The Psychology of Inefficient Markets

The irrationality of humans can be a thorn in the side of efficient markets, and the problem has been exacerbated by the fact that it’s now easier than ever for single person to move an entire market — for example, if an oil trader gets drunk, buys 7 million barrels of crude, and sends the global price of oil to its highest point in eight months. While the dangers of drinking and trading are well-established, what other specific things might lead financial traders to act irrationally?

One answer is that the human tendency to think comparatively leads traders to be influenced by information about other traders. For example, in a new study led by Columbia’s Eric Schoenberg participants engaged in 15 rounds of trading in an experimental market. After each round they were shown the value or either the leader’s account, or the account of the person in last place. When participants viewed the leader’s account they tended to act much more aggressively in the next round:

The type of relative performance information provided has a significant effect on market prices: average trading prices are higher, the peak deviation of trading price from fundamental value is higher, and there are more periods when trading prices are higher than fundamental value in markets where all participants observe the higher Account Total as compared to those were all participants observe the lowest Account Total.