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Robert Folsom

Robert Folsom

Elliott Wave International

Robert Folsom is a financial writer and editor for Elliott Wave International. He has covered politics, popular culture, economics and the financial markets for two…

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Irrational Market Bubbles: Are They "Post-Modern"?

Newsweek magazine recently ran an article with the headline "Mind Reading," and the subhead, "The new science of decision making. It's not as rational as you think."

The piece rehashes a bit of year-old news about an experiment conducted by economists at Princeton University, known as the Ultimatum Game. The game has two players and goes like this:

"Subject A gets 10 dollar bills. He can choose to give any number of them to subject B, who can accept or reject the offer. If she accepts, they split the money as A proposed; if she rejects A's offer, both get nothing.... A makes the most money by offering one dollar to B, keeping nine for himself, and B should accept it, because one dollar is better than none."

The rational choice is to accept the dollar, yet the outcome was consistently irrational:

"People playing B who receive only one or two dollars overwhelmingly reject the offer. Economists have no better explanation than simple spite over feeling shortchanged. This becomes clear when people play the same game against a computer. They tend to accept whatever they're offered, because why feel insulted by a machine?"

As I said, this story was in the news more than a year ago. The only new twist in Newsweek had to do with a scanning gizmo that apparently spots which region of the brain produces the irrational choice. Yet what got me was Newsweek's claim that this research will "help understand some of the most vexing problems in postmodern society," such as "irrational market bubbles." Now, I'm a big fan of science 'n'all. I really am. But ... we're supposed to believe that market bubbles are "postmodern"? HEL-LO!! Calling all search engines! Tulip Mania? South Sea Bubble? The panics of 1837, 1857, 1873? And wasn't there a little episode in 1929?

Another question: Were market bubbles in the good old days something besides "irrational"?

Irony and history aside, results from the Ultimatum Game and brain scan have noticeably excited the economists quoted in the article. In fact, Newsweek assumes that other economists who are not quoted must be equally excited:

"The new paradigm sweeping the field, under the rubric of "behavioral economics," holds that studying what people actually do is at least as valuable as deriving equations for what they should do."

Economists are just now getting around to studying the real habits of real people, instead of ... what, the potential behavior of conceptual people? That would make too much sense, if only the part about "sweeping the field" were true.

But it's not. Paul A. Samuelson's Economics -- first published in 1948 and in its 18th edition this year -- remains the most broadly used and influential economics textbook in history. He coined the phrase "efficient market hypothesis" (EMH), which propagates the idea of "rational" investors and "efficient" financial markets. Another economist later dreamed up a more user-friendly term for the EMH, the "Random Walk" - this emphasized a deeper assumption of the EMH, namely the absence of trends or patterns. Investors are supposed to believe that the market is utterly unpredictable, especially in the short term.

And during the very time when the Ultimatum Game first made the news, John Allen Paulos's A Mathematician Plays the Stock Market was a popular and widely reviewed book about the way markets work. The author of the best-selling Innumeracy, Paulos here told the story of how he lost money investing in WorldCom shares, namely by committing the classic emotional mistakes of a novice: He mistook hype for analysis, purchased a "hot" stock at an inflated price, and failed to have an exit strategy in place when his trade went south. Paulos also dove off the most emotional cliff of all by throwing good money after bad: He purchased more shares as the stock plummeted.

Yet in a book-length contemplation of his own irrationality and the inefficient price of WorldCom, did Professor Paulos embrace the "new paradigm"? Heck no. He endorsed Samuelson and the economics establishment, saying the EMH holds "most of the time," because "people believe it to be false and so, by their exertions, bring about efficiency."

Perhaps your own irrationality becomes easier to live with if it furthers your profession's meta-thesis? Why else risk appearing arrogant enough to presume that investors will read your explanation of how the market works, when your one attempt to trade a real stock in a real market rendered you emotionally identical to a compulsive gambler.

In any case, there you have it. Whether the behavior is rational or otherwise, it remains the "cause" of the same "effect" -- namely a stock market that is efficient, random, and unknowable.

An article in Newsweek can talk all it wants to about a new paradigm, but a real reporting job would have pointed out the fact that plenty of books and long papers and Nobel Prizes still prop up the old one.

If you doubt me, type "efficient market hypothesis" or "random walk" into Google. Search long enough into one of these beasties and you'll eventually scroll across some ghastly mathematical formula -- and we all know what a formula allows: Punch in the variables and get a precise outcome, which is exactly what a linear (or straight-line) thinker wants. Compared with a terrain marked by chaos, emotions, and irrationality, a cause-and-effect world is a far more comforting place to live.

The myth of rational investors and efficient markets has been seen for what it is by a generation of successful traders and technical analysts; in fact, their success depended on knowing that the OPPOSITE is true. This knowledge came by learning from their wins and losses with real money at stake, not by watching what subjects A and B do with dollar bills in a room in a game under controlled circumstances.

If experiments in ivory towers indeed validate the truth about irrational investors and inefficient markets, that's great. What they cannot legitimately call it, however, is "new science." This truth has always been obvious to anyone who sees real patterns unfolding in real markets.

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