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.