Irrationally rational or rationally irrational?

Posted by on December 22, 2011 @ 8:15 am in Investing

I remember first being introduced to the concept of market efficiency during business school. At the time, I was working for a large Wall Street firm in close proximity to the equity trading floor. As I thought about the precision with which market efficiency was being described in class and contrasted that with the controlled chaos of the trading desk, I couldn’t quite reconcile the two.

As the years have passed, I’ve had more opportunities to learn about financial theory, as well as observe how people make financial decisions in general, and investment decisions in particular. I still struggle with how markets can be efficient when people are involved!

As it turns out, two new books address this very conflict. The first, Thinking, Fast and Slow by Daniel Kahneman, suggests that humans are irrational. Kahneman, a psychologist by training, won the Nobel Prize in economics in 2002. He challenges one of the key tenets of economics—that humans are essentially rational. The book’s premise is that we, as humans, have two minds: One that is quick and intuitive (System 1), and one that is deliberative and rational (System 2). According to Kahneman, we rely on System 1 more often than not. This, of course, has interesting implications for how we “interpret” the world around us and ultimately make decisions.

The second book addresses our tendency to put too much faith in quantitative financial models. Models Behaving Badly is written by Emanuel Derman, the former head of quantitative analysis at Goldman Sachs. Derman’s premise addresses our tendency to put the same amount of faith in financial models as those based on the laws of science. Whereas the latter are good measures of reality, the former are less so. According to Derman, most financial models “fail to reflect the complex reality of the world around them.” It’s intriguing to think about the role financial models have played in the markets over the past five years. They work until they don’t work (remember subprime mortgages?). To be honest, we do employ several models at Vanguard when we think about measuring risk in a portfolio or forecasting future capital market returns. We always do so, however, with a healthy dose of humility about what they can—and cannot do.

If there are other books or articles you’ve found of interest on this topic, please feel free to share.

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