How can you say that people are rational given all of the research that seems to show otherwise in addition to all of the booms and busts throughout history?

Okay, this is really important.  To really understand this point, let’s first understand how economists usually define rationality.  An economic actor (that is to say, a person)  is rational if he or she always makes decisions which will maximize his or her economic well being.  Now, there is an enormous body of research in psychology and behavioral economics (the same field by the way – just that the economics know how to use statistics) that shows otherwise.  This we do not dispute in the least.

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.