Unpredictably Rational

3rd Apr '10 by timarr

4 comments 3765 reads

As we go about our everyday lives we don't spend a lot of time reflecting on the irrationality of the people around us. Certainly from time to time people do stupid things, but by and large most of us make it through most of our days without driving the wrong way up roads, roasting our dogs in microwaves or buying stocks in stupid companies. Even when we do odd things there's usually some recognisably rational reason for us doing them.This version of human rationality is virtually unknown to all brands of economics which largely insist on defining rationality in an irrational way and then sniggering at the human race when it fails to live up to the standards that some rather over-focused economists think it should. The problem for them is that we're not the irrational ones, they are. The problem for us is that the people that matter listen to them, not us.

Maximal Utility

The definition of rationality that's at the centre of modern economics is a strange conceit, based around the idea of maximising utility. Underlying this is an assumption that rationality means that we're consistent in our choices: faced with the same situation we should always do the same thing. From this position economists have then spent a great deal of time trying to design experiments to show that this is what we do, which is just about possible when you remove all vestiges of reality from the situation (see, for instance, Be a Sceptical Economist). However, real-life isn't like this. We rarely, if ever, face the same situation twice: life is a stream and we can't stand in it twice. Mostly we must face each situation anew and make new choices each time. Obviously we rely on past experience to guide us in our decision making and, as we all have different experiences to guide us, we make different decisions. We even make different choices ourselves between very similar circumstances and most of us will see nothing wrong in this. It's certainly not irrational to change our minds – as Keynes himself said, when the facts change you should change your mind: it would be stupid not to. So when a pseudo-science like economics tells us that when we change our minds we're being irrational it has a lot of explaining to do if it's to genuinely convince anyone that it…

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emptyend

4th Apr '10

Hi Timarr,

Good piece! I've added some comments [in the square brackets] to yours:

Firstly he argues that simple inertia is a factor – rationality gets taught to each succeeding generation of economists and they pass it on....[I'd see this as a form of chain letter, as used in pyramid selling schemes - the first few adopters of a new idea can make money, but eventually it results in collapse of the theory or in bubbles. The demise of the "small company effect" theory and the puffing of bank stocks for the decade up to 2007/8 are cases in point]

Secondly he thinks that the mathematical clarity of the models is a major issue – the ease with which they can be used to solve problems in economics makes replacing them with messy real-life difficult and unattractive......[Yup. It is difficult to properly model societies or markets. The views of the George Soros and the Hugh Hendry carry much more weight than those of you or I in the short term, but it doesn't mean they will be any more correct....per Buffett's comments on weighing machines and voting machines! ;-)]

Thirdly he suggests that economists may be operating as apologists for free market economics, essentially engaged in developing theories that justify the behaviour of markets and their participants. A few years ago this would have seemed an extraordinary suggestion but no longer: with hindsight it's perfectly clear that many economic theories were at best descriptions of what was happening in markets and at worst post-hoc justifications of a culture of excessive greed and risk-taking. This model of economists as apologists comes from a fairly simple association. The idea that markets are efficient and that people are behaving rationally fully justifies virtually any behaviour in the markets..... [This reminds me of Descartes: "Dubito ergo cogito ergo sum"......"I doubt, therefore I think, therefore I am"........and I have little doubt that the Efficient Market Hypothesis is to blame for the economists' view. I was taught it 25 years ago - but a few months' practical experience in the real world showed me it was incomplete, despite being a seductive and largely correct idea at the very macro level! The problem with such an approach is that when it becomes clear that the models have omitted some crucial variables, the whole edifice falls over - often in quite dramatic fashion, thanks to the perpetuation of groupthink over many years due to the inertia point above. Again the banking system is a great example!!]

Fourthly he points out that experimental evidence could support the ideas of rational economics only, as we've frequently seen on these pages, they don't. Not even economists behave the way that rational agents are supposed to once they leave the chalkboard and start engaging with the real-world. The truth is that the real-world is far too messy to allow for the type of rational behaviour that economists desire. We don't make decisions through a logical step-by-step analysis but instantaneously in the context of the social situations that we find ourselves in. Most of the time we make things up as we go along, hoping for the best and, generally, not anticipating the worst.

Great Works

It's an unfortunate by-product of economics that this perfectly normal human behaviour gets labelled as irrational and then derided. It's not the "irrational" behaviour of everyday people that should be being sneered at but the "rational" attempts of economists to build all-encompassing models that can be used to straightjacket peoples' behaviour. [I'm not sure there is a good answer to this problem. In many cases it is perfectly sensible for the irrational to be very firmly and actively derided (including, IMO, the application of "technical analysis" to individual stock prices)....but in others there is certainly very good sense in deriding things that many people accept as established facts - even though they are merely theories that have been given added credence by a few decades of history and frequent repetition!]

On this last point, one of my favourite pieces of complete bunk - but which is nevertheless "accepted wisdom" - is that "equities always rise over the long term"......

.....The source of much of this belief is the Barclays Equity Gilt Study, that has been published since 1956 but has (over the last 25 years....ever since people started trying to flog derivatives, you'll note! ;-)) been cited with increasing frequency to justify all manner of behaviours......from "buying dips" to selling volatility in precipice bonds and other FTSE-linked products. An example of a recent citing is here.

.....it is my view that this stuff is merely hokum created by data-mining and has been used and abused to bolster the "cult of the equity" - a phenomenon that started around the mid-1950s, perhaps not coincidentally at the same time as Barclays started publishing. It is increasingly my opinion that this multi-decade run that the equity market have had since the 1950s is now, to all intents and purposes, over.....and was largely down not to some inherent advantage that equities possessed, but was in fact largely down to above-average inflation stoked by rapid population growth and investment in new global technologies (mainly centred on data-processing, communications and transport). Accordingly, I see the current bull market as being built on extremely shakey ground....relying, as it does, on much of the theory espoused by Barclays and now embedded in the very core of financial markets, including (for example) the concept of a steady "equity risk premium", betas and a whole raft of other stuff that underpins option theory etc.

And it probably won't surprise anyone to learn that I think the denouement for the "cult of the equity" will prove to be close to Jim Rogers' theory regarding commodities....because the rising prices of oil and other commodities which are in high demand but have restricted supply will eventually kick the props of the bull market away and FORCE people to reconsider whether equities really CAN outperform over the longer term. Ultimately the laws of geology and population growth will come to trump what are now seen as the "laws" of economics [because the laws of economics always assume that there are no physical constraints on supply].

yours cheerily

marben100

Superb article Timarr. :0) Perhaps certain economists and some that pontificate on economic theory should play a little poker to understand "rational behaviour" a little better? See Caro's Law of Loose Wiring .

Best,

Mark

timarr

5th Apr '10

Love the poker piece, marben. Tim Harford did a nice write up on Chris Ferguson in The Logic of Life: game theory meets the table. But, yeah, there's a lot of life and investing in poker.

Hi ee, I did a write up on the blog about Rob Arnott's research showing that bonds had outperformed equities for 40 years a while ago. It does, in fact, look like equities do always go up in the long run - but the long-run can be very, very long indeed. The best estimates now reckon that the equity-gilt premium is only about 2%, which makes a big difference over a very long time but over shorter periods - which can be up to our entire investing lifetimes - it's small enough to lose money. The only caveat to that is that re-investing dividends does ensure you end up ahead, but it's no substitute for picking the right stocks.

I'm also with you on population pressure and commodities. Of course Malthus made the same argument a couple of hundred years ago, but the Agricultural and Industrial Revolutions undid him. I can't quite see how we pull off that particular trick again ...

Hi timarr,

It does, in fact, look like equities do always go up in the long run - but the long-run can be very, very long indeed. The best estimates now reckon that the equity-gilt premium is only about 2%, which makes a big difference over a very long time but over shorter periods - which can be up to our entire investing lifetimes - it's small enough to lose money. The only caveat to that is that re-investing dividends does ensure you end up ahead, but it's no substitute for picking the right stocks.

Yup the equity risk premium has always been around 2% or so. Thats the figure that gets plugged into the CAPM etc. I've highlighted the key point though......

.....I'm happy to accept that 2% was a decent enough figure based on historical data for several decades towards the end of the last century - and the model appeared to work. However....if you look at returns since about 1996 (IIRC) they look pretty damned shabby - and I am of the view that this is no coincidence. For those who have recently started investing and who have got sucked into the equity cult (together with the efficient markets hypothesis etc) I don't think their experience so far has been, on average, that great! Of course stockpickers have done OK over the same period ....and some of us have made small fortunes.....but the great mass of people will not!

I'm not at all sure that the dead-cat bounce we've had (large though it has been over the last year!!!) can continue.....and those who have just started investing and got lucky over that timeframe may be well-advised to take cash off the table? Incidentally, I forgot to mention the other obvious reason why the wheels will soon come off the rally - in addition to demographics and commodities, we also have the pesky global problem of starting to pay down unprecedentedly-large amounts of systemic debt!

cheers

Unpredictably Rational

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Timarr

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