While economists argue that markets are driven by rational behavior, psychologists have found that the markets are not immune from human irrationality, whether that irrationality is due to optimism, fear, greed, or other forces, a new study has found.
Analysis published in the Proceedings of the National Academy of Sciences (PNAS) shows that markets are indeed susceptible to psychological phenomena.
Colin Camerer, the Robert Kirby Professor of Behavioral Economics at the California Institute of Technology (Caltech) and the corresponding author of the paper said that there is a tug-of-war between economics and psychology in which psychology wins.
Camerer said that it is difficult to claim that markets are immune to apparent irrationality in human behavior as the recent financial crisis have shaken a lot of people's faith as the government still had to bail out banks, and millions of people lost their homes.
According tot the study, an effect called 'partition dependence' was analysed in which breaking down or partitioning, the possible outcomes of an event in great detail makes people think that those outcomes are more likely to happen.
Psychologists said that providing specific scenarios makes them more explicit in people's minds and Camerer explained that whatever one is thinking about seems more likely.
The researchers looked for bias in a variety of prediction markets, in which people bet on future events. In these markets, participants buy and sell claims on specific outcomes, and the prices of those claims, as set by the market, reflect people's beliefs about how likely it is that each of those outcomes will happen.
Camerer said that while partition dependence hadn't been studied in prediction markets and what makes this particular analysis powerful is that the researchers observed evidence for this phenomenon in a wide range of studies, short, well-controlled laboratory experiments; markets involving intelligent, well-informed traders at major financial institutions; and nine years of horse-racing data.