Wednesday, October 15, 2008

Irrational Investors?

Today, I wanted to talk about something a little more philosophical. In the world of economics there seems to be quite the debate over people behaving rationally versus irrationally. We are told repeatedly these past few weeks that investors are behaving irrationally. That we humans are digressing into the primitive parts of our brains and basing decisions on emotion and not on reason. This is where I disagree. I do not think that irrational behavior is even possible.

First, let’s define rational and irrational behavior. If, like some seem to think, that rational behavior is based on facts and irrational behavior is not based on facts, then this makes it difficult for me to conceive of an irrational thought. Do investors panic for no reason at all? Is it merely a phenomenon where many people randomly panic and start to sell everything? Not likely. As has been the case in recent weeks, dark clouds have been slowly growing for months. People were acting on facts.

Now the retort will be that people oversold in the market, and that they were selling stocks whose true value is more than current prices. More simply, that people are acting on a limited number of facts, but not on the full truth. If the definition of rational behavior requires omniscience, this creates an impossible hurdle and no thought can be considered rational.

As an example, imagine that you are in the middle of a crowded theater and a teenage boy yells “Fire!” Should you race to the rear exit, or stay in your seat assuming the kid is just pulling a prank? I would say that either choice is rational depending on what you know. Is it irrational to flee a burning building? Is it irrational to ignore some teenager yelling “Fire!” when you can’t see it or smell anything? Neither is irrational given the information that you have at the time. If in reality there was an unlit exit at the side of the theater that no one else could see, this would not make the other thoughts irrational.

Many people invest without much knowledge of finance or economics. They generally stick to a few rules about their choices. Their brokers tell them to “buy and hold” and not to try to time the market. These are nice rules, but in 1929 in the U.S. and 1989 in Japan these were horrible strategies. It took 23 years for the DJIA to recover its losses and the Nikkei is less than a quarter of its 1989 high (was 38957 is ~9600).

What naïve investors often do is look at trends (i.e. they extrapolate). Extrapolation is a very important and rational approach to life, but it is a very inaccurate way to judge stock prices. If floodwaters are rising, extrapolation tells you to get the heck out of there. We don’t call people irrational because they didn’t know that a 5 inch rain event in their watershed would leave them 3 or 4 feet above the flood waters. When time is of the essence we have to rely on less information. This is rational and pragmatic.

In the long run, those who base their decisions on more precise techniques and more complete sets of information are going to make fewer mistakes, but all decisions are based on limited information and imprecise techniques. The difference between rational and irrational investing in the common lexicon is arbitrary. I conclude that irrational investing does not exist.

In essence, we have economists on the left trying to help protect those who are “irrational”. What they truly are doing is rewarding ignorance by taxing the prepared.

5 comments:

Ad Hoc Committee for Property Rights said...

Knowledge is contextual. We know what we know. Omniscience is not the standard of rationality.

Rationality has only one component-- adherence to reality. But this means that we recognize what we know, as well as what we don't know. It means that we recognize that we are not omniscient and can't be.

If one evades this fact, for whatever reason, one is behaving irrationally. If one panics because the market is dropping, and does not identify why and what the long term implicatins are, one it behaving irrationally.

Certainly there are valid reasons for the market dropping. But why has the market been so volatile? Has the information been that dramatically different day to day? I certainly don't think so.

More fundamentally, if there is no such thing as irrational behavior (whether in investing or any other sphere of life), then you are saying anything goes. There is no distinction between building the Twin Towers and blowing them up. Both actions were undertaken with the knowledge available to the people undertaking them.

Brian Shelley said...

Ludwig Von Mises - Human Action - Chapter 4

Thought you would appreciate the thoughts of a good friend of Rand.

"Human action is necessarily always rational. The term rational action is therefore pleonastic and must be rejected as such. When applied to the ultimate ends of action, the terms rational and irrational are inappropriate and meaningless. The ultimate end of action is always the satisfation of some desires of the acting man. Since nobody is in a position to substitute his own value judgements for those of the acting individual, it is vain to pass judgment on other people's aims and volitions. No man is qualified to declare what would make another man happier or less discontented."

Brian Shelley said...

The reason I have a strong dislike for what I consider the gross over use of the term irrational are similar to Mises' complaints about polylogism. Those on the Left constantly claim it exists so that they can assume the control they desire. It is in their hubris that they conceive that their thoughts are somehow above the irrationality of the rabble, which justifies their accumulation of power and their need to be in control.

Ad Hoc Committee for Property Rights said...

I am not sure that Rand and Mises were good friends. Regardless, she disagreed with his views on epistemology, and your quote is a good example why.

Mises position is essentially that of the Left—we cannot judge others. He is claiming that since all actions have some goal, then those actions are inherently rational. This is a complete dismissal of the meaning of rationality.

Rationality is the devotion to reason as one’s guide to thinking. A person who consults tea leaves, or follows whatever idea pops into his head without giving that idea any consideration, is certainly not rational.

Back to Mises: If we can’t pass judgement, then the actions of terrorists are no different from those of our soldiers. After all, the terrorists have a goal—our extinction. To proclaim one evil and one good is a value judgment.

Brian Shelley said...

I'll agree that Mises' perspective is rather clinical and amoral. None the less, any moral system someone subscribes to should be based on facts. If I can not conceive of a irrational thought, I can't project that pejorative on others.

I think our main difference lies in the time span we're referencing. I am looking at individual decisions, and you are looking at a lifetime pattern of behavior.