Economics: Rational Agents Have Feelings Too

In the beginning, there was adaptive expectations. People formed their outlook of the future based on what happened in the past. This usually worked until events contrary to expectation occurred, and trends changed. What happened then was forecasts were usually plunged into a brief era of confusion, as the present (formerly the future) no longer resembled the past, the future became undivinable.

This would persist until a trend was perceived with the current situation, and adaptive expectations resumed to model the future.

Obviously, this was not an efficient model. So in 1961, a new model emerged: rational expectations. People now acted relying less on past data, but more of their anticipations of future events. This was the new classical macroeconomics, the basis of efficient markets.

Adaptive: 
People, and by aggregate, society and the economy, will continue to do what they have in the past.

Rational:
People, and by aggregate, society and the economy, will do what they ought to do given the circumstances.

Rationality is a compelling idea, and continues to be the basis of many decisions. We are all rational agents, which seek to optimize a situation given the available information. Although the theory has great merits, it ignores a fundamental fact: rational agents are also emotional agents.

Emotion! Traditionally considered the enemy of Reason. This has been one of the great dichotomies of our modern age. Even neurology and psychology refer to left (reason) and right (emotion/intuition) brain dominance when describing behaviour.

Unlike the critics of efficient markets, I’m not one to completely dismiss rational expectations off the bat. But a modified theory is in order:

Behavioural:
People. and by aggregate, society and the economy, will do what they feel they ought to do given the circumstances.

Big difference? Definitely. If you have been investing for some time, you have probably encountered references to “emotional investing” before. The Trading Doctor had an interesting chart labeled with common blurbs associated with market movements:

It’s a very evocative chart which does illustrate the emotions that “rational agents” experience during market peaks and troughs. These emotions have been identified in other sources. There is a popular emotion chart, a version of which I found on QSuper which categorizes the blurbs cited by Trading Doctor above:

The qualification of risk can now be tied to emotions, or general public sentiment. This kind of analysis is also partly contributory to contrarian investing–or the act of bucking the market sentiment at the time.

However, I must add that both charts above are geared towards long-only types of investors–those who seek to buy low and sell high. In today’s modern marketplaces, investments are done both ways: long and short. Value is no longer absolute, as even currencies fluctuate relative to each other–the strength of one item of value is hinged on the weakness of another.

For instance, the prices of stocks rising can also be said as the price of the dollar falling relative to stocks.

In a two-directional world, emotions run both ways as well. In which case, I’ve adapted a chart similar to the two above to accomodate the feelings of two agents: the pessimist and the optimist. This chart made its first appearance on the Financemanila blog months ago:

Note that highs and lows are usually relative to the prevailing situation at the time. What tips the tide of emotions is the break from a relative high or low into a new level where emotions can form a base of sentiment again. For our two emotional agents, the reactions to various points is bi-polar:

Which gives birth to our hypothetical conversation between two rational agents:

1. Market Rallies
Bull: Everything’s fine!
Bear: How high can it go?

2. Uptrend Accelerates
Bull: What a Market!
Bear: Irrational! Things are so expensive!

3. Market High
Bull: I’m gonna be rich!
Bear: I gotta get out now!

4. Correction
Bull: We’re now in a bull market.
Bear: How could I have been so wrong?!

5. New High/Test of High
Bull: This market’s unstoppable.
Bear: Market? Feh!

6. Break
Bull: It will come back.
Bear: Thing’s are just beginning.

7. Crash
Bull: How low can it go?
Bear: Everything’s going to hell.

8. Downtrend accelerates
Bull: Irrational! Things are so cheap!
Bear: What a market!

9. Market Low
Bull: I gotta get out now!
Bear: I’m gonna be rich!

10. Bounce
Bull: How could I have been so wrong?!
Bear: We’re now in a bear market!

11. New Low/Test of Low
Bull: There’s no hope!
Bear: This market’s unstoppable!

12. Breakout
Bull: A light at the end of the tunnel!
Bear: It will come back.

And so goes the cycle with every peak and trough.