The Emergent Rationality of Markets

Frogs and Philosophers

In Games People Play we alighted upon the germ of an idea that bears further investigation – that although individual investors may themselves be as mad as a box of frogs on mescaline their combined behavior can somehow result in relatively rational markets.  The idea is that, somehow, rational markets arise out of irrational traders doing stupid things.

Odd though this may seem as an idea the possibility of new properties emerging from systems made up of complex component parts isn’t new, although it does serve to make a lot of scientists and philosophers extremely annoyed.  Which is a good reason for pursuing the idea, is it not?

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Whither Forecasting? The Butterfly Stirs …

Weathered

Earnings forecasting is a triumph of accountancy over reality: given the complexity of most corporations an accurate forecast of earnings is logically, and numerically impossible.  Yet corporations guide and analysts analyse and, mostly, they all end up looking wise.

It’s all nonsense, of course.  The economy is a complex adaptive system comprised of billions of working parts.  The realistic chance of anybody predicting anything minutely accurate about anything of any interest is approximately zero, to several decimal points.  As any weather forecaster could tell you.

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Game On: Basel III

Bonfire of the Principles

The next set of banking regulations, aka Basel III, has arrived, albeit it'll be implemented one micro-step at a time. It has, of course, been accompanied by horse-trading of the kind that can only be done behind closed doors by an unelected and unaccountable body. After all, it’s not as though their actions will ever affect the rest of us, is it?

Regardless of what this shadowy group has decided the actual behaviour of the world’s financial community will continue to be cautious while the pain engendered by its latest fiasco remains large in the minds of its officers. Yet these memories will fade and animal spirits will once again take over, when Basel III will become, like its predecessors, an opportunity to be gamed, not a constraint on unethical behaviour. In the end we need less rules, more principles and better regulators.

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Complexity in Financial Systems

What's Complexity?

We can probably all agree that modern day financial systems are complex, but what that actually means isn’t something that everyone agrees on. Typically, though, a system characterised by complexity isn’t something that anyone’s designed – it emerges, it adapts spontaneously and it produces stunningly unexpected outcomes when no one’s expecting them.

Which, let’s face it, sounds a lot like modern finance. The problem is that many economists are focusing on how they manage this system when, in reality, it’s impossible to do so. It’s like trying to contain swine flu using a butterfly net.

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Capitalism Evolving: Be a Cockroach, Not a Dinosaur

Not Dying, Adapting

Many of the world’s most ardent free market economists would have us believe that the current wave of government intervention in markets heralds the end of capitalism. It’s not, because capitalism isn’t something you can kill, it simply adapts itself to the prevailing reality and carries on, regardless of economists and their ideas.

The proper metaphor for capitalism is evolution – which is ironic because Adam Smith’s invisible hand was one of the inspirations for Charles Darwin’s intellectual breakthrough, the theory of natural selection – a rare case of science imitating economics. Evolution, the process of life adapting to the complex changes in the natural world, is mimicked by capitalism, the process of markets adapting to complex changes in the financial world.

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Contrarianism

Don’t Drive The Wrong Way Up One-Way Streets

We often hear that it pays an investor to be contrarian but, in reality, what does that mean? Running against the herd is, in the real world, usually a desperately stupid thing to do – driving the wrong way up one way streets or wagering blindly against the odds on horseracing are not strategies that should recommend themselves to any even half-way rational person.

So if contrarianism doesn’t simply mean doing the opposite of what everyone else does but is, somehow, the key to successful investing, what is it? What’s the magic formula that tells us when we should and when we shouldn’t bet against the markets?

Beware, Faulty EMH Ahoy

Contrarianism is, in itself, an assumption that the Efficient Markets Hypothesis (EMH) doesn’t work. In reality most investors implicitly accept this, even while the majority of our academic institutions continue to operate as though it’s a natural law. It’s like teaching our kids that Creationism is correct while the professors work on gene therapy.

Just because EMH is faulty, though, doesn’t mean it’s easy to exploit it. Firstly markets do behave normally (in both statistical and common parlance) most of the time. Inefficiencies are either arbitraged away or are fundamentally difficult to exploit for smaller retail investors. In such times there isn’t much money to be made being contrary at a gross market level. Quite the opposite.

Secondly, when markets do go badly awry it’s usually because of some kind of crisis, the outcome of which isn’t easily predictable. These are the points at which expectations become divorced from fundamentals because it’s very difficult to know what the latter are. The trick, if you’re a contrarian, is to pick these points and then set yourself a sufficient margin of safety as markets overreact.

The Wisdom of Crowds

That markets do overreact tells us something interesting about the nature of humans: it suggests that somehow collective human rationality is being overcome by group effects. It also runs contrary to one of the fundamental tenets of EMH – that humans are not rational but because they act independently their irrationality cancels out.

Well, it’s perfectly obvious – given that markets do exhibit inefficiencies, and sometimes for quite a long time – that this assumption must be flawed. The question is why is it flawed and how does this help us become better, contrarian, investors?

This assumption of irrationality being cancelled out underpins the concept of the Wisdom of Crowds, so smartly summarised by James Surowiecki in his eponymous book. The phenomenon was first noted by Frederick Galton back at the beginning of the twentieth century and essentially suggests that as long as people act independently of each other the sum of their guesses can produce a better result than any individual guess – aka the EMH.

Counterintuitive this may be, but it seems to be broadly correct. The key is that the individuals must genuinely be acting independently. Dependencies may be hidden – so, for instance, asking an indigenous population for their views on immigration won’t yield an independent result in a blind vote because voters will already have shared views based on a whole variety of social factors.

(Although, interestingly, research suggests that the type of immigrants you’ll be against will depend on your own economic self-interest.)

Complex Emergent Systems

In stockmarkets, of course, we don’t have a blind vote. The prices of shares indicate the current state of investor belief and we often find examples where shares have been marked up or down to an extent that doesn’t seem to make sense unless there’s some inside knowledge at work or investors are being driven by group effects.

The shape of these behaviours is similar to the type of outcomes seen in a class of systems known as complex adaptive systems. In these the outcomes – the behaviours – are “emergent” and arise out of the interactions between the various agents acting within the system. The agents in the stockmarket are, of course, the humans and the interactions are all of those numerous information flows between us. Everything from tipsheets to bulletin boards to analyst recommendations and even share prices themselves.

Emergent systems are brutally complex – you can’t understand them by the classic process of reductionism, breaking everything down into its constituent parts. Ask any human what’s happening in the markets and they’ll basically have no idea (although virtually every investor will have an opinion) yet the overall market behaviour emerges from the interactions between the human investors.

Contrarianism and Timing

If you accept that modelling stockmarkets based on complex adaptive systems seems to make sense then the next step is to figure out when it pays to be a contrarian. Clearly most of the time markets – at the gross level – are fairly efficient. Yet sometimes they’re not – the output of the adaptive system goes awry. So what’s happening?

It’s the idea that underpins the Wisdom of Crowds that’s being violated – investors stop behaving independently and irrationally and start behaving dependently and irrationally. It’s not the irrationality that’s the problem, but the interdependence. Can this happen? You’d better believe it.

Social psychology is full of examples showing individuals aligning their responses with the group even when the group’s view is clearly wrong going back to the Asch conformity experiments in the 1950’s. We have a powerful inclination to want to be part of a group – for good evolutionary reasons since being part of a group, no matter how stupid, misguided and irrational, provides us better protection than being correct, lonely and likely to be eaten by the next hungry carnivore that happens along.

Peak Fear and Greed

Unfortunately being contrarian at the market level is awfully difficult. When these periodic breakdowns in market efficiency occur the group effects will be at their maximum. You’re looking at moments of peak greed and fear, the very points at which herd behaviour is the most rational for socially organised creatures in a dangerous environment.

A second problem, which dogs the professional investment industry in particular but which is also an issue for individual investors, is that contrarianism, even when correct, takes time to work. Rationality doesn’t reassert itself overnight and markets can, as Keynes is famously misquoted as saying, “stay irrational longer than investors can stay solvent”.

The fund management industry faces real issues with this. Fund managers have a short-term need to generate fees, which mitigates against taking a longer term approach to generate better fund returns. They’re also incentivised to be successful in the short-term, with both bonuses and their jobs on the line. In such an environment it’s hard to see how fund managers can be contrarian.

For individual investors the problem is being able to divorce themselves from the social group effects sufficiently to be able to take advantage of market breaks. It’s also all too easy to get sucked into the idea that going against the market is good for its own sake. It’s not, it’s dangerous. A stock may be cheap because it’s fallen a long way, but it may not be – a stock that’s fallen 99% can still fall another 100%.

Go Long Term, Contrarian or Not

Deciding when markets are being irrational is, in part, a judgement call and in part down to detailed analysis. Even when markets are in their normal, nearly rational mode, longer term contrarian investing opportunities will arise with specific companies, usually smaller ones. This is the normal warp and weft of value investing which you don’t get right without proper fundamental analysis and a judgement about a margin of safety.

The alternative to contrarianism is, of course, to simply ignore short-term oscillations in the market and to invest through thick and thin. Regular drip feeding into passive funds will, in fact, capture some outperformance due to the larger stakes bought while markets are unduly pessimistic – although this advantage will partially be removed by also buying at overly optimistic times. Still, it’s a simple strategy if you don’t want to risk your mortal sole on being contrarian.


Related Posts: Don’t Give Index Trackers The Bird, Alpha and Beta: Beware Gift Bearing Greeks, Darwin’s Stockmarkets, Is Intrinsic Value Real?

Darwin’s Stockmarkets

Reagan's Revolution

Ronnie Reagan, when asked for his beliefs about the Theory of Evolution, shrugged and replied; “Hey, it’s only a theory”. Which it is, I guess, in the same way that the Theory of Gravity is “only a theory” although somehow I doubt my pet dog will start exhibiting signs of weightlessness anytime soon. In fact Darwin’s great intellectual jump wasn’t evolution itself but an insight into what underlay the concept – an idea applicable to financial markets and sobering in what it suggests about our ability to predict anything, let alone something as complex as the screamingly mad world of finance.

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