesco looks well-placed to ride out the cost of living crisis – investors take noteAnalysis Surging inflation is bad news for retailers. But supermarket giant Tesco looks better placed to cope than most, says Rupert Hargreaves.
-
It may not look like it, but the UK housing market is cooling offAnalysis Recent house price statistics show UK house prices rising. But John Stepek explains why the market is in fact slowing down and what this means for you.
-
Think the oil price is high now? You ain’t seen nothing yetAnalysis The oil price has been on a tear in recent months. Dominic Frisby explains why oil in fact is still very cheap relative to other assets.
-
What can markets tell us about the economy and geopolitics?Sponsored Markets have remained resilient despite Russia's war with Ukraine. Max King rounds up how reliable the stockmarket is in predicting economic outlooks.
