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Persistence of Diversity in Investor/Trader Beliefs

April 15, 2012 • Posted in Big Ideas

Is there a “correct” (or at least most correct) view of how financial markets work? If so, why do the beliefs of market participants, sophisticated and naive, never converge narrowly to that view? Why do investors disagree so much all the time? The following items offer some ideas, from a generally behavioral perspective, on the persistence of diversity in investor/trader beliefs. Specifically:

Seeking Confirming Opinions Rather Than Information?: “Investors exhibit confirmation bias in their use of stock message boards, with prior beliefs substantially predicting assessment of message validity.”

Classic Essay: The Foolish, the Theoretical and the Practical: “…it seems that nature to a significant degree favors diversity over survival of the fittest.”

Why Gurus Go to Extremes: “…forecasters trying to beat other forecasters tend to take extreme public positions that reflect the motivational bias of competition.”

The Diversity and Persistence of Quacks: “…naive customers for services with outcomes for which it is hard to distinguish skill from luck will attract and sustain a diverse set of quacks.”

Holding Court with Stock Market Gurus: “…investors/traders should consider a courtroom-like discipline in determining the value of a guru’s advice. It may be that very few stock market gurus would qualify as expert witnesses.

Seer-Suckers, or the Efficient Everything Hypothesis: “No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers.”

One interpretation of such observations is that complex financial markets are highly forgiving of “errors” and “irrelevancies” and “irrationalities.” Fundamental characteristics of the markets seem to value diversity persistence, as something like a hedge against market breakdown in response to shocks. There may be an analogy to biological and behavioral evolution. The system characteristics that support/encourage diversity (random drift) are strong enough to balance system tendencies to optimize (convergence via natural selection), thereby strongly resisting non-adaptive stasis.

Another interpretation is that the “errors” and “irrelevancies” and “irrationalities” are hypotheses awaiting evidence from wild distributions. They appear erroneous or irrelevant or irrational in the context of an incorrectly assumed tame distribution.

In summary, while financial markets may be adaptive, the adaptive process appears to be very messy, strongly preserving a wide diversity of investor/trader beliefs.

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