Zubin Jelveh has a good post over at Portfolio.com on rationality and markets. Here’s my take:
Behavioral economics is very useful to practitioners, and we are grateful to those who say it is not, because it makes it more useful to the rest of us.
Think of the Adaptive Markets Hypothesis as a tree, and every anomaly/strategy as a bird. As a strategy works, the bird gets fed more, reinforcing the return pattern. When a bird gets too fat, the branch breaks, and the strategy can have a colossal failure. The bird hits the ground, walks away, and the branch re-grows. Eventually, after the bird slims down, he flies back to the branch.
Anomalies/strategies come and go. Too much money can pursue any strategy, even indexing. Wise investors try to ask the question “Where is there too much investor interest?” and then they avoid those strategies until they blow up.
To give an example, it is a great time now to manage unlevered structured product, agency or non-agency, MBS or ABS. Too many levered players have blown up, and there is a lot of good paper that needs a home.
The concept of rationality is a fuzzy one. I’m not sure that all rational people could agree on a definition. 🙂
My view is that people are not uniformly rational, but that they are in aggregate predictable.