Nonrational Actors and Financial Market Behavior

Abstract

Are financial markets efficient? Do their participants behave rationally? Does a positive answer to the second question imply a positive answer to the first? And vice versa? These remain open questions despite decades of effort by economists and numerous claims that the issues have been resolved. Financial markets are extremely competitive (with near-instantaneous price adjustments and little room for strategic behavior), with virtually no externalities from participants' actions. Under such conditions, individual rationality can aggregate to collectively efficient outcomes. A body of work developing this view was honored by the Nobel Committee in Economics when it awarded its 1990 prize to modem finance's pioneers, Harry Markowitz, Merton Miller, and William Sharpe. But does this paradigm capture most financial market behavior? Clearly, some of the participants in financial markets do not act with perfect rationality; that is, they make mistakes.' But more astute players stand ready to capitalize on their mistakes-for example, to buy when panic leads to speculative market crashes, to extract I /8s and l/4s from individuals who trade in and out in the mistaken belief that they can beat the market, or to take positions to bring mispriced stocks into line. Given this sort of "poaching" (which includes arbitrage), the collective outcome may be indistinguishable from the one that would result if all participants behaved with perfect rationality. Consequently, one might expect to find few instances of nonrational financial behavior at aggregate levels. But then how can we account for speculative fads, from the Dutch tulip mania of the seventeenth century to the rash of junk bonds in the 1980s (see Shiller, l989)?2 Equally puzzling is the crash of October 1987, which reduced the stock market's value by onethird, although no significant bad news had broken. Such events hint that the rationality paradigm may not be universally applicable, but since each case is unique in important respects, their true cumulative significance is difficult to interpret. Academic attempts to identify inefficient aggregate behavior, or to refute the assumption of a rational representative agent, have focused predominantly on asset prices. Shiller' s (1981, 1For our purposes, a nonrational or irrational agent is simply one who differs from the neoclassical homo economicus prototype characterized by Von Neumann-Morgenstern utility, optimal expectatIons. Bayesian updating rules for probability revision, and so on. The qualifier behavioral.' in our paper, is interchangeable with "nonrational,' and carries no pejorative connotations. 2Bad overall outcomes can result from good individual choices as well as from poor ones. In this spirit, the economist explains various undesirable social phenomena, from unemployment to traffic congestion. a,s collectively suboptimal outcomes that result 1mm rational individual choices (Sehelling, 1978).

Temporal Changes in the Determinants of Mutual Fund Flows

“…Several variables other than returns may affect current fund flows. Zeckhauser, Patel, and Hendricks (1991) demonstrate fund‐flow autocorrelation, finding prior‐year fund flows to be the most significant regressor in explaining current‐year fund flows. They also document that dollar fund flows are directly correlated with fund size.…”

“…These studies concentrate on the relation between fund flows and prior‐period performance for equity mutual funds. Zeckhauser, Patel, and Hendricks (1991) look at a sample of no‐load funds from 1975 to 1987. They find that current‐period fund flows are a linear function of prior‐period fund flows, prior‐period raw and ranked returns, and fund size.…”

“…The asymmetric flow‐performance relation is also consistent with several psychological models of investor behavior, which attribute irrationality to individual investors. Zeckhauser, Patel, and Hendricks (1991) point to status‐quo bias—the tendency to stick with strategies already adopted. Kahneman and Tversky (1982) cite regret aversion, which causes investors to regard errors of omission less seriously than errors of commission.…”

Room to Move: International Financial Markets and National Welfare States

“…See Feldstein and Horioka 1980;and Obstfeld 1993. 38 See Shiller 1989;and Zeckhauser, Patel, and Hendricks 1991. 44.…”

Investors’ distraction and strategic repricing decisions

“…12 To the best of my knowledge the issue of autocorrelation of flows first appeared in the works of Zeckhauser et al (1991) and Patel et al (1994). More recently the issue has been addressed by Fant and O'Neal (2000) and Cashman et al (2007).…”