When it comes to investing, I’ve always been a fan of the Efficient Market Theory.  For those unfamiliar, the Efficient Market Theory states – in short – “you get what you pay for” when buying stocks.  Expensive stocks are priced high, because they’re worth a lot.  Cheap stocks are priced low because they’re not worth very much.  The current price of each equity perfectly reflects the equity’s true value based on all the information available to the market.

This style of investing has always led me to invest in broad index funds looking for capital appreciation at a steady rate over time, or in individual companies that I think will go on to do great things in the future over the long term.

However, recently, I’ve been scrutinizing my approach.

The corner stone of the Efficient Market Theory is human rationality.  For the theory to work, all investors must purchase stocks for rational reasons – such as material information about a company that would influence the value of the company’s stock.  On average, a large enough pool of perfectly rational investors will price each equity in accordance to its true value.

The problem here is that humans are not perfectly rational.  This certainly shouldn’t be a surprise; irrationality is all around us.  From smoking cigarettes to gambling, it’s clear that people will act irrationally when presented with an immediate and short-term benefit.

How does this irrationality present itself when it comes to investing?

The more I think about it, the more it seems that the concept of “perfect rationality” is an oxymoron.  If any investor were perfectly rational, they would sit around all day trying to decide what to do.  Such a rational individual would be crippled, unable to act at all.  How could you possibly ensure 100% maximization of utility in the face of so many possible trades?

Recognizing the problem with perfect rationality – it now seems somewhat attractive to act irrationally when making investing decisions.  If you know that it will take you an infinite amount of time to make the absolute rational decision (and hence be rendered action-less), it then seems logical to short-cut rationality.  That is, consider an investment option for a limited amount of time and then make a decision.  In this scenario, I would argue that it is actually rational for us each to act irrationally – and make decisions before we have pegged down the absolute 100% rational choice.

Because, I argue, it is actually rational for investors to act irrationally – it seems that there may be a few cracks in the Efficient Market Theory after all.

Thoughts?

Investing with Perfect Rationality
  • Dadio

    Hey Drew, good post. In a previous comment on one of your posts, I mentioned the “decision tree”. You replied with some version of it I had not seen. So, it never went anywhere. This post reminds me of one of the lessons I have learned from it so it may be worth revisiting.

    Basically, we all use both rational and emotional skills when making decisons. We start with our rational skills, once a problem or opportunity presents itself, but after exhausting ourselves thinking we fall back on our gut to finish the job. In selling, it’s important to know when your prospect makes that shift because one must change from emphasizing the rational aspects of ones product or service to emphasizing the emotional elements that will close the sale.

    There is much more to it but your post, today, reminds me of how ubiquitous the “decision tree” is and how useful it’s lessons can be for us in everything we do.

  • Simon Dexter

    Andrew,

    I wonder how seriously the stock market is influenced by the high frequency trading? It seems that a good deal of volume in transactions could be attributed to robot-based activity. Perhaps it somewhat undermines the rationality we all expect in valuation of stocks?

    It be interesting to know your thoughts…

  • High frequency trading doesn’t have much of an impact on stock prices.

    The EFT is obviously false, and is trivial to demonstrate.

    There are, however, strong and weak versions of the Efficient Market Hypothesis. The “strong” version states that all information about a particular stock is known the moment that any one investor knows i.e. the market price contains all possible available information. Or, insider trading is impossible.

    The weak form just states that a stock price factors in all publicly known information.

    The problem with all forms of the EFT is that it assumes that there is no transaction cost to communicating information. Given the work that some of us have to do to shuffle information around or communicating a point to someone else, that seems … improbable.

    Index funds are still your best bet.

    Also, avoid financial advisors.

    http://www.samefacts.com/2012/03/financial-crises/think-twice-about-that-financial-advisor/

  • Andrew

    Simon,
    My POV is that High Frequency Trading must do something to stocks – whether it simply adds liquidity – or actually adds efficiency, i’m not sure.

    Some would argue that the increase in use of high frequency trading leaves us especially prone to “black swan” events (events that have never occurred before and therefore have not been factored into the high frequency algorithms).

    In the end, I think I agree with Michael that the best bet is always Index funds.

  • Well, I agree that HFT significantly increases volatility, and in certain situation you can have massive distortions in stock price when a feedback loop commences. You can probably set up some standard rules to cut out a large swathe of those possibilities.

    Most of the time, they just reduce arbitrage opportunities, i.e. make prices more accurate. Which, broadly speaking, is a good thing.