Oh, and one last thing:  speculating is just a more acceptable synonym for gambling.

Now, one type of non-public information would be to have a different (better) view on the company’s prospects or on say, macroeconomic prospects.  Three things make this very difficult in practice.  Firstly, it is very difficult to be smarter than the market.  Second, even if you are correct, it often takes much longer to be proven right, hurting your returns (or worse).  This is analogous to Keyne’s famous statement that the market can remain irrational far longer than you can be solvent.  I would, of course, modify this to say that the market can remain stupid far longer than you can be solvent. Third, since the market tends to lean towards optimism most of the time, having a contrarian view usually means being short the market.  Shorting the market brings its own set of risks and is a strategy that is extraordinarily difficult with which to make money.  You may have noted that numbers 2 and 3 help illustrate why bubbles can persist for a long time.

Given today’s economic situation, the irrationality of investors and economic actors is being used to justify hugely significant policy decisions.  Instead we should be focusing on, for example, the horribly wrong incentive structures throughout the finance system that led to (rational) decision making which in turn led to the our current economic woes (much more to come about this under Current Economic Situation category).   We also should be focusing on how to educate people to make smarter decisions (i.e. to understand economic and finance decisions).

It is also important to understand the fallacy of irrationality because it is being used as key evidence of the inherent failure or instability of a free market system.   This couldn’t be further from the truth, as we will also discuss in other posts.

What we dispute is the above definition of rationality.  It is wrong in three ways.  The most obvious way it is wrong is that we don’t maximize our current economic well being but the present value of our well being.  Now, I would guess that almost all economists would probably agree with this modified definition.  But it is a very important distinction because people have very different discount rates.  That is to say, some people place much more value on well being today versus well being in the future.  To place more value on well being today is not irrational if one’s discount rate at the time is higher.

The second error in the definition of rationality is that people don’t seek to maximize their economic being (that is to say, their wealth or income) but their overall well being or their “utility”.  (I have a lot more to say about the definition utility but for now leave it as one’s overall well-being).  Now again, most economics would agree with this modification to the definition but alas, fail to internalize the distinction.  Understanding that many decisions (even investing ones) are affected by things are than income or wealth goes far to explain many of the experiments that claim to prove that people are irrational.  For example, many studies have shown that individual investors trade too much even though they know that trading costs hurt their overall investment performance.  Therefore, they are irrational, right?  Not necessarily.  Most individuals who trade in and out of stocks get other utility out of their actions.  That is to say, trading is fun, not unlike, say, going to Las Vegas.  In other words, the entertainment value of trading adds more to their utility than the lost money due to trading costs subtracts.  There is nothing irrational about that.

The third and final error is probably the most important one and also the least understood.  Many experiments have shown that when faced with a probability based decision many people make the wrong choice (that is one that results in lower expected value) or given two sets of decisions, make inconsistent choices.  These types of experiments are used to demonstrate the irrationality of human beings.  But this is wrong.  What they demonstrate mostly is that humans are bad at probabilities (they demonstrate other things as well – for example that most of us would rather not lose money than gain money).  Perhaps we’re all dumb, perhaps we all slept through statistics class in college or perhaps our incentives are messed up.  That we don’t fully understand the question or that we didn’t bother (or don’t know how) to do the expected value arithmetic does not demonstrate irrationality.  So the third distinction that we need to make to our definition of rationality is that we make decisions to maximize the present value of our utility based on the decision maker’s understanding of the decision and NOT the experimenter’s understanding of the decision.

Assuming you’re still reading this and haven’t fallen asleep, you might be wondering so what?  Who cares if people are rational or  not?  Let’s talk about that next.