Jonathan Davis: The truth on irrational investors

Markets may not be efficient but neither are we as investors entirely rational

The trouble with beautiful ideas, we are told by Ben Franklin, every American's favourite homespun philosopher, is that they tend to be murdered by a brutal set of facts. So it is with one of the most beautiful ideas that infect those who write and theorise about the way that markets work. This is the concept that markets are "efficient", in other words that they reflect the sum total of current knowledge about the value of a share or other kind of financial instrument.

Professor John Kay, who a few years ago produced the best work on corporate strategy I have yet read from a non-US author, sums up the status of efficient market theory neatly in his latest blockbuster offering, The Truth About Markets. "Most financial market analysis," he tells us "is still based on the efficient market hypothesis and more money will probably be lost by defying it than believing it." In other words, it is against the odds that any would-be investor who thinks they have found a surefire bargain that nobody else seems to have noticed have in fact done so. The chances are that the market knows more than you do.

"But that belief," he goes on, "should be tempered with scepticism." The American stock markets fell by more than 20 per cent in a single day in October 1987. On 15 July 2002, they fell by 5 per cent in the morning and rose by 5 per cent in the afternoon. Such apparently causeless bouts of volatility, says Professor Kay, cannot "possibly be explained by new information about company prospects".

At the same time, research suggests there is a statistically robust tendency for share prices to go up in January and down on Monday. No insider knowledge, he points out, is "required to establish that Monday follows Sunday and January follows December". And as for the great stock market bubble of 1999-2000, he says simply that it was a case of "irrational investors" being overwhelmed by what the academics like to call "noise traders", in other words those who "buy and sell stocks without knowledge or concern for fundamental values".

It is indeed hard for anyone looking back on that episode to conclude anything other than that markets are indeed gripped periodically by bouts of chronic inefficiency. Such speculative periods, Professor Kay argues, are not with their costs: it is simply not the case, as Milton Friedman once asserted, that speculative activity is defensible as a means of stabilising markets. While markets provide mechanisms by which financial risks can be shared effectively with others, there is no reason to believe that the price at which investments actually sell in the marketplace actually reflects what an omniscient observer, should such a person exist, might decide is their true value.

What financial markets do manage to do very effectively, as is evident every day of the year in the City, is to take advantage of the fact that we all adopt skewed attitudes to risk, often for temperamental reasons. In all investment booms, notes Professor Kay, money is raised cheaply from people who expect very high returns but do not in the end receive them. Investment bankers, he says, have become skilled in managing the issue process to appeal to "irrationalities" in the minds of potential investors – a comment that the continuing fallout from the excesses on Wall Street fully supports.

The volatility of stock markets creates its own larger risks for those who take part in them. "Talking heads" on 24-hour business channels encourage investors to make judgements about whether Cisco is a better bet than IBM, ignoring the fact that anyone who acts on such advice inevitably has to deal with another investor who thinks that the reverse is true.

There is much more in this vein when Professor Kay moves on to argue about the broader implications of a belief in the market as a policy instrument. His theme, which runs through the whole book, is that reality, sadly for those of a dogmatic tendency, is more complex and multi-faceted than the protagonists in the headline argument usually allow. Markets, he suggests, can be a powerful force for both good and ill.

Most of us, wrestling daily with the issue of how to invest our money, can afford not to take notice of this important conclusion. The concept of market efficiency leads us inevitably to entertain doubts about the ability of fund managers to outperform the market consistently over time, and to doubt our own ability to second guess the thousands of professionals who daily trade on the basis that in their view the price of X or Y security has diverged from its correct value.

Yet at the same time, it must not blind us to the reality that there will be times when markets conspire to produce results of breathtaking illogicality. The bubble of 1999-2000 was clearly one, but there are many others. A more recent example of how our emotions and the clamour of the crowd can lead us astray lies in investors' somewhat hysterical reaction to the tribulations being suffered by many with-profits funds.

The fact that most life assurers now impose a penalty on any policyholders who want to take their money elsewhere is greeted, not as a welcome defence of the remaining policyholders' long-term interests, but as a signal that they are somehow being cheated of what is rightfully theirs. Nothing could be further from the truth (though this is not to say that the policyholders might have put their money somewhere more sensible at the outset, which is a quite different issue).

The truth is, as Professor Kay suggests, that while markets may not be efficient, nor are we as investors entirely rational. Whether the markets create the irrational behaviour, or the irrational behaviour creates the inefficient markets, is one of those moot points that academics like to debate, but which need not concern us overly. Rationality still seems to point in the direction of a modest increase in stock market exposure and a lessening of exposure to bonds and property, but the prediction only holds in the medium to longer term.

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