I have been partial to the market laboratory work used in economics and finance. These experiments are not perfect given the limitation associated with lab experiments, but it provides a controlled environment for testing specific economic hypotheses. Of course, these controlled experiments are not the same as the real world, but they provide useful information especially for events that are infrequent or have many competing influence factors. Unfortunately, digging deep into the construction of these lab experiments takes time and effort.
Market efficiency and rationality has been often tested with laboratory work, but now we have some insightful experiments on "market rushes" which can exist as either market declines, panics, or market increases, frenzies or bubbles. The results for these experiments are presented in "Market Panics, Frenzies, and Informational Efficiency: Theory and Experiment" by Chad Kendall American Economic Journal: Microeconomics 2020 12(3).
The author finds that if there is fear of an adverse price movement up or down it causes traders to trade before they are better informed. They will rush forward with their trades to beat others to the market. That is, they will sell or buy before others relative to the future information flow and use the signals in price as an alternative to revealed future information. Given information can be noisy or of poor quality, it can make sense to use a heuristic like momentum to take action quicker. If there is good information quality and prices start to move, traders may rush ahead given the assumption that others know what is going on. However, if information quality is low and it makes sense to wait, traders may delay their actions and there is less likely to be a market rush. Unfortunately, information quality is hard to measure, so there is tendency to focus on price action or momentum as a signaling mechanism. There is a cost of waiting for further information just as there is a cost based on the quality of information.
The result of traders acting rushed will be a reduction information efficiency for the market. What may seem to be good for the individual may not be good for the market as a whole. Momentum trading which can lead to rushes creates negative externalities. Running for the exits is rational for one but negative for the information flow embedded in prices.
When playing the game repeatedly, there is a tendency for traders to use a momentum heuristic to get ahead of trading competitors who may have useful information. If there is anticipation of new high quality information, traders may want to rush before the information becomes available. When information quality is poor and there should be a reason to wait with trading, there is still a tendency for following prices and act based on some price threshold.
The author focuses on potential inefficiencies and the downside of following prices, market rushes. I am biased toward thinking of what makes sense from the perspective of a trader. There is a threat of panic and frenzies but in a competitive uncertain world, it may make sense to get ahead of information and use price behavior to direct decisions. If you cannot predict, then doing the next best thing of acting in response to price action is rational. Heuristics like following the trend may be both rational and prudent under uncertainty.
Market efficiency and rationality has been often tested with laboratory work, but now we have some insightful experiments on "market rushes" which can exist as either market declines, panics, or market increases, frenzies or bubbles. The results for these experiments are presented in "Market Panics, Frenzies, and Informational Efficiency: Theory and Experiment" by Chad Kendall American Economic Journal: Microeconomics 2020 12(3).
The author finds that if there is fear of an adverse price movement up or down it causes traders to trade before they are better informed. They will rush forward with their trades to beat others to the market. That is, they will sell or buy before others relative to the future information flow and use the signals in price as an alternative to revealed future information. Given information can be noisy or of poor quality, it can make sense to use a heuristic like momentum to take action quicker. If there is good information quality and prices start to move, traders may rush ahead given the assumption that others know what is going on. However, if information quality is low and it makes sense to wait, traders may delay their actions and there is less likely to be a market rush. Unfortunately, information quality is hard to measure, so there is tendency to focus on price action or momentum as a signaling mechanism. There is a cost of waiting for further information just as there is a cost based on the quality of information.
The result of traders acting rushed will be a reduction information efficiency for the market. What may seem to be good for the individual may not be good for the market as a whole. Momentum trading which can lead to rushes creates negative externalities. Running for the exits is rational for one but negative for the information flow embedded in prices.
When playing the game repeatedly, there is a tendency for traders to use a momentum heuristic to get ahead of trading competitors who may have useful information. If there is anticipation of new high quality information, traders may want to rush before the information becomes available. When information quality is poor and there should be a reason to wait with trading, there is still a tendency for following prices and act based on some price threshold.
The author focuses on potential inefficiencies and the downside of following prices, market rushes. I am biased toward thinking of what makes sense from the perspective of a trader. There is a threat of panic and frenzies but in a competitive uncertain world, it may make sense to get ahead of information and use price behavior to direct decisions. If you cannot predict, then doing the next best thing of acting in response to price action is rational. Heuristics like following the trend may be both rational and prudent under uncertainty.
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