Linguistical Differences Amongst Market Theorists: Efficient Market Practitioners vs Behavioral Economists*

Ever listen to how people speak?

I don’t mean their verbal tics or habits (“um”), I refer specifically to the words and phrases they choose to use. The way they deploy language can be quite revealing about their beliefs, training, and thought process.

Consider, as an example, the bond market. The discussion of late have been about whether or not its a bubble. This has come up quite a bit in conversation lately (see this and this), and have been fascinated by the different ways people have described the situation.

Consider the following overheard phrases, each of which come from traders, fund managers, and strategists:

The first two reflects a certain belief in the rationality of markets: “Bonds are pricing in a deflationary outcome” is how one strategist described it. Another (quoted in MSM) said that “the fixed income market is discounting a double dip.”

But a fund manager described it quite differently, relying on language of sentiment: “Traders fear an economic slowdown.

The actual language used suggest a clear theoretical underpinnings:  The first two speakers are likely adherents of the efficient market hypothesis (EMH). They consider market action to reflect the collective knowledge of all participants. Hence, the interest rate action is only the collective wisdom of the crowd, as more economic information works its way into bond prices. The crowd (of course!), will be more right versus than any single individual.

Truth be told, crowds have not appeared particularly full of wisdom over the past few years. They seem to act like lemmings, engaging in group think. If the EMH proponents are honest, they will admit this theory has flaws.

The second is a behavioral economics approach: It considers the irrational and emotional processes of the human participants in the markets. But traders who adhere to this philosophy will have to admit that the majority of the time, trader emotions remain in mostly in check. Behavioralism only seems to create actionable insights at market extremes.

I find its helpful to deploy both theories. During the meat of any market move — call it the middle 60-80% — the crowd is the trend. That is when deferring to not the crowd’s wisdom, but their collective muscle, is the most lucrative.

When the crowd morphs from a peaceful assembly to a mindless mob, that is when the behavioral aspects kick in. The contrary bet can be placed once extremes in emotions are visible in market and sentiment data.

What does your language say about the way you think . . .  ?


* Isn’t that a great headline? I made it up, but it sounds like it should be an academic research paper from HBS or one of the Fed Research departments . . .

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