The Behavioral Revolution
For a long time it was difficult to make the argument that people might behave irrationally from time to time. Sure we could demonstrate different irrationalities with experiments, but people would always tell me “clearly when it comes to important decisions like the stock market people will be perfectly rational!”
I didn’t think so, but it is hard to experiment with the stock market.
Sadly, the recent events have shown that the market is not as rational as we might hope, and making the case for irrationality is now rather trivial. It is an expensive lesson, but when David Brooks from the NYT makes the case for behavioral economics, I think we have arrived.
Maybe the most irrational tendency of them all is our belief that we are rational!
I just hope this would have been a cheaper lesson.
Sadly yours
Dan
The Upside of Irrationality, explores some positive and some negative ways that irrationality plays out in our lives.
How dismal.
Rational or not depends on who the judge is. Here is a hypothetical dialogue between Dan and Paul:
Dan: The stock market is behaving clearly irrationally: people in panic are driving the stock prices of many wonderful, very profitable companies to an unreasonably low level. On one day, they rush in and the prices would spike. On the next day, they flee and the prices would drop. It seems that they simply do not know what to do.
Paul: I do not think so. The stock market is performing in an amazingly rational way. Due to the uncertainty of the economy, people lose their confidence in the market. They can not predict when the price will bottom. If they leave market now, they can get in once the uncertainty is reduced. People are behaving completely rationally.
- A mind will not refute a conclusion it has just reached after a long time of struggle, regardless whether the conclusion is correct or not.
Dan,
The case is made, but the real work is still to be done. The task now is to put into place specific business practices and consumer skills that reinforce predicting the irrationality to smoothing out its wide swings. Isn’t this just the beginning? We understand it, now we have the difficult task of creating first order change.
The case for irrationality has not been made. What has happened is that we are more aware that the assumption of rationality is unproven. It is one of the foundational assumptions of economics, and economics was the science that studied stock markets in any depth. Now that economic phenomena are being studied from other perspectives, the assumption of rationality will have to compete with other assumptions, which is how it should be. Stock markets are complex enough that anyone studying them has to make simplifying assumptions, but we have to remember that any study of the market is based on unproven assumptions.
I’d like to agree with Dan on this one and say that the market is indeed (or can be)irrational. I must respectfully disagree with Pense in that we must distinguish between rational and systematic. Just because a behavior can be explained does not necessarily mean it is rational. Otherwise there’s almost no such thing as irrational as long as we can provide an explanation.
As an example, let’s imagine a hypothetical publicly traded company. In a short amount of time the company’s stock has plunged. However, during that time its leadership, products, earnings, employees, and market share have remained unchanged. Just because the investors are fearful and uncertain doesn’t make the company less valuable any more than someone spreading a vicious rumor about me lowers my IQ.
The questions that come to my mind after reading the linked NYT article are:
1. Why do many individuals subscribe to “black box” theories? That is, why do we not look deeper to actually find out how a system works, but simply trust that if I put A into the black box, I will always get out B?
2. Are the results of the behavioral studies conduted in Predictibly Irrational typical of all cultures? or are they particular to American culture?
3. If more individuals were aware of how certain “black box” systems worked – for example the stock market – would this alter behavior in relation to the market? And would the capitalist respond similarly to the socialist?
The rationality of pricing behavior decreases with the increase in the number and weight of variables that determine net present value of a future stream of earnings. The complexity of our trading systems (and lack of systems) for financialized stuff has overwhelmed rationality, even when augmented by enormous computer modeling and trade execution.
Indeed, moods determine prices, with some uncertain feedback adding to the complexity.
Or as Scott Adams put it:
“Nothing defines humans better than their willingness to do irrational things in the pursuit of phenomenally unlikely payoffs”
Enjoyed the book thoroughly. Am baffled, however – you have not listed the ten commandments correctly, at least according to any Bible I have in my house!
I am on Chapter 3 of this book and am enjoying reading it. Rationality certainly has its cultural imprint. This is especially
true when we are talking about social norms.
To simply classify people’s decisions into rational and irrational is too crude. Use a
scale of 1 to 10 is a better choice. But then, people show their rationality differently when they are in different situations. People can be perfectly rational in one situation and then very irrational in other situations. To characterize a person’s dicision making process, it seems that we need a rationality matrix: in one dimension, we list different ways people make their decisions: by following certain principles
(like the ten commendments), by reasoning and calculation (economist’s assumption), and by animal instincts. In the other dimension, we list situations people need to make decisions. But then we still need some ways to measure the level of rationality. I am not aware of the existence of quatitative analysis.
In this blog I expose something similar, though my idea is less brilliant than Dan Ariely’s approaches. The Spanish university is very bad, I am sorry.
http://misproyectosacademicos.blogspot.com/
Corporations have a fiduciary responsiblity to make money for their shareholders. We need to retool this part of a corporations charter. This fiduciary responsiblity has driven greed to new heights. This greed created new products, CDO’s, derivatives, Credit default swaps and more, all to bring in more money. Logic was no longer a factor. Most of those computer models only used historical data over the last 7 years or so. MOst of these products were made with the assumption that a total loss was impossible.
So, they got a good credit rating based on those false assumption which made them easier to sell, and here we are paying for these fallacious assumptions.
Every brokerage agreement states, “past performance does not guarantee future results” but, we buy products often created with computer models that base all of their assumptions on past performance being able to reliably predict future performance. DUH!
The way I know that the world is irrational, is that when I talk to God, I am praying, but if God talked to me, I would be labeled schizophrenic with auditory hallucinations.
It’s our economic models that are irrational.
The world is inherently unpredictable , and sudden large deviations are best explained (but not predictable) by Thom’s Catastrophy Theory. “Charlie Wilson’s War” is a good example of how large changes come from small events. So is the fact that Archduke Ferdinand was assassinated because his chauffeur turned down an unplanned street where Princip was sitting outside a cafe.
If the United States had not intervened in WWI, and Germany had conquered France, would we have had Hitler, WWII, and the Holocaust?
The real problem with corporations is that the boards of directors and the CEO’s are not the owners, so they are always playing with Other People’s Money. The old-time bankers (Rothschild, Morgan, Lloyd’s insurance) put up their own money, and did not work on commissions or bonuses, so they performed extremely careful due diligence.