Rationality and equilibrium in the economy and in capital markets : From Theory to Practice.

The issues of rationality and the attainment of equilibrium (as well as its stability and uniqueness ) in the macro economy and in capital markets lie in the center of the most important  theoretical debates. Great original  theories stressed the rationality of economic agents and investors. Equilibrium is automatically attained with the help of free markets.  They were later challenged.

Each side  has dedicated supporters ! 

The Classical economic theory and the Efficient Market Hypothesis (EMH)were challenged by the Keynesian tradition and the recent rise of Behavioral Economics. The counter attack on the notion of a perfect real world  is based on irrationalities, the internal dynamics of the system and on  institutional factors. Exogenous shocks are the usual original culprits for disequilibria. How do we return to equilibrium. Does this notion exist ?

The policy implications, the prevailing political ideas and the interpretation of actual developments rely on these  legendary debates of theorists and econometricians

Very Important economic, financial , political  issues arise :

-Can the economy and capital markets be in disequilibrium ? 

-For how long ?  Will they return to equilibrium fast by themselves ?

-Did the irrationality and behavioral mistakes of agents play an important role in creating disequilibria ?  

-What are the implication for Government policies? 

-Is intervention justified or will it create more problems ?

Concerning the Economy, the Classical economists believe in the automatic attainment of equilibrium at full employment. Efficient functioning of all markets and absence of interventions are key. On the opposing side, Keynesians believe in the possibility for prolonged deviations from Full employment and welcome Government interventions

Neoclassical and Monetarist economics follow the original traditions.

Equilibrium is possible, inflation depends on monetary policy and conclude that governments should keep intervention at minimum. Alternatively, Neo Keynesian economists stress the possibility of failures in markets, the absence in the real real world of simplifying assumptions and the existence of irrationalities. A Key consideration in these debates is the rational or irrational response of consumers and workers to their environment and what happens to markets as a whole.

In capital markets automatic adjustments of prices to public information is a main topic. The EMH maintains that great speed of adjustment exists and that future prices are independent of past prices. The model of pricing securities mostly according to market variability ( Beta and CAPM) and the efficient diversification principles characterize Modern Portfolio Theory( MPT).

Behavioral Economics questions the rationality of investors. Systematic individual mistakes and biases are reported. Rationality is a myth. Manias and crashes depend on mass psychology and are not necessarily linked to economic and financial news. Extended disequilibria are possible. Especially, for the market as a whole.

The key issue in Capital Markets is whether we can predict the systematic mistakes of investors on an aggregate level. If they cannot cancel out in a market environment adding up all individual errors , can we profit from these mistakes and inefficiencies ? 

In conclusion, What is the best model , policy and course of action for investors ? Do individual mistakes persist and can we profit from them ?

Can we have a general model or separate analysis and specific reactions ?

PS

will examine several examples in Finance :

Aversion to taking losses

Risk taking with gains (risk averse) and losses (more risky)

Momentum

Reversion of returns to mean

Assigning wrong probabilities on future events

Overweighting recent events 

Not changing initial portfolio (inheritance bias)

Home markets bias

Seasonality ( monthly) and week end effects

Sale regret in bull markets 

Influenced by the crowd, the media, etc

The importance of valuation 

…… and more to come!