Share markets are not individuals, and we should not attribute emotions and beliefs to them as if they were. Market behaviour is not simply individual behaviour writ large, and it can be misleading to think of the market as if it were.
Who best guesses other people’s estimation?
When people buy or sell shares they are often not trying to predict the future state of the economy. What they are instead doing is trying to anticipate others’ beliefs. If we expect others traders to be optimistic in future, we’ll buy now and if we expect them to be pessimistic, we’ll sell.
As Maynard Keynes famously said, investing is like the sort of newspaper beauty contest which was popular in the 1930s in which the winner is the person who best guesses other people’s estimation of the prettiest face: “It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
Why markets are like musical chairs
This means that share prices can be high and rising even if everyone believes there might be a crash in the future.
If I expect that others will continue to buy before the crash, I might buy because I believe that prices will rise sufficiently in the short term to compensate me the risk of a crash.
This can produce what Mark Watson and Olivier Blanchard (who went on to become International Monetary Fund chief economist) in 1982 famously called rational bubbles.
This is what Charles Prince, CEO of Citigroup meant when he said in 2007: "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance.”
In this way, it’s possible for intelligent traders to produce a stupid market – one in which shares are grossly over-priced (or, by the same reasoning in reverse) under-priced. The market can be irrational even though the individuals in it are rational.
Stupid people can produce rational markets
However, as Niels Bohr once said, the opposite of a great truth is sometimes another great truth. Just as smart people can produce stupid markets, so stupid ones can produce rational markets.
Some recent experiments by Yale University’s Shyam Sunder and colleagues have shown how. They created an artificial market on a computer in which half of traders were well-informed whilst half were ignorant and updated their beliefs about future prices using a simple rule of thumb. They discovered that in this market in which many traders, by design, had zero intelligence prices quickly converged to what they would have been if all traders were intelligent.
This, they say, shows that rational markets don’t require all traders to be sophisticated. Instead, efficient markets arise from market structure rather than from the characteristics of particular traders.
Lessons from the French fish market
This is consistent with studies of fish markets by Alan Kirman at the University of Aix-Marseilles.
He’s found that many individual traders do not buy more fish as prices fall; the first thing we learn in economics – that demand curves slope down – isn’t true. For the market as a whole, however, demand curves do slope down. Market stability, then, is a property of the whole market, not of individual participants.
You might think these two cases contradict each other. In a sense, though, they don’t. These are all examples of markets being emergent processes. Prices are the unintended outcomes of interactions between people. The behaviour of social structures such as markets is not necessarily the same as the behaviour of individuals within it.
This means that your view of human psychology need not be the same as your view of markets. You can believe that people are stupid but markets are efficient. And you can believe that people are rational but that markets are inefficient. And, in fact, depending upon the precise way in which markets and incentives work, you can believe that both will be true sometimes.