NCPA - National Center for Policy Analysis

Stock Markets Are (Largely) Rational

June 28, 2002

Every time traditional financial theory is challenged, behavioral economists quickly declare markets irrational. However, research indicates some of most important market "anomalies" -- or seemingly irrational behavior of markets -- can be explained within rational market theory. Some of these seemingly irrational behaviors, and the rational explanation for them, are:

  • "Excess volatility" -- in which security prices supposedly fluctuate too much relative to their fundamentals (or underlying value) -- reflects the fact that investors have to adjust their behavior based on that of other investors.
  • The "risk-premium" (or equity premium) for bonds is too high -- a consequence of the volatility of security prices explained above.
  • "Calendar effects," of which the Monday effect is the most significant, usually implying that Monday is the worse trading day of the week; however, since 1987 Monday has been the best trading day.

The existence of irrational behavior is not enough to dismiss market rationality. The key issue is whether irrational behavior is large or important enough to be reflected in prices. Researchers say markets can be considered rational once we take into account two qualifications:

  • Sometimes a small group of investors can affect prices
  • Irrationality mainly takes the form of overconfidence, which in turns makes the market hyper-rational (too much information is reflected in prices).

Source: "Minimally Rational Markets," Economic Intuition, Summer 2001; based on Mark Rubenstein, "Rational Markets: Yes or No? The Affirmative Case," Financial Analysts Journal, May/June 2001.


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