Question

Assess the following statement: "Although many investors may be irrational, it is unlikely that over time they will behave irrationally in exactly the same way—such as always buying stocks the day after the Dow has risen by 1%."

Short answer

Many investors behave irrationally in the short run. Still, they will not continue to do so over time as they will adjust to the market changes according to the efficient market concept.

Step-by-step solution

Irrational choice and efficient market hypothesis

The stock prices are fairly valued in an efficient market, reflecting all currently available information about fundamentals.

Individual investors and professional money managers often doubt efficient market hypotheses and believe that markets often behave irrationally. Individuals make irrational choices that leave them worse off economically. While such behavior is the subject of behavioral economics, Robert Shiller et al. won the Nobel prize in 2013 for justifying how financial markets show clear signs of irrationality.

Investor's behavioral change over time

Irrational behavior such as buying the stocks the day after the Dow rose by 1% might give a mixed experience. Rational investors can make a lot of profit at the expense of irrational investors' choices.

If investors consistently buy stocks the day after the Dow rose by 1%, any other investor will sell the stock on the same day because of high demand and prices of the stock on that particular day. If the process (buying and selling) earns a significant profit, many investors will sell the stock on that day.

This proves the statement contradictory that investors always buy the stocks the day after the Dow rise by 1%. Eventually, people learn and consider this information and start behaving as per market changes.