Field of Play
The myth of rational markets
In this post I propose to outline some of my thinking as to how the stock market works. The ideas come from various sources as I will explain.
The conventional view of the stock market is based on the premise that its participants are essentially rational. The problem with this is that the actors in the stock market are simply normal human beings who are neither fully rational nor completely selfish. The nature of humankind is explained by behavioral psychologists like Daniel Kahneman who has won a Nobel Prize in Economics.
Stock market as complex adaptive system
In 1987 a conference of physicists, biologists, and economists took place at the Santa Fe Institute. Robert Hagstrom writes: “The conference was organized in the hope that the ideas percolating within natural sciences, namely ‘the science of complexity,’ would help stimulate new ways to think about economics. Common to the study of complexity is the notion that complex adaptive systems operate with multiple elements, each adapting or reacting to the patterns the system itself creates.” (Hagstrom, Investing – The Last Liberal Art, 2000) P.63.
One of the most fascinating features of complex adaptive systems is feedback mechanisms.
Shiller writes: “In feedback loop theory, initial price increases … lead to more price increases as the effects of the initial price increases feed back into yet higher prices through increased investor demand. This second round of price increases feeds back again into a third round, and then into a fourth, and so on.” (Shiller, Irrational Exuberance, 2005 Second Edition) P.68.
He adds: “In the most popular version of the feedback theory, one that relies on adaptive expectations, feedback takes place because past price increases generate expectations of further price increases. In another version of the feedback theory, feedback takes place because of increased investor confidence in response to past price increases. Usually such feedback is thought to occur in response not so much to a sudden price increase as to a pattern of consistency in price increases.” (Shiller, 2005 Second Edition) P.69
And, as noted, feedback mechanisms are simple one of the features of complex adaptive systems.
The stock market as a complex adaptive system
Let me set out what I think is a reasonable working description of the stock market. It is a system that is: complex; adaptive; of multiple interacting agents; with some of its systems operating far from equilibrium; containing feedback loops; and, exhibiting the non-linearity of some interactions where small stimuli can cause a big impact all working in the same basic fashion as an ecosystem.
Some readers’ reaction may be “yikes”. It sounds very difficult. Can it be simplified?
Our human connection to sheep
Charlie Munger tells “a story of kids in a third grade class, they’re learning arithmetic. And the teacher says, “There are nine sheep in a pen and one sheep runs out of the pen. How many sheep are left? So you just raise your hand and say, “Eight.” She says, “Yes.”
And then a little kid raises his hand and he’s a farmer’s son and he says, “No, that’s not right” And she says, “What do you think the answer is?” He says, “The answer is none.” And she says, “I can see you don’t understand arithmetic.” He says, “I can see you don’t understand sheep.” Complexity Economics – Proceedings of the Applied Complexity Network – Proceedings of the Santa Fe Institute’s 2019 Fall Symposium. P.299.
Justin Fox quotes Henri Poincare the celebrated French mathematician and physicist who apparently had reservations about applying statistical mathematics to the human behavior. Poincare wrote: “When men are brought together, they no longer decide by chance and independently of each other, but react upon one another. Many causes come into action, they trouble the men and draw them this way and that, but there is one thing they cannot destroy, the habits they have of Panurge’s sheep.”
Fox tells us that Panurge was a character from Rabelais’s satirical Gargantua and Pantagruel novels, who got a flock of sheep to jump off a ship by throwing the lead ram overboard. (Fox, The Myth of the Rational Market, A History of Risk, Reward, and Delusion on Wall Street. 2009) P.7.
So, another way of explaining complex adaptive systems is to say that to understand sheep farming you need to understand sheep. To understand the stock market, you need to understand humans.
To make it all more understandable, let’s look at a couple of issues this raises.
Quants cannot model sheep
“With every level of abstraction you make your models prettier, but your link back to the actual world is further and further away.” Comment by Katherine Collins, Proceedings of the Santa Fe Institute’s 2019 Fall Symposium. p.303. For more on this see my post:
Naïve belief in arbitrage
Many quite sophisticated investors believe that arbitrage like an invisible hand swiftly brings prices back into equilibrium. These investors don’t reckon with Panurge’s sheep. For more on this see my posts:
In a brief blog post it is impossible to dig into complex adaptive systems deeply. The report on the 2019 Proceedings of the Santa Fe Institute’s Fall Symposium is over 300 pages. I hope that I have stimulated readers to learn more. Investing is more than a left brain exercise.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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