In economics and finance, investors are perceived as rational actors focused on maximizing profits, and markets are anticipated to operate near a state of perfect efficiency. However, in reality, market sentiment creates radical swings like we've all seen. In order to understand how financial markets change, the purely efficient view has to be reconsidered.
The way we act on markets is highly affected by our primal instincts. When stocks fall - we feel threatened and as a result, we start selling the stocks at the same time. As you might imagine, this kind of behavior causes a market crash. Markets are swung by emotion, not just a rational pursuit for profits.
Andrew Lo has written a new book about this topic, “Adaptive Markets,” published this month by Princeton University Press. In the book, he draws on insights across fields including evolution, psychology, neuroscience, and artificial intelligence to show us a new picture of human investors.
Read more about the book and Lo's theory in MIT article here.
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