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Myth of the Rational Investor

1The events of 25th July when the Nintendo stock dropped by 18% created a lot of buzz in the market, on the face of it might look normal. For those who don’t know : (Refer Table 1)


Chart 1: Nintendo stock Price (6th July - 28th July)

Financial markets are supposed to be aggregators of information and investors are assumed to be rational. However, when on July 22nd. Nintendo issued a press release clarifying the limited nature of its revenue share from Pokémon go its share price fell to ¥23220 on the next trading day(link here).

This means that a lot of investors had invested with the presupposition that Nintendo owned Pokémon go. This herding behavior has been observed time and again in the financial markets. It typically starts with the emergence of a novel product with the revenue anticipation from it being high, it leads to a phenomenal rise in price and volume traded of the stock as it did for Nintendo (Refer Table 2). These are cases where there are high expectations about the future which have run amok.

However, in this day and age where we talk about the efficiency of markets it is surprising to see past data which is easily available not being taken into account. In the case of Pokémon go it was existing financial information that was not taken into account even after it was pointed out by the Guardian, Forbes and Nomura well before the stock rose. The stock price fell in the Tokyo stock exchange by 18% the maximum amount allowed, after the management released information regarding its economic stake in Pokémon go.

This incident implicates the neoclassical school of thought which assumes that people act independently on the basis of full and relevant information. We see the formation of a classic positive feedback loop which got reinforced by investors who related Nintendo’s stake in Pokémon go due to its previous associations, thus implying that they were not acting independently. Neither did they act on the basis of full and relevant information. They were boundedly rational as advocated by behavioral economics which means that they took reasoning shortcuts which lead to a suboptimal decision. Now when we add a lot of these suboptimal decisions together it leads to a trend and the feedback loop ensues. This incident where data available previously was not taken into account should force a rethink amongst all regarding the prevailing neo classical school of thought.
Is it rational anymore to consider financial markets to be efficient and investors to be rational?

Table 1

  • The game Pokémon Go was developed by Niantic labs and the Pokémon company and not Nintendo this information was covered by the Guardian(Link Here) on July 10 before the game was released.
  • This fact was subsequently covered by Forbes(Link Here), Mashable(Link Here) and Nomura on July 11. Nomura also commented that the share price rally is excessive based on profits from Pokémon go alone.
  • The Pokémon company is owned by Nintendo, Game Freaks and Creatures. Nintendo owns 32% stake in the Pokémon company, 10% of stake in Creatures and an estimated 7% stake in Niantic labs.
  • According to Macquarie Securities analyst David Gibson Nintendo has an effective economic stake of 13% in the app.1

Table 2

DateBefore July 7July 7July 8July 11July 19
Volume traded (in shares)20000-50000900000792000980000013300000
Share price¥14410-14810 ¥14935¥16270¥20260¥31770

1 http://www.bloomberg.com/news/articles/2016-07-25/nintendo-set-to-plunge-after-saying-pokemon-go-s-impact-limited

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