Are investors rational?

There has been, for some years now, serious disagreement in theoretical finance about the nature of investor decision making. In an upending of the usual formulation of Sayre’s Law, this particular academic argument is vicious, precisely because the stakes are so high.

There are two main sides in the debate. This is how a finance professor might respond, if a junior postgraduate student asked about it. Firstly, there is traditional finance, in which it is assumed that people make investment decisions in conformity with the von Neumann-Morgenstern axioms of utility theory, and Bayes’ formula. 

Secondly, there is behavioural finance. It assumes nothing of the sort. Instead, investors display Friedman-Savage double-inflection utility functions, and make decisions in accordance with Kahnemann-Tversky prospect theory. Oh, and they also satisfice (this is not a spelling mistake) under conditions of Simon (1957) bounded rationality. [Understand?—Student suddenly remembers urgent appointment, and makes a run for it.]

Have sympathy for that student: this explanation is useful only as an illustration of why he will probably spend his first postgraduate year wandering around campus in a semi-permanent state of dazed confusion. For our purposes, we’ll stick to plain English. The position in traditional finance: investors are rational. In behavioural finance: investors are their own worst enemy. 

In traditional finance, people are cold, calculating analytical machines. In the behavioural version of events, they are chaotic and emotional, and prone to a colourful collection of human failings. Investors are overconfident, excitable and lazy. Lots of things frighten them: regret, loss, change, doing statistics. They frequently make shockingly poor investment decisions.

Award round one to the behaviouralists. It’s pretty clear that their description of human nature sounds about right. But the traditionalists do not give up so easily. They say that individual irrationality may be rife in financial markets, but it does not reign supreme. Instead, there are forces that keep it in check, and even if market equilibrium is sometimes shattered, it is always restored. In other words, markets are efficient. Problem is, the academic evidence for market efficiency is famously ambivalent. So round two is a draw.

As for round three, there is one fundamental part of finance in which behaviouralists have, so far, failed miserably and unambiguously: they have no asset pricing models with the mathematical elegance of those in traditional finance.

So neither side has yet emerged as a clear winner. Thus, back in the real world, finance professionals are left applying an awkward hybrid of the two theoretical positions, and investment finance remains as much an art as it is a science.

By Prof Mark Bunting

Mark Bunting CFA, CA(SA) is an associate professor of finance at Rhodes University.

This column was originally published in Accountancy SA