6 ideas
How efficient a market is depends on how many participants compete for the same profit opportunities and how well their heuristics fit current conditions. When many well-adapted competitors crowd a niche, prices become efficient and profits vanish. When the environment shifts or competitors exit, inefficiencies reappear until new or better-adapted participants move in.
Behaviours labelled irrational, such as loss aversion, overconfidence and panic selling, are rules of thumb that natural selection or learning tuned to earlier conditions. They look like errors only when the environment changes faster than the heuristic can adapt. Irrationality is therefore a mismatch between a behaviour and its current setting, not a fixed flaw in cognition.
When a risk hits every member of a population at once, an individual who always picks the most likely option risks the whole lineage being wiped out together. Randomising choices in proportion to their probabilities looks irrational for the individual but maximises the survival of the group. The type of risk an environment presents, correlated or independent, determines which decision rules evolution favours.
In early August 2007, many hedge funds running similar statistical-arbitrage equity strategies suffered sudden, severe losses at the same time. A probable trigger was one large fund unwinding its positions, which pushed prices against every fund holding overlapping trades and forced further liquidations. The strategies had become so crowded that the niche collapsed, as happens when too many species overexploit the same food source.
The payoff for bearing a given risk is not a fixed constant. It shifts as the population of investors, their preferences and the regulatory environment change. Strategies go through cycles of profitability, so an approach that worked for decades, including passive buy-and-hold, can stop working when conditions change.
Patients with damage to the brain regions that process emotion keep their intelligence but cannot make sound practical decisions, because they can no longer attach value to outcomes. Measurements of professional traders' physiology show that emotional arousal rises with market volatility. Too much or too little emotion both degrade performance. Rationality is the product of calibrated emotional responses, not their absence.