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Saturday, 3 April 2010

Unpredictably Rational

Common Sense

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 has anything to offer the real-world of finance and human interaction. Unfortunately there’s a lot of the world which is convinced by models which pertain to explain everything important which offer spurious but comforting precision about the future. Economics, as a whole, taps into this need and has been remarkably successful in persuading many people, some of whom are quite intelligent, that it has something to offer.

Framed by Economists

At the root of this problem is this amorphous concept of “rationality”. The idea that rationality is a desirable quality for humankind has a very long history, reaching back to Socrates and then passing down a long line of philosophers. Rationality and intelligence are, broadly speaking, felt to be good things – apart from amongst groups of teenage boys who generally seem to think that possession of a working brain is a failure of education which can be fixed with a good kicking.

Because of this we’re predisposed to place a higher value on any approach which carries the label of “rational” and to place negative connotations on concepts associated with “irrationality”. Economists have neatly parasitized this inclination by taking a quite stupid definition of rationality and then holding it up as a shining example of what we should all aspire to. We have all, quite literally, been framed by the economists.

Nudged

This problem, unfortunately, extends beyond the traditional ideas of economics to the more modern psychological approaches underlying behavioural finance. The idea that people are deviating from some desirable norm of rational behaviour – exhibiting behavioural biases – is woven into the very fabric of behavioural economics. Of course, such approaches are better than the alternatives, as we saw in Utility, The Deus Ex Machina of Economics, the assumption that there is a desirable level of rational behaviour underpins them still.

Even worse, as outlined in Investor Decisions - Experience Is Not Enough, the current definition of behavioural finance leads to what appear to be some irrational predictions, justified by some artificially constrained experimental situations. The consequence of this is that behavioural economists are quite comfortable in offering us advice on how we should behave – or invest. They see nothing wrong in finding ways of nudging us to make us less irrational and positively glow in the satisfaction of finding ways of valuing differences in human behaviour. They can do this because they “know” that there’s a set standard of rational behaviour to which we should all aspire.

Irrational Economists

Of course, a world in which we were all selfish maximisers or even simply brutally logical would be a horrible, horrible place. So the perseverance of economists with these rational choice theories, even in the clothing of behavioural sheep, is an odd thing. Peter J. Hammond, in Rationality in Economics, suggests four reasons for the subject’s attachment to a frankly strange theory.

Firstly he argues that simple inertia is a factor – rationality gets taught to each succeeding generation of economists and they pass it on. 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. Anyone who’s read enough economic papers will sympathise with this view: at times it almost looks like economists feel they need to write really, really complex equations in order to justify themselves.

Free-market Apologists

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. As Hammond puts it, wryly:
“Defenders of free enterprise would have the force of their arguments considerably reduced if consumers were known to be behaving irrationally. Yet then economists might have a new role to play advising consumer organizations instead of business. Perhaps, however, they see that business can afford to pay better.”
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. We shouldn’t be dismissive of this either – early attempts by psychology to define similar concepts of good and bad behaviour led to forced sterilizations, the state sponsored dismembering of families and, ultimately, the development of eugenics and its terrible legacy.

Behavioural finance is a step in the right direction – at least acknowledging that people don’t behave as rational economics would want them to. However, it needs to go further, to accept that irrational human behaviour is no such thing: it’s created wonderful art, astonishing architecture, beautiful music and probed the very corners of creation. It's just that our rationality is rather more unpredictable than economists know how to handle. Time for a rethink.

Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our DecisionsNudge: Improving Decisions About Health, Wealth, and HappinessRationality in Economics: Constructivist and Ecological Forms

Related Articles: Save More ... Tomorrow, Investor Decisions - Experience Is Not Enough, Utility, The Deus Ex Machina of Economics, Investors, You've Been Framed, Be A Sceptical Economist

7 comments:

Robert Wasilewski said...

Economists do not say that everybody acts "rationally", especially in line with somebody's definition, all of the time. They do say that assuming that people act rational can explain a lot in terms of how wealth is created. If you lower the price of movie tickets you'll sell more movie tickets. If you lower the cost of tuition more people will go to college. Hey - there is a theory of value called supply and demand. On a macro basis if people are allowed to keep what they produce they will tend to move towards that activity which society values most. Hey - there is an "invisible hand" and it is people pretty much acting rationally - not walking around making decisions willy nilly. You can tell pretty much what people like ( yes - what brings them the most satisfaction by what they spend their money and their time on). Nobody is saying they stand around doing an elaborate marginal utility calculation every time they make a decision but assuming they do gets us to an understanding of how resources are allocated that we never had before the time of Marshall et. al.
This is not to say that behavioral finance is not useful. It is. It is an extension not a negation. The Classical economists thought long and hard and were pretty smart men and women.

timarr said...

Hi Robert

Agreed. No modern economist believes that people act wholly rationally, although most of the ways of dealing with this are extensions of an approach that starts with the assumption that people act rationally and then adds adjustments. The question being posed here is: is it possible to extend this approach to encompass human psychology, as behavioural finance is doing?

I'm begging the question, of course, and being a bit melodramatic about it, but I think it's a question worth asking because generally behavioural finance is presented as a whole new slant on economics. And really it's not.

But none of the above is supposed to question the findings of classical economics. As I've written before personally I suspect that Adam Smith got a lot closer to understanding how humanity and finance interact than a lot of his more modern counterparts.

Robert Wasilewski said...

Hi Timarr,

We are more on the same page than it might appear. I'm a huge fan of behavioral finance. For example I like Dan Airely's work. If you haven't seen his TED talk take a look. I think you'll like it

http://www.youtube.com/watch?v=9X68dm92HVI

I agree with the "melodramatic" observation but that's ok. I like a good dialogue.

I have to say that I was ready to jump in on your comment in a previous post to the effect that the war on terrorism was against a bunch of rock throwers in caves. I think they're a bit more dangerous than that! On the other did we over react? Did we act somewhat irrational in allocating resources to counter this threat given what's out there? Sure we did.

Also I have to say I agree with the observation that mathematics is over done in economics. We understand why though - you can't publish in academia without heavy math.

Rob Bennett said...

I believe that classical economics and behavioral finance both have important things to offer. But for both to co-exist, those who favor classical economics need to develop more of a humble attitude. Today they often put forward their findings as if they were accurate when their failure to include behavioral factors means that their numbers are wildly off the mark.

I don't believe that our free market economy will be able to continue much longer unless this change is made. In a free market economy, it is important that all citizens be able to make reasonably accurate calculations of what is in their best interest and it is not possible to do this without considering behavioral factors. So we all need to work together to encourage the proponents of classical economics to take the arrogance meter down about 17 notches.

Rob

Robert Wasilewski said...

Maybe I've come to the discussion too late or haven't read the right things but I didn't know there is a war going on between those who believe the Classical economic theory and behavioral finance. Is this an either or proposition? Is it a contradiction to think that people freely making decisions in the market place need to be told what "...is in their best interest..." and how to make those decisions?
I've always thought that behavioral finance was an extension of Classical ideas. Am I wrong?

Rob Bennett said...

I've always thought that behavioral finance was an extension of Classical ideas. Am I wrong?

Different people have different opinions on this one, Robert.

My view is that you are describing how it should be, not how it is. The Classical Economists contributed some wonderful ideas and the Behavioral Finance people contributed some wonderful ideas. The constructive thing is to take the best contributions from both and try to build something that really works.

My experience has been that many people get too caught up in their own theories to appreciate what the other school has to offer. But I am confident that there are people who do not agree with me re this. My views on investing are not today mainstream views.

Rob

timarr said...

Technically Robert's right although the popular view seems to be that behavioural finance is a whole new take on economics. There are plenty of people who dispute that behavioural finance has anything practically to offer economics, especially as enshrined by efficient market theories.

However, the question, at root, is how does people's "irrationality" impact financial systems? Both branches of economics more or less take the definition of rationality, as given by classical economics, as read. What I'm arguing in this article is that we need to take a hard look at this definition before we start accepting the proposals generated by behavioural finance uncritically. This is especially true if we're going to see governments and corporations using the learnings of behavioural finance to point us towards "correct" behaviour.

It's a subject for debate, though, not a definitive position.