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?