It may be a Rembrandt to you, but markets can beg to differ

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Wherever there is uncertainty, market prices reflect the beliefs of those who are more than averagely sanguine. The result is a reserve of illusory value, constantly depleted by events and replenished by fresh uncertainties.

One of the great insights of 18th-century economics was that exchange can benefit both parties to a transaction. Since then, the mercantilist view – in which trade is a mechanism by which one party tricks the other into giving up something valuable for inadequate recompense – has disappeared from economic theory, if not popular discourse.

Exchange takes place for many different reasons. Gains from trade are typically the product of differences in capabilities or preferences. Rembrandt is a skilled painter while I am a knowledgeable economist. He gives me a picture in return for economic expertise. (If you think this is not a good deal for Rembrandt, you do not realise how inept he was in managing his finances.) Or, you and I are both hedge fund managers, but I admire Picasso while you prefer Rembrandt. If my collection includes Rembrandts, and yours Picassos, then we each gain from exchange.

Beneficial exchange is possible whenever there are different perceptions of the value of the same object. Such an opportunity may be the product of differences in tastes. (We both agree that a painting is a fine example of Rembrandt’s work, but I like it and you don’t.) Or the difference in perception may be the result of uncertainty. (There is considerable dispute about which of the many works of the school of Rembrandt were actually painted by the master himself. I think the painting is probably a genuine Rembrandt, and you are not so sure.)

But the possibility that trade might be mutually beneficial does not mean it actually is. In both the above cases, an exchange in which I buy the Rembrandt from you might appear a good deal for both parties. But the second case, in which different perceptions result from uncertainty, is fundamentally different from the first, in which they result from idiosyncrasy. The painting is either genuine or not. One day, we might find out. And when that happens, we will realise that the deal was not good for both parties: one gained, the other lost.

Better information may destroy value, while ignorance may create value by permitting people to sustain and act on divergent beliefs. If the issue is the authenticity of a Rembrandt, the truth may never emerge. Some forgeries will grace national collections for ever. But if the issue is the earnings potential of a company, or the value of a complex debt security, divergent valuations based on divergent perceptions will eventually be resolved. Either the business becomes profitable, or it does not: eventually borrowers either pay what they owe, or they don’t.

In practice, differences in perception based on idiosyncrasy and those based on uncertainty may be associated. I am more likely to believe a Rembrandt is genuine if I like it; and we often say that fund managers are in love with the shares they buy. But much trade in all markets – and almost all in financial markets – results from different perceptions of the same thing.

You might expect that mistakes of assessment would average out. Sometimes we overestimate values and sometimes we underestimate. But valuations have an inherent bias towards optimism. There is a general human tendency to be overconfident. But there is another large bias. It is a lot easier to sell fake Rembrandts to someone who believes they are genuine than to sell genuine Rembrandts to someone who suspects they are fake. Objects are therefore much more likely to be held by people who overestimate their value than by people who underestimate that value.

Wherever there is uncertainty, market prices reflect the beliefs of those who are more than averagely sanguine. The result is a reserve of illusory value, constantly depleted by events and replenished by fresh uncertainties. That is why markets display a systematic propensity to boom and bust. And why zealots who can only describe markets by reference to rational expectations and market equilibria generated by efficient markets so often miss the point. Differences in perceptions and beliefs are what make the world of finance and business go round.

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