Stock markets are not people.

I say this because yesterday's big fall in European stocks makes many believe that markets look more like casino than textbook efficient markets. Jonathan Portes is right to point out that, technically, this is a mistake. But it is a very understandable one. A man who cuts his valuation of an asset by over 5% on the basis of almost no worthwhile information doesn't look terribly rational.

We can avoid this mistake by recognising that the stock market is not like a person. Share prices are not an individual's valuation of companies' future prospects. They are instead the emergent, unintended outcome of countless individuals' behaviour.

This point was grasped by Keynes. Actual stock market investing, he said, is a "battle of wits to anticipate the basis of conventional valuation a few months hence":

The actual, private object of the most skilled investment to-day is "to beat the gun", as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

It is, he said, like those newspaper competitions, popular in the 30s, in which people have to guess which faces others will find prettiest:

Each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which 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 practise the fourth, fifth and higher degrees.

Investing is like a co-ordination game in which the successful trader is the one who anticipates which co-ordination equilibrium others will alight upon. The man who worries when others don't will lose money; he may be right eventually, but this is little comfort if he's on the dole.

What's happened is that the focal point of this game has changed. Before Friday, the focal point was a belief that the US economy will grow nicely this year - or a belief that others would believe that others would believe that. Today, the focal point is the possibility that inflation will rise - or the fear that others will believe that others will believe....

Even small changes in the probabilities you attach to future focal points can cause big price changes.

Let's take a simple example. Imagine someone thinks there's a 90% chance the FTSE 100 will be at 8000 by year-end and 10% chance it'll be 6000. Then he'll think the FTSE should be at 7800: (0.9 x 8000) + (0.1 x 6000). If he then revises his probabilities of these scenarios to 80% and 20%, he'll revise his valuation down by 200 points.

You can see how this can generate volatility.

But only if people agree upon such changes. If everybody agrees a share is over-valued, it'll have to fall a lot in price before someone changes their mind and buys. If on the other hand I think a share is cheap and you think it expensive I'll buy and you'll sell without the price moving. The VIX index is often called a "fear gauge" but it should perhaps instead be called a disagreement gauge.

Volatility will vary as the extent of agreement varies - one cause of which will be expected shifts in focal points. Personally, I'm not sure such shifts are foreseeable. I suspect forecasts of volatility are a bit like forecasts of GDP growth: they aren't too bad normally (pdf), but fail when they are most needed. Which is why I have little sympathy for those who've lost on XIV.

And here's the thing. Aggregate market moves tell us nothing about the rationality or not of individual participants. It's possible for rational individuals to generate market moves that would look irrational if they were due to a single person's behaviour: this is the message of models of rational (pdf) herding or chasing noise. Conversely, stupid individuals might generate apparently efficient markets. It's possible that either or neither of these will be true in different times and places.

Granted, there might be some longer-term predictability of prices (based on, say, consumption-wealth ratios (pdf) or dividend yields), but perhaps there isn't in the short-term. Stock markets are more complex things than glib soundbites from empty suits would have us believe.