Efficient Irrational Markets

Abstract

Statistical analysis of interest rate forecasts published in the Wall Street Journal since 1981 suggests that investors do not need to be rational for market prices to be efficient. A market populated by imperfect agents can be efficient if there are enough agents and they are suitably interconnected. That is, numbers and interaction compensate for individual imperfections. A maximum–likelihood model of a market inhabited by irrational heterogeneous investors produces a distribution of interest rate forecasts that agrees with the Wall Street Journal polls. From a practical viewpoint, if price efficiency is independent of individual rationality, then passive index investing dominates active investing, whatever the individual investor behavioral biases.