We have classified market participants into five types. In this post, we describe the irrational investors or traders in more detail. As explained before, the irrational traders are foolish market participants who are informed but still transact although they understand that they are buying securities above fair value or are selling securities below fair value. Even so, they believe that their strategy will lead to out-performance.

Simply put, irrational traders trust in the greater fool theory. In other words, irrational traders believe that they will be able to trade profitably in a security with an even more irrational trader, a gambler, a deluded agent or even a rational uninformed participant. (See the explanations on these types of participants in my earlier post.)

Irrational investors know the fundamental value of a security, but rather than basing their decisions on its fundamental value, they base it on their expectation of how other market participants will behave.

To describe this type of behaviour Maynard Keynes used as analogy a fictional newspaper beauty contest. Participants need to select the most beautiful face from six faces. Those who pick the most popular face win. In Keynes words: “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”1

The Thaler challenge is another, more practical example, of this game. Guess a number between zero and 100, with the goal of making your guess as close as possible to two-thirds of the average guess of all participants in the contest. This game has been run twice by the Financial Times. If all participants are rational and informed, they should all guess zero. In game theory, this is referred to as the Nash equilibrium. However, to win this game one should adopt a strategy similar to that of irrational traders: base your decision on your expectation of how other participants would behave.

The winning number in these two experiments were 13 and 12 respectively. Contestants had to give reasons for the number they entered.  From the reasons quoted by the Financial Times, it is evident that there were gamblers and deluded participants. Instead of rational reasoning, the gamblers based their entry on a superstitious belief.  The deluded participants used flawed logic but believed in the correctness of their answer.

There also was a third group of participants who did account for (1) gamblers and (2) the deluded as well as (3) other participants like themselves, who similarly accounted for gamblers and the deluded. The winners came from this group.

The rational uninformed participants (those who are aware that they do not know the correct answer) would probably not have bothered to enter. Alternatively, they could have turned into gamblers as they have nothing to lose by participating.

Both these games are different from financial markets. You can only win these games by correctly judging how the other players will behave. In a securities market, you will win, given a suitable long time horizon, if you trade on the fundamental value of a security. You will in time receive the future cash flows used in calculating the security’s fundamental value. Over shorter time periods you may outperform by correctly assessing the behaviour of the other participants. This is the basis on which irrational traders are happy to participate.

In a future post, we will consider experimental evidence of irrational behaviour in financial market situations.

1 Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money. London: MacMillan (reprinted 2007).