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Assuming rationality

People aren't always rational, but investors can save money by assuming they are

Assuming rationality

Economists have for years been debating the question: does it make sense to assume that people are rational?

The case for not doing so is obvious, as any conversation with a real live person will reveal.

But there are reasons to make the assumption. One is that irrationalities can cancel out across millions of people: for everyone who’s unreasonably optimistic, another might be irrationally pessimistic. A second is that in some circumstances irrational behaviour is weeded out: the customer who buys lousy products learns not to do so, or the company that fails to maximise profits goes bust.

For investors, though, there are other good reasons why we should assume our fellow investors are rational.

For one thing, doing so can protect us from expensive mistakes. If we assume investors are rational enough to price assets correctly we’ll not waste money on dealing costs as we buy too many stocks or on fund managers’ fees. And we’ll also save ourselves from the mistake of buying newly floated shares which are often overpriced because their sellers know to sell at the right time.

We’ll also not bet heavily against the market, thereby saving ourselves from the danger that apparently expensive assets will become even more expensive. Much was made of the recent closure of Hugh Hendry’s Eclectica macro hedge fund, but in fact his was only one of hundreds of funds that have closed this year. This fact warns us that it’s harder than you think to make money from assets being mis-priced – perhaps because they often are not.

A second reason to assume that others are rational is that doing so can help us learn.

For years, government bond yields have fallen. For almost as long those people who overrate their own wisdom have been calling this a bubble. And – so far – they’ve been wrong. Rather than deplore others’ behaviour as stupid, we should instead ask: why might rational people do such a thing? Simply asking this question of negative bond yields draws our attention to important facts about the world economy: Asia’s savings glut; the shortage of safe assets; the dearth of real investment opportunities in the west; the slowdown in medium-term growth; and the willingness of investors to buy insurance against recession even at high prices. These are important facts. Egomaniac talk about a bond bubble has distracted some investors from them.

The point also applies to equities. For years, some investors have pointed to the high cyclically-adjusted price-earnings ratio on the S&P 500 as evidence of a bubble. And yet the market has continued to rise. This might tell us there were rational reasons for the market to be highly priced – for example that large companies have greater monopoly power than in the past and hence more sustainable profits.

Even if you are confident that a share is overpriced, however, you should ask: why haven’t the (small) minority of rational investors sold it short and corrected the mispricing?

The answer is often that it is risky and difficult to do so; you face the danger of having to put up more cash if prices rise even further. Irrational markets can become even more irrational. When you’re betting against the market, it’s not good enough to be right. You must be right at the right time. And that’s a much tougher job.

Let’s take another example. We know that some categories of shares have been systematically underpriced and so have done better than they should according to basic textbook theories. Asking why rational investors might underprice such shares alerts us to a reason for them to do so – risk.

Defensive shares, for example, carry the danger of underperforming a rising market, which could cost a fund manager his job or bonus. And cyclical stocks such as housebuilders run of the risk of big losses in a recession. These risks might or might not be worth taking – but you should be aware of them.

It seems, then, that there’s a good case for assuming that others are rational.

Or is there? Brock Mendel and Andrei Schleifer at Harvard University have pointed out that doing so can steer us into overpriced assets. They say that banks bought credit derivatives in the mid-2000s in part because they thought they were correctly priced. In hindsight, that was an error.

Tracker funds can do the same thing. Because these replicate indices that are weighted by market capitalisation they might sometimes invest in overpriced shares: for example, they had a big weighting in tech stocks at the peak of the tech bubble. This isn’t in itself a case against passive investing, simply because many active funds made the same mistake. In fact some had even bigger tech exposure – especially those that had an apparently good track record. But it does warn us of the dangers of relying too much upon the rationality of others.

What we have here might be yet another example of the point made by Columbia University’s Jon Elster – that there are no lawlike generalisations in the social sciences. The law 'assume others are rational' works in some contexts but not in others.

We should, though, distinguish between thinking and acting. Assuming that others are rational is a good place to start thinking, as it directs us to ask why they are behaving as they are. But whether it is the right place to end our thinking is another matter. It is not therefore an infallible guide to action. For some of us, this is a reason why we should not do very much.