In previous posts, we considered informed and uninformed market participants. We then introduced another type of participant which we called the foolish investors. In an attempt to outperform the market, foolish participants actively trade to their detriment at inefficient prices.  Here we refine our definition of foolish market participants by dividing them into three groups:  the gamblers, the deluded traders and the irrational traders. Each group is foolish in a different way.

So altogether we classify market participants into five distinct types. Below we describe each type in further detail. For the purpose of this discussion we assume that there are no latency arbitrageurs, so no participant has the advantage of speed in accessing the market.

The informed participants: Informed agents access all publicly available information to determine the fair value of securities. Using this information, they trade rationally and hence perform at least as well as the overall market. If anyone of the other four types of market participants, described below, exists, then the informed participants will outperform. As the market is a zero-sum game, this outperformance will equal the size of the underperformance of the other four groups of participants, after accounting for costs. See, for example, my post explaining how informed participants outperform uninformed ones. So informed traders “know that they know” and act accordingly.

The rational uninformed participants: These are market participants who realise that they do not know the fair price of market securities. They do, however, trust that the informed agents will ensure that the market is largely efficient. They are rational and thus do not attempt to outperform by transacting in specially selected stocks. Instead, they track the market by investing in a fraction of the whole market. Therefore they buy all the securities constituting the market in the same ratio as their market capitalisations. Hence, the rational uninformed participants “know that they do not know” and act accordingly.

The gamblers: The gamblers participate in financial markets knowing that they are uninformed, but they trade actively either for entertainment value or because of a flawed belief system. 

Many people gamble, as is evident from the size of the casino and lottery industry. Some simply gamble for recreational value. The money lost is considered to be the cost of the entertainment provided. Others gamble because of a flawed belief that they are special and can beat the odds. They would typically suffer from behavioural biases such as over-optimism and gambler’s fallacy.

For the same reasons that people gamble in casinos and lotteries, they would gamble in financial markets. Online contracts for difference trading platforms provide easy access to financial markets.

We also classify uninformed agents, who participate in financial markets for fear of missing out, as gamblers. When a financial instrument’s price rises or falls rapidly or continuously, some market participants who are not benefitting from these price changes experience a feeling of regret.  They then transact, without knowing the fair price of the security, in an attempt to also benefit from the price moves. Refer to the post Herd Behavior in Financial Markets by Marco Cipriani and Antonio Guarino for evidence of such behaviour.

Simply put, gamblers “know that they do not know” but unlike rational uninformed participants, do not act according to this knowledge.

The deluded agents: These are market participants who are uninformed, but transact in financial markets with the delusion that they are informed. They would trade actively in a security in an attempt to outperform when it is mispriced according to their analyses. However, they are wrong in believing that they know the fair value of the security. Deluded agents “don’t know that they don’t know “. We discuss deluded traders in more detail in this post.

The irrational traders: The irrational traders are market participants who are informed, but still transact even though they are well aware that they are buying securities above fair value and/or are selling securities below fair value. Even so, they believe that their strategy will lead to outperformance. Simply put, they believe in the greater fool theory. In other words, irrational traders would believe that they will be able to trade profitably in a security with an even more irrational trader, a gambler, a deluded agent or a rational uninformed participant. So irrational traders “know that they know”, but unlike the informed participants, do not act according to this knowledge. Do irrational traders exist? We discuss this in more detail in this post. Note that irrational traders and gamblers are often referred to as speculators as well.

Note that market participants who do not take heed of the fundamental value of assets they trade are often referred to as speculators. In terms of our classification, speculators could either be irrational traders or gamblers.

Even though we classify market participants into five types, a participant’s classification may vary from transaction to transaction. For example, in one transaction a participant could be informed, while in the next he could be deluded. At another time a trader could be gambling for fear of missing out, while in the next he could simply be irrational.

The rational uninformed participants are possibly the least likely to change their classification from trade to trade. This is also the only group who participates in the market without the aim to outperform the market.