The challenge for today’s modellers is to quantify irrationality. Hindu theology’s six passions — desire, anger, greed, delusion, pride and jealousy — may help in analysing irrational behaviour.
A report in Business Standard (September 6, 2011) quoted Dr D Subbarao, Governor of the Reserve Bank of India, as saying to officers of the Indian Economic Service, “But the rule of the game is that you are rewarded for not choosing the person you think is most beautiful… Now, most people may think Kareena Kapoor is the most pretty, so I would have to go with Kareena rather than Katrina.”
His speech took me back to my PhD days at IIT Madras. As part of the course on advanced finance theory, I gave a seminar on rational behaviour in the stock market, for which I used a fictional newspaper contest created by Lord Keynes to describe the action of rational agents in a stock market.
As per the contest, participants have to choose a set of six faces from photographs of women that are the most beautiful. The normal strategy would be to choose the six faces that, in the opinion of the participant, are the most beautiful. If I were to choose, I would choose Madhuri Dixit as the first of the faces.
However, as per the rules of the contest, the participant who chooses the six most beautiful faces correctly (which means he who chooses the six eventual winners) gets a handsome prize. While naïve participants may continue with the original strategy of choosing the faces they consider beautiful, sophisticated participants may change their strategy. Wishing to maximise the chances of winning a prize, sophisticated participants would think about what the majority perception of beauty is, and then make a selection based on some inference from their knowledge of public perceptions.
I am not sure whether I would continue to vote for Madhuri, although I continue to rate her face as most beautiful. I would like to choose the face that is perceived to be the most beautiful by the majority. I may perhaps vote for Katrina Kaif, if I consider that she is, in general, perceived to possess the most beautiful face.
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If a majority of participants are naïve and vote for the face that they consider most beautiful, then voting for the face that is perceived to be the most beautiful is fine. But the other participants may not be that naïve. They also may like to vote for the face that is perceived to be the most beautiful. Under this understanding, the vote should go not to the face that is perceived to be the most beautiful, but the one perceived to be perceived as the most beautiful face. I may still rank Madhuri to possess the most beautiful face; I may still view that general perception of beautiful face to be that of Katrina’s; but I know that Kareena Kapoor is in general perceived to be the winner of the contest. Thus my strategy should be to vote for Kareena, based on my analysis of others’ strategies.
The strategy can be extended to the next order, and the next, and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other participants. As Keynes, in his General Theory of Employent, Interest and Money (1936), notes, “It is not a case of choosing the faces that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
Keynes extended this behaviour to the stock markets. Market participants price shares not based on what they think the fundamental value is, but rather on what they think everyone else thinks the value is, or what everybody else would predict the average assessment of value to be. What a beautiful idea!
For a fairly long period, the underlying assumption for several models developed in finance was the rational behaviour of market participants and the consequential assumption of normality of returns. It was not that these assumptions were not questioned. But they are being questioned much more now. It is now accepted that it is not rational to believe that man is not irrational. Abnormality is not so abnormal.
But it is not just enough to say that man is not rational, as it does not lead the finance theory development any further. It is necessary to analyse and find where the irrationality stems from and to attempt to model it. Researchers are focussing on aspects like greed and fear that drive behaviour of individuals in general and as market participants in particular.
It is in this regard that arishadvargas identified by Indian theology may help. The arishadvargas are kama, krodha, lobha, moha, mada and matsarya. They are said to be negative characteristics in a human being, and when they become dominant, can lead to irrational behaviour. Kama, though generally associated with lust, means desire. Krodha means anger and associated hatred. While lobha refers to greed, moha, mada and matsarya mean delusion, pride and jealousy respectively.
Let me take an illustration outside stock markets, but very common today, to see how these passions play a role in the irrational behaviour of a person. Mails that have become very prevalent recently relate to offers of a large sum of money, for varying reasons like a lottery, will or even loot. The rational thought should be to ignore such a mail. Yet, some correspond with the sender and sometimes part with their money for the unknown return. They don’t even discuss with others until they incur the loss.
Why does it happen? Why do they not get driven by rational thought? The reason could be one of the arishadvargas.
“Don’t I need money for a luxurious car?” (Kama)
“Should I not show the fellow who laughed at me, his place?” (Krodha)
“Am I a fool to miss an opportunity to amass wealth?” (Lobha)
“Why should I miss such an offer?” (Moha)
“How can anyone cheat me?” (Mada)
“Should I not surpass my neighbour?” (Matsarya)
Unfortunately, while deciding to continue with the mail correspondence, negative passions that are hidden in the mind of the person drive him to act. Similar thoughts, hidden even from the person himself, take place in the mind of a stock market participant, making his actions irrational. The challenge to today’s modellers is quantification of irrationality. For this the traits behind irrationality need to be studied. Keynes’ fictional game of six beautiful faces helped understand rational behaviour. Hindu tradition’s six passions may help in analysing irrational behaviour.
The author can be reached at asramasastri@rbi.org.in.
The views expressed here are his own and do not necessarily reflect those of the organisation he works for