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I am just finishing up writing a new book on behavioral finance and investing. I am not sure what I will title it yet, but it will have to do with several “investment illusions”. I plan to have it published before Thanksgiving.
In this blog post I share with you a few excerpts from a chapter on the illusion of rationality.
Rationality
The science of economics relies heavily on assumptions because we don’t know and can’t know what is going to happen or how people will respond. Many assumptions are reasonable, but one is both wrong and costly to the investor. Classical economic theory, and all appendages to it, assume that individuals are rational – that they act rationally.
On the surface, this seems to be a reasonable assumption. Merriam-Webster defines rational as “having reason or understanding.” But the economic definition is not the same as our definition. Economics defines a rational individual as someone who doesn’t make errors in calculation or judgement and is not influenced by emotions. In other words, the human being is not a rational being in the economic sense. Pretending humans are economically rational is nothing more than an illusion.
Economic models, which rely on humans not making errors or being influenced by fear, greed or temptation, are used in almost everything that has to do with investing. Economic and market forecasts are based on these models. Risk profilers and subsequent recommendations for your asset allocation are based on these models. And optimizers also assume rationality. Harry Markowitz, who developed the most popular and widely used optimizer known as the Mean Variance Optimizer (or Modern Portfolio Theory) acknowledged that his optimizer is based on rationality, but then said, “The Rational Man, like the unicorn, does not exist.” At least he was honest.
Our “Irrational” Decisions
There are many ways in which we act “irrationally”. This is not about us choosing or acting poorly. When the economist or forecaster gets something wrong, they will chalk it up to “people are irrational”, as if it’s our fault. It’s not. They are pretending we are something we aren’t. As we learn about the illusion of rationality, we can see the flaws in those things we may have previously accepted as true. And that will help us make better investment decisions.
If We Are Not Rational, What Are We?
Given classical economics’ faulty and dangerous assumption of rationality, something better and more descriptive of how humans actually behave was needed. In 1979, two psychologists, Daniel Kahneman and Amos Tversky, developed Prospect Theory. Prospect theory acknowledges that we are influenced by emotion, that we make relative (not absolute) judgements and that we are influenced by reference points. It opened the door to what is known today as behavioral economics or behavioral finance. It marries human psychology with financial decision making.
Edward de Bono, an expert in the science of thought, opined that economic behavior is roughly 30% rational and 70% psychological. It’s not that we aren’t rational at all when making economic decisions, it’s just that we have a lot of other things influencing our perceptions and decisions. The way our brain is hardwired gives us insight into how we think, perceive and decide…
Hope you enjoyed!