Professional Investor

FEATURE: NEW DISCIPLINES
(25% chance of winning
£1,000,000/75% chance of getting
nothing), humans tend to go with the
guaranteed thing. But when given the
choice of a sure and signifi cant loss
(£750,000) or a big chance of losing
even more (75% chance of losing
£1,000,000/25% chance of losing
nothing), humans tend to take the risk.
Th e lesson is that we are naturally
risk-averse with gains and naturally
risk-taking with losses, which can lead to
poor fi nancial decisions.
ADAPTIVE MARKETS
Until recently, such examples of
presumably ‘irrational behavior’ were
brushed under the carpet in virtually all
models of economics and markets.
Assuming that humans do behave
rationally works tolerably well often
enough that it is often considered a
reasonable approach. Besides, it has the
added benefi t of making us feel better
about ourselves – we all like to view
ourselves as cool, calm, collected and, of
course, rational.
“A sense of fairness is so important to
Most tellingly, the fundamental
bedrock underlying economics – the
Eﬃ cient Market Hypothesis (EMH) –
humans that it can trump personal
relies on the assumption of rational
behaviour by all market participants. Th e
fi nancial gain, sometimes resulting in lost
problematic assumptions made by the
EMH have been well documented
opportunities or even worse, self-infl icted
elsewhere, but it is worth noting three:
instantaneous access to perfectly correct
information, totally rational behaviour
monetary loss”
by all market participants and that each
price movement is totally independent of
all prior price movements. Why make
anything less equitable than splitting the pot about 70-30 is such obviously wrong assumptions?
considered unfair. Regardless of how the answer is
Th e lesson is that a sense of fairness is so important to humans worded, it usually boils down to:
that it can trump personal fi nancial gain, sometimes resulting in “without these assumptions, we could
lost opportunities or even worse, self-infl icted monetary loss. not do the maths”. Instead of describing
Other studies have shown that humans are rather contradictory markets and economies the way they
in their own risk appetites, often depending on how the question actually behave, followers of the EMH
is worded. For example, when told that a necessary medical want the markets to behave the way their
procedure has a 1% mortality rate, far more people decline than framework says they should.
when they are told that the same procedure has a 99% survival Fortunately, several areas of research
rate, which teaches us that our interpretation of risks is highly are showing promise in fi lling the gaps in
infl uenced by the framing of the situation. When given the choice the EMH and if successful, they may pave
of sure fi nancial gain (£250,000) or a chance at a bigger gain the way to a truly useful framework for
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32-3532-35 adaptive markets.indd 33adaptive markets.indd 33 1/6/091/6/09 11:56:0411:56:04Professional Investor Summer 09.35 35 4/6/09 15:40:59
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