Playing on Rational Irrationality of Sophistical Investors

Sergey Okun  This “Countering behavioral biases for sustainable investment success” article was written by Sergey Okun – Senior Financial Analyst at I Know First, Ph.D. in Economics.

Highlights:

  • The inherent unpredictability of market behavior brings about both increased risks and profitable opportunities.
  • Contrary to the prevailing theory, institutional investors often navigate a nuanced landscape, where they may be more inclined to “ride” market trends than actively oppose price inefficiencies.
  • AI algorithms emerge as powerful tools, demonstrating precision in recognizing and capitalizing on complex market scenarios, unveiling asymmetries that may elude human experts and providing a comprehensive understanding of investment landscapes.

Market Impact

In the realm of traditional finance, the contention is that errors made by investors would not disrupt market prices. The argument goes that when prices deviate from their fundamental value, rational traders would seize the opportunity to exploit the mispricing for their own gain. But who are these market arbitrageurs responsible for maintaining efficiency? The prime contenders for this role are institutional investors, equipped with the necessary knowledge and wealth. Picture them as knights, diligently upholding fair prices and shielding the market from the unpredictable actions of individual investors. In a previous article, we delved into the motivations driving the irrational behavior of individuals in their investment decisions. Now, our focus shifts to institutional investors. These are entities that pool significant sums of money for investment purposes, managing funds on behalf of others, including pension funds, endowments, insurance companies, mutual funds, and hedge funds. Unlike individual investors, institutional investors boast substantial financial resources, empowering them to make sizable investments and play a pivotal role in the financial market.

When It is Beneficial for a Rational Player to be Irrational

Despite the fact that institutional investors possess both the expertise and capital required to pinpoint mispricing, aiming to secure arbitrage profits and restore prices to their fair value, they frequently find themselves driven by incentives to align their trades with prevailing trends. This tendency, unfortunately, contributes to an escalation of mispricing in the market, thereby exacerbating overall inefficiency. The primary reasons for such a course of action include:

  1. Fundamental risk arises due to imperfect matching of long and short positions.
  2. Noise trader risk looms large, as mispricing can expand, potentially leading to the bankruptcy of an arbitrageur before the mispricing resolves.
  3. Implementation costs pose a significant hurdle. Consequently, the limits of arbitrage may thwart rational investors from rectifying price deviations from fundamental value, leaving room for the possibility that correlated cognitive errors among investors could influence market prices.

One of the most talked-about stories of recent times is the GameStop stock saga. In January 2021, the financial world was rocked by the sudden surge in the stock of the video game retailer GameStop, which had been on a downward trend. The company was facing losses, and its shares were depreciating. Institutional investors took short positions on the stock, expecting it to continue falling. However, a blogger named Keith Gill, known as “Roaring Kitty,” managed to convince individual investors to buy GameStop shares to prevent them from falling and to profit from the potential rise. As a result, on January 21, 2021, GameStop shares skyrocketed by 360% in a single day and continued to rise to 1000%. Major hedge funds that had bet against the stock suffered losses of at least $5 billion. The GameStop situation even led to hearings in the US Congress. GameStop shares became the most popular meme stocks, which do not have an underlying fundamental value, and their price is based on the current hype in social media.

The ebb and flow of capital play a pivotal role in fanning the flames of irrational behavior. A positive convex relationship exists between capital flows and the historical performance of mutual funds, indicating that efficient funds attract a disproportionate influx of capital from outside investors. This trend incentivizes fund managers to augment risk levels based on year-to-date returns. The ripple effect of this capital-chasing behavior casts a shadow on the future performance of highly efficient hedge funds.

Institutional investors, encompassing mutual funds and hedge funds, find themselves compelled to weigh the considerations of their investor base. Funding shocks may force these institutional investors into the unwelcome position of redeeming their investments. In instances where such forced redemptions, or ‘fire sales,’ synchronize among institutions holding specific stocks, the prices of these stocks experience a significant albeit temporary decline. This phenomenon becomes especially pronounced during financial crises, as exemplified by the impactful events of the 2008 crisis, and periods marked by profound global macroeconomic uncertainties.

While the prevailing theory assumes that institutional investors endeavor to offset the perceived market inefficiencies in their pursuit of profitable asset management, reality paints a more nuanced picture. In various scenarios, institutional investors, in a broader context, find themselves inclined to “ride” rather than trade against price inefficiencies. A prime illustration of this is the phenomenon of “predatory trading,” stemming from the imperative of other investors to trim their positions. When some investors possess knowledge about the imperative of others to liquidate positions, the temptation to sell and subsequently repurchase the same assets becomes a powerful incentive. This dynamic results in notable price deviations from fundamental indicators and heightened illiquidity precisely at the junctures when traders are actively seeking liquidity.

Finding Investment Opportunities with AI

Recognizing that even the most logical participants in the market may have motivations leading to irrational investment decisions, resulting in mispricing in the market, our quest is to discover a tool capable of precisely identifying and capitalizing lucratively on these situations. Artificial Intelligence (AI) emerges as a potent solution, adept at grasping our biases, emotions, and unearthing knowledge often obscured for the average investor. It’s essential to acknowledge that intricate investment models possess the capability to unveil certain asymmetries within the capital market that may elude human experts. AI, armed with its deep machine-learning capabilities, can systematically explore a myriad of potential investment scenarios. Its prowess lies in painting a comprehensive portrait of the investment landscape, revealing risks and rewards in a manner beyond the capacity of the human brain.

AI helps not only make investment decisions but, through analyzing price behavior, makes irrational decisions that are rational in a current irrational market environment. Such an approach enables IKF AI to provide valuable investment advice to our clients from short-term horizons where an irrational environment is dominant to long-term horizons which are a home for rational investments. The I Know First predictive algorithm is a successful attempt to discover the rules of the market that enable us to make accurate stock market forecasts. Taking advantage of artificial intelligence and machine learning and using insights into chaos theory and self-similarity (the fractals), the algorithmic system is able to predict the behavior of over 13,500 markets. The key principle of the algorithm lays in the fact that a stock’s price is a function of many factors interacting non-linearly. Therefore, it is advantageous to use elements of artificial neural networks and genetic algorithms.

I Know First has used algorithmic outputs to provide an investment strategy for institutional investors. Below you can see the investment result of our sector rotation strategy for the period from January 1st, 2020, to April 12th, 2024. Also, we discuss the sector rotation here.

The strategy provides a positive return of 511.08% which exceeded the S&P 500 return by 449.14%.

Conclusion

The unpredictable nature of market behavior introduces both additional risks and opportunities for profit. While the dominant theory posits that institutional investors strive to counter perceived market inefficiencies for profitable asset management, reality presents a more nuanced perspective. In various scenarios, institutional investors, within a broader context, often find themselves more inclined to “ride” rather than oppose price inefficiencies. AI algorithms serve as tools adept at precisely recognizing and capitalizing lucratively on these circumstances. AI models possess the ability to uncover specific asymmetries in the capital market that may elude human experts. Their capability lies in creating a comprehensive depiction of the investment landscape, elucidating risks and rewards beyond the capacity of the human brain.

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