Never expected this. Yeah, right… whatever!

By Stephen Rollings, a Master of Business Administration student

We human beings are irrational. If I were to ask you what value you would place on a sandwich, your answer would not be based on the attributes of the sandwich alone. How much you value the sandwich will be influenced by the price of other sandwiches, the availability of other lunch options, what other people are eating and prepared to pay, and what else you have been exposed to directly before I ask you the question. If I then ask you to explain your evaluation you will come up with some delusional reason as to why you valued the sandwich how you did, when in reality it is unlikely you understand the real reasons for our behaviour.

When we look at financial markets the irrational nature of our behaviour is clear to see. The regularity with which speculative bubbles have formed and subsequently burst is well articulated by authors such as Robert Schiller. The relatively young yet fast growing field of behavioural finance studies the effects of psychological, social, cognitive and emotional factors on the investment decisions of individuals and institutions.

The research in behavioural finance brings in to question the underlying assumptions of Efficient Market Hypothesis (EMH), that markets are rationale and informational efficient and consequently that one cannot consistently achieve above average market returns on a risk adjusted basis. Well it turns out the research tends to suggest that both are true and that while asset prices tend to behave rather irrationally, changes in market prices do tend to be random as a result of new information. We can try and predict future price changes with our models however ultimately changes in asset prices will vary randomly go through large swings in valuations.

The premise that market price changes in finance are random is in stark contrast to the basis for operating in other fields such as Physics. In Physics and other “hard sciences” the starting premise is that everything happens for a reason and can be predicted (the Law of Cause and Effect). This concept is traceable through Hebrew, Babylonian and Greek civilisations and became a fundamental principle of science in the 16th century. The prominence of the presumption of causality is greater in what are colloquially known as the “hard sciences” given the nature of the subject matter lends itself to more general and consistent rules – think of constants in our everyday life such as gravitational or centripetal force. As such the applications of experimental design and scientific methods to effectively isolate the variables that may influence an outcome is easier and consistent rules and conclusions can be reached from the data.

If we contrast these physical phenomena to something as complex as human behaviour we can see the challenges in being able to confidently and accurately predict an outcome. How someone acts will be dependent on their own attributes (such as values and personality), the situation they are confronted with, including the information presented to them and how it is presented, and the other factors in the environment around them. Once we consider all of these variables and the innumerable interactions between them we have an extremely complex system.

Now consider the complexity of the global financial system and the ridiculous magnitude variables at play in financial markets. To think that one can predict the outcomes of such complexity is completely irrational. The Global Financial Crisis (GFC) is an example of major implications rippling through an interdependent and highly complex financial system. While such a specific event itself is not predictable, we delude ourselves in hindsight that we could have predicted it and fail to appropriately setup our systems to deal with the future unpredictable, rare events that will no doubt occur. Not another GFC similar to what occurred before but another, different, significant and rare event with huge impact.

Nassim Nicholas Taleb writes of these Black Swan events and our failure to learn from them. The failings of the financial practitioners and community are not that we cannot predict events such as the GFC but that we fail to adjust to their existence. In finance we focus on what the average returns, the most likely outcome, the normal, which can sometimes be irrelevant. However, what is more consequential is the rare events, those that we need to acknowledge that we probably can’t predict but can accept and plan for.

As humans we are irrational and tend to overestimate our explanatory capabilities and believe that we can explain the past therefore the future is predictable. The truth is that in complex environments we cannot predict what will occur and it is irrational to think otherwise. When it comes to predicting the future of asset prices we are all in the same boat together and we can’t get away with a free lunch.

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