Are stock prices more predictable than human behaviour?

Malvika Saraogi tries to rationalise the markets

"The financial markets generally are unpredictable. So that one has to have different scenarios... The idea that you can actually predict what's going to happen contradicts my way of looking at the market."

- George Soros (LSE alumni, investor, political activist and philanthropist)

In today's world the financial markets deal with trillions of dollars and even slight movements can have tremendous impacts on global economies and the individuals within them. Thus it is important to understand how they function together with the nature of their impact.

As financial markets affect and are influenced by millions of individuals worldwide, it is difficult to predict their movement. It is for this precise reason that human beings have made several attempts to develop theoretical frameworks which will enable them to better understand the complex world of financial transactions. One of the most widely used frameworks is the 'efficient markets theory'. This states that the price of a security (equity, bond, property, etc.) reflects the collective belief of investors about its future prospects. Thus markets are efficient as price is the only information needed to make a decision regarding the purchase or sale of a stock.

However in reality this is rarely the case - human begins are influenced by 'cognitive bias' (when behaviour is not the same as that predicted by rational choice theory). As the economist Adam Smith said in his 'Theory of Moral Sentiments', "Our conscience tells us what is right and wrong: and that is something innate, not something given us by lawmakers or by rational analysis." If stock prices reflect complete private and public information, as in strong-form efficiency, then there is no money to be made. But clearly this is not true as several people depend on the stock markets for their livelihood.

Human behaviour and stock prices can also be seen as a chicken-and-egg situation. Human behaviour effects stock price movements but at the same time is influenced by it. Based on their beliefs, human beings buy and sell stock taking into account profit and many other factors such as a firm's ethical policy. When markets are behaving in a certain way, individuals can decide to go against it. This is how investors are able to beat the market, even though initially it may appear irrational or a senseless risk.

The complexity of the effect of human behavioral patterns on stock prices has given birth to the filed of behavioral finance. It is important to point out that the predictability of human behaviour does not necessarily make stock prices predictable.

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