Adapting financial models to irrational investors

A review of Prof. Andrew W. Lo's book, Adaptive Markets: Financial Evolution at the Speed of Thought.

Paul Kaplan 23 October, 2018 | 5:00PM

Economics in general, and financial economics in particular, has a long history of building elegant mathematical models. These models assume that economic agents, such as investors, are fully rational utility-maximizers and that markets are fully efficient. In finance, the best known of these models is the Capital Asset Pricing Model. Although the CAPM has repeatedly shown not to hold empirically, due to its simple and elegant conclusions it continues to be central to valuation and investment practice since no single model has emerged to replace it.

The main challenges to the assumption of rationality comes from the relatively new field of behavioural economics, which includes behavioural finance. So far, two of the leaders of this field have received the Nobel Memorial Prize in Economic Sciences; namely, Daniel Kahneman of Princeton in 2002 and Richard Thaler of the University of Chicago in 2017. Rather than making abstract assumptions about investor behaviour, Kahneman, Thaler and other behavioural economists used the experimental methods of psychology to determine by observation how real people go about making economic decisions. What they found was that real people behave very differently from the rational agents in traditional economics and finance. Instead of solving utility maximization problems, real people use various heuristics and are subject to various biases that lead them to make suboptimal decisions, and my even act against their own best interests. Such behaviour is often regarded as being irrational.

While traditional and behavioural economics have been at odds, there have been at least two efforts to reconcile them. One is the concept of popularity. I am a co-author of a forthcoming book on this. In the popularity approach, my co-authors and I extend the set of security characteristics that investors care about in the CAPM to include characteristics that are popular (or unpopular) for no rational reason. The result is a mathematical asset pricing model in which all characteristics that investors care about, both rational and irrational.

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Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.