Irrational traders are one of five types of financial market participants. They know the fundamental value of a security, but rather than basing their trading decisions on this, they base it on their expectation of how other market participants will behave. Here we discuss experimental evidence demonstrating this irrational behaviour. 

In a previous post, we considered Keynes’s beauty contest and Thaler’s challenge as examples of games that are won by being the best in judging the behaviour of the other participants. This strategy is, however, suboptimal in financial markets. Informed participants who base their decisions on fundamental values will outperform, given a long enough time horizon.

It is difficult to prove that there are irrational participants in the financial markets. However, economic experiments, using games in which artificial assets are traded, show that this irrational behaviour arises in circumstances that mimic financial markets.

For example, De Martino et al. (20013) devised an experimental financial market game during which participants were prepared to buy assets well above their fair values. There was a probabilistic element to the fundamental value of the traded instrument, but its expected return was simple to calculate at any stage of the game. Also, unlike financial markets, the game lasted a set number of rounds after which contestants realised their returns.

So even in this very simple game, played in a finite time period with the fair value of the artificial security readily available, some of the participants acted irrationally and bought the security when it was clearly expensive.

In an attempt to find out why participants behaved irrationally the researchers used functional magnetic resonance imaging (fMRI) to analyse how their brains functioned during the game. They concluded that social signals, such as taking into account the intention of other participants, or even ascribing intention to the market as a whole, influenced their decisions.

This is precisely the behaviour which we ascribe to irrational investors: they do know the fundamental value of an asset, but trade at prices away from the fundamental value, because they believe in the greater fool theory.

Asset bubbles and initial public offerings (IPOs) are two specific financial market situations in which irrational traders are likely participants.

Asset bubbles

We define an asset bubble as the active trading of assets at prices that are considerably higher than their fundamental value. Two of the most recent stock market asset bubbles are the Japanese equity market in 1987 and the technology sector of the US market in the late 1990’s.

As in the experimental game, there are almost certainly irrational traders who participate in bubbles with the hope to trade with greater fools. Unlike the experimental game, there is no set time period during which prices will revert to their fundamental values. This, I believe, makes it even more enticing for irrational traders to participate.

The other types of market agents would also participate in bubbles. Gamblers trade for fun, or for fear, of missing out. Rational uninformed investors, who typically track the market, would participate as well.

That deluded investors participate in bubbles is evident from the various new and non-traditional valuation methods proposed at the time, such as internet traffic volume, for justifying the inflated prices of technology stocks. Refer, for example, to the thesis of Glenn Behrmann.

Initial Public Offerings (IPOs)

IPOs also provide fertile ground for studying the behaviour of foolish traders.  Professor Jay Ritter analysed 8061 IPOs in the USA between 1980 and 2014. Usually, IPO shares had significant price increases on their first day of trading, with the average gain being 17.9%. However, over a three-year period, these stocks underperformed the market by 17.8% on average. This implies that IPO’s were generally overpriced at issue and, given their first day’s performance, IPOs were even more overpriced after their first trading day.

In light of this track record, informed investors are less likely to buy IPOs. If they do participate, in the hope of selling to greater fools, we would classify them as irrational traders. The data suggests that it would make the most sense for an irrational trader to sell at the end of the first trading day.

As with asset bubbles, the gamblers, the deluded and the rational uninformed traders would typically also participate in IPOs.