Rational Markets: Yes or No? The Affirmative Case Mark Rubinstein With the recent flurryof articles declaiming the death of the rational market hypothesis, it is well to pause and recall the very sound reasons this hipothesis was once so widely accepted, at least in academic circles. Although academic models often assume that al investors are rational, this assumption is clearly an expository device not to be taken seriously, What 's in contention is whether markets are "rational " in the sense that prices are set as if all investors are rational . Even if markets are not rational in this sense, abnormal profit opportunities still may not exist. In that case, markets may be said to be "minimallyrational." I maintain that not only are developed financial markets minimaly rational, they are, with two qualifications, rational. I contend that, realistically, market rationality needs to be defined so as to allow investors to be uncertain about the characteristics of other investors in the market. I also argue that investor irrationality, to the extent that it affects prices, is particularly likely to be manifest through overconfidence, which in turn, is likely to make the market layper - rational." To dlustrate, the article reexamines some of the most serious historical evidence against market rationality. n November 1909, at a program puton by the imply that investors act as though they maximize Berkeley Program in Finance at the Silvarado expected utility using subjective probabilities, In Country Club in California's Napa Valley, I addition, rationality requires that these subjective was charged with debating Richard Thaler, probabilities be unbiased, I confess to finding this oneof thefounders of behavioral finance. Theissue definitionof rationality somewhat vague, but I take was "Rational Markets: Yes or No?" It struck me it to mean that if we were able to run theeconomy then, as I tried to marshal the arguments in the over and over again, as set returns would trace out affirmative, how far modern financial economics has come unstuck fromits roots. Eversince research a realized frequency distribution and an investor's supporting market irrationality became respect- subjective probabilities are "unbiased" if they are able, perhaps dating from the June/ September the same as these frequencies. 1978 issue of the formal of Financial Economics, our On the one hand, this definition of rationality profession has forgotten the good reasons the affir. is even more restrictive than is sometimes meant mative proposition was once so widely believed. because it insists on more than rational means; Seemingly every day, some new "anomaly" is using it, rather, implies an entire rational probabil reported that drives yet another nail into the coffin ity distribution. These days, any good derivatives of the rational market hypothesis. The weight of theorist knows that unbiased means are not cuffi paper in academic journals supporting anomalies cient for rationality because options can be used to is now much heavier than evidence to the contrary. profit from even the slightest mistakes in as serving Old enough to remember and respect the "old probabilities." On theother hand, I do not want to school," I was asked to present this forgotten case. define "rational" so narrowly as to say that it pre- Thaler and I agreed to interpret "rational" to cludes unresolved differences of opinion or that it mean that investors follow the Savage (1954) axi- precludes investors being uncertain about what coms (a set of rational precepts such as the transitiv- other investors are like. Rationality means "know ity principle-that is, "if A is preferred to Band B to C, then A will be preferred to C"). Theseaxioms thyself" but not necessarily knowing others. Types of Market Rationality Mark Rubinstein is Paul Stephens Professor of Applied Let me suggest the following categorization as a twovestment Analysis at the University of California at convenient way of thinking about what will be Berkeley. meant here by "rationality in markets": May/June 2001 15Financial Anulys ts journal Maximally Rational Markets. 1 define mar- kets as \"maximally rational" if all investors are rational. If markets were maximally rational, inves tors would probably trade relatively infrequently and would make intensive use of index funds. Although most academic models in finance are based on this assumption, I believe financial econ- omists do not take it seriously. Indeed, they need only talk to their spouses or to their brokers to (now it cannot be true. Rational Markets. What is in contention, "towever, is whether markets are simply \"rational,\" 'n the sense that asset prices are set as if all investors are rational. Clearly, markets can be rational even 'f not all investors are actually rational. So, in a ational (but not maximally rational) market, inves- :ors may trade too much or fail to diversify enough :or their own good. These matters are not in con- :ention here, and in fact, I do not dispute them. In ational markets, money managers acting in the 'nterests of their clients work to correct their own and their clients' irrational investment choices. Minimally Rational Markets. Even if we decide markets are not rational, they may still fail to supply opportunities for abnormal profits. For example, if you tell me that markets are irrational because prices are too volatile relative to funda mentals or that closed-end funds sell at discounts, there may be no way I can use that information to make profits. If you tell me such-and-such stock is overpriced but there are significant obstacles to short selling or significant costs to trading the stock, again, I may not be able to do much about the opportunity. In these cases, I say that although markets are not perfectly rational, they are at least \"minimally rational\"; that is, although prices are not set as if all investors are rational, nevertheless, no abnormal profit opportunities exist for the investors who are rational. If markets are only minimally rational, investors will be more easily misled into thinking they can beat the market, and it then becomes even more important for money managers to give sound advice. As I discuss various anomalies, I will address which kind of market rationality they contradict. Clearly, the most interesting anomalies will be those that show the market is not even minimally rational. The Prime Directive When I went to financial economist training school, I was taught the \"Prime Directive\": Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior. That is, as a trained financial economist, with the special knowledge about financial markets and sta- tistics that I had gained and aided by the new high- tech computers, databases, and software, I must be careful how I used my power. Whatever else I did, I should follow the Prime Directive. The burgeoning behavioralist literature indi- cates that many behavioral finance economists have lost all the constraints of this directivethat whatever anomalies are discovered, illusory or not, behavioralists will come up with an explanation grounded in systematic irrational investor behav- ior.3 But this approach is too easy. For example, if we discover that asset prices exhibit reversals (sur prise of surprises), the behavioralists say the cause is the documented tendency of individuals to over react to recent events. Of course, that explanation could be true, but to believe it requires that we extrapolate from studies of individual decision mak- ing done in narrow and restricted conditions to the complex and subtle environment of the security markets. The explanation also smacks too much of being concocted to explain ex post observations much like medievalists used to suppose that a dif- ferent angel provided the motive power for each planet. And then, when we discover that price reversals occur in the short run, momentum in the intermediate run, and price reversals again in the long run, behavioralists find some more convo- luted way to explain that pattern based on irrational behavior (reminding me of Ptolemaic epicycles). In short, the behavioral cure maybe worse than the disease. Exhibit 1 is a litany of explanations drawn from the burgeoning, clearly undisciplined, and unparsimonious behavioral finance literature. Many of these errors in human reasoning are no doubt systematic across individuals and time, just as behavioralists argue, but for many reasons, as I argue, they are unlikely to aggregate so as to affect market prices. We do not know enough to fall back to What should be the last line of defense, market irrationality, to explain asset prices. With patience, we will find that the anomalies that appear puz- zling today will either be shown to be empirical illusions or be explained by further model general- ization in the context of rationality. Two qualifications: I must qualify my view sup- porting market rationality in two ways. First, a small group of irrational investors can occasionally determine asset prices, and the large body of inves- tors will not be able to do anything about it. For example, the finding in mergers that acquiring companies overpay is inconsistent with rational 16 @2001, Association for Investment Management and Flesearch Rational Markets Exhibit 1. Behavioral Explanations for Market Phenomena Ooerconfidence Statistical errors Miscellaneous errors in reasoning Sunk costs influencing decisions Overpricing long shots Poor self-control Selective recall Anchoring and framing biases Time diversification And why riot add while we are at it undoing, somatization, conversion Reference points and loss aversion (not necessarily inconsistent with rationality) Endowment effect: what you start with matters Status quo bias: more to lose than to gain by departing from current situation House money effect: nouveau riche are not very risk averse Overconfidence about the precision of private information Biased self-attribution (perhaps leading to overconfidence) Illusion of knowledge: overconfidence arising from being given partial information Disposition effect: tendency to hold losers but sell winners Illusion of control: unfounded belief in being able to inuence events Gambler's fallacy: need to see patterns when, in fact, there are none Very rare events assigned probabilities much too high or too low Ellsberg paradox: perceiving differences between risk and uncertainty Extrapolation bias: failure to correct for regression to the mean and sample size Excessive weight given to personal or anecdotal experiences relative to large-sample statistics Overreaction: excessive weight placed on recent relative to historical evidence Failure to adjust probabilities for hindsight and selection bias Violations of basic Savage axioms, namely, the sure-thing principle, dominance, transitivity Preferences not independent of elicitation methods Compartmentalization and mental accounting \"Magical\" thinking: believing you can influence the outcome when you cannot Dynamic inconsistency: negative discount rates, \"debt aversion\" Tendency to gamble and take on unnecessary risks in some situations Selective attention and herding (as evidenced by fads and fashions) Cognitive dissonance and minimizing regret (the \"confirmation trap\") Disjunction effect: waiting for information even if it is not important to the decision Tendency of experts to overweight the results of models and theories Conjunction fallacy: probability of two things co-occurring believed more probable thana single one Confusion of probabilities with preferences (religion, money management) Freudian defense mechanisms: repression, displacement, reaction formation, isolation of affect, I