Here’s why the market is irrational – it’s the City’s fault

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.

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.

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