Irrationality

The three mini-fictions in the last post are true stories during the Mississippi Bubble, revealing the madness of the public. There is no denying that the public should take responsibility for the bubble. Charles Mackay is the first one to show the whole story of Mississippi Bubble. He shows that psychological failings of investors may contribute to the bubbles, in his famous book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. The book is worth reading, as Ross Emmett says, “Mackay’s tale reaches further than the facts, but that should not stop us from enjoying it.” To read this book online you can click here. But I sincerely recommend buying it if you are interested in the book.

Kindleberger and Aliber (1996) suggest in their book, Manias, Panics, and Crashes: a History of Financial Crises, that it is the rationality assumption which is inconsistent with the reality (especially during the manias) that form the basis of economic theory. “Rationality is thus an a priori assumption about the way the world should work rather than a description of the way the world has actually worked”, they write. 

Robert Shiller (2005) indicates in his book, Irrational Exuberance, that psychological factor play a key role in irrational exuberance. They introduce two kinds of psychological anchors for the market, quantitative anchors and moral anchors. Quantitative anchors are used by some investors as indications of whether the share price is over-valued or under-valued and whether it is a good time to buy. Moral anchors are more complicated in my opinion. It is associated with measuring investors’ intuition and emotion.

What cause such irrationality?

Shiller argues the overconfidence and intuitive judgment of investors may be one reason. Investors think they know more than they do. Perhaps this is because of their self-esteem from my point of view. For some investors, it is more unbearable to admit their wrong predictions than to accept their loss, such as John Maynard Keynes (the story is told by Barton Biggs in Hedge Hogging). Shiller writes, “We have all observed at one time or another that there are a lot of know-it-alls out there”. However, in fact, if people say they are certain they are right, they are right only about eighty percent of the time shown by Baruch Fischhof, Paul Slovic, and Sarah Lichtenstein (Calibration of probabilities: The state of the art to 1980, 1982). Shiller presents three reasons which give rise to overconfidence, hinder-sight bias, magic thinking and representativeness heuristic. Investors with such ideas believe the world is predictable; it is time to take certain action which will bring their wealth; history is about to repeat. Thus, their overconfidence “plays a fundamental role” in speculative bubbles.
 

Herding is another reason to cause the irrationality. Shiller mentions, “The behaviour, although individually rational, produces group behaviour that is, in a well-defined sense, irrational”. This phenomenon may be generated by an information cascade. For example, suppose you want to have dinner in a restaurant, you find two restaurants in the street, one being full of customers while another empty. Which one will you chose, assuming you are full of patience and not hungry? Intuitively, you are more likely to choose the crowded restaurant because you obtain the signal that this one is more popular. However, the truth may be the first customer chose it randomly while others just followed the first customer’s choice. Another example is the bank run from Mary Poppins, shown as the following video.
 

 

 

In addition, Shiller points out that new media as a cultural factor may cause the irrationality. “The stock market also has star quality. The public considers it the big Casino, the market for major players, and believes that on any given day it serves as a barometer of the status of the nation—all impressions that the media can foster and benefit from”. News media is able to provide guidance in terms of cultivating a debate or reporting on the market outlook to investors, even though the guidance is inaccurate. Moreover, investors may be confused by the record overload which create obstacle for them to make correct decisions. Victor Niederhoffer (1971) who aims to find whether big stock price movements are related to news, in his paper, the analysis of world events and stock prices, defines a crisis as a time when more than five large headlines in the New York Times occurred within a week and find eleven such crises accompanied by big stock price changes from 1950 to 1966.

Recalling the stories during the Mississippi Bubble, it is apparent that the public is irrational. Can we conclude that John Law is innocent? The bubble is largely of the investors’ own making?  To find the answer, perhaps the better way is to ask the question: What causes bubbles? In the next post, we may find it.