Rick has done an excellent job summarizing my previous post: "In Theory" Pt. 1 and providing an excellent segue to this discussion. In the series opener, we discussed some of the problems with using academic models in real-world settings without questioning the assumptions that underly those models. To recap, models are excellent teaching tools and allow us to instantiate an ideal world in order to discuss how markets should work. Our charge as practitioners in any field -business, politics, or the sciences- is to take these theories with a grain of salt and apply them to the difficult, complex interactions that take place in reality.
In this post, I'd like to turn our attention to a first key assumption that is a pillar of economic and financial theory. This assumption have been well documented in numerous academic journals and dissertations, but I thought it well worth a recap that doesn't require footnotes, symbols, or polysyllabic constructs. MBA students are notoriously bad with numbers and words.
The first, most laughable assumption is that of the famed "Rational Actor." Like the Loch Ness Monster, the Abominable Snowman and a Cubs bid for the World Series, the Rational Actor has never been seen despite being an annual topic of discussion. Textbooks describe this incarnation of Homo Sapiens Sapiens as essentially self-interested, risk averse, and capable of conducting a cost-benefit analysis using all relevant information. This mythical creature makes calculated bets, never takes on catastrophic risk, and conducts his or her affairs with a realpolitik that would make Kissinger blush. The rational actor is the perfect, unemotional computer operating inside a human's body. And it doesn't exist.
Now, don't get me wrong; intelligent (and otherwise) human beings try their best to act rationally given their education, personality, and individual circumstances. But to believe that a marketplace based on human interactions will always operate smoothly because people make "smart decisions" is delusional. Work in psychology and behavioral economics have repeatedly shown astounding instances of humans making irrational decisions through heated emotions or simple breakdowns in logic. Humans are capable of denying themselves monetary or other gains in order to spite adversaries with greater losses, or to punish a class of people based on perceived injustices. Every boom and bust cycle -think Alan Greenspan's "irrational exuberance"- hinges on market participants sweeping stable markets past their equilibrium points into untenable extremes.
Technical traders use the concepts of support and resistance levels to mark the points where markets should "auto-correct" prices that have crept too low or too high, respectively. But a key part of technical analysis is that once these constraints are broken, market actors will start behaving differently in anticipation that underlying assumptions have changed. In a self-fulfilling prophecy, a cadre of traders anticipate further movements past the breaking points and hope to profit by being the first in and first out of these swings. Group psychology is an inherent component of market trading (and some would say long-term investing) and is difficult to reconcile with the emotionless "rational actor."
But can it be reconciled? Supporters of the rational actor theory might claim that these traders are making the best decisions given current conditions. Once a technical marker has been broken, conditions have changed and merit a change in tactics. The fact that everyone has panicked and run for the Exits like lemmings, thus causing a market collapse, is no reason to try to turn the tide by martyring one's portfolio and not cashing out. Indeed, the markets can stay irrational longer than I can stay solvent. In the study of systems and behavior, emergent behavior is an important consideration for group cohesion and disarray.
In a similar vein, firms that make seemingly irrational choices by forgoing a profit opportunity to spite a "rogue" counter-party actor may be trying to reinforce a set of established norms in order to preserve stability. Game theory and its implications for cartel behavior suggest that sometimes short-term considerations must be foregone for long-term stability.
But what does all of this mean for a discussion that supposedly lambasts the theory of rational actors? It means that we still need to question the market conditions in which we operate, even if we believe that our fellow players should act in accordance with our world view. After all, given the same set of information, why is a transaction taking place if we -as a market- both agree that a stock is worth $50?
When investing in finance, making capital purchases, funding a marketing campaign or running a government office, we should always remember that the customers and constituents we serve may not share our faith in rationality, or their reality may not seem rational to us. Organizations of any size and individuals of any kind may be blind-sided in their attempts to act rationally in an irrational world. In theory, we did the best we could. In practice, we should have known better.
-Brian Rozental is a 2nd Year MBA student at the University of Connecticut and a Vice President of the MBA Finance Club.
Brian,
ReplyDeleteI found your article very interesting, and of course ended up with a number of questions and comments. Hoping that you would excuse my complete ignorance, here they are:
The Rational Actor that you are referring to appears to be what I’d call a “Perfectly Rational Actor”. However, in my experience in the real world I’d say that what most of us (hopefully) are or try to be is an approximation that I’d call “Statistical Rational Actor”, when most of the time the conduct is substantially rational.
While agreeing with your concept that the “(Perfect) Rational Actor“does not exist, your article does not provide an alternative model for more accurate human behavior in the marketplace. Any ideas?
I’d like to make two other points.
The first has to do with your standard definition of the “Rational Actor” as self-interested, risk-averse, and capable of conducting accost-benefit analysis using all relevant information.
In my mind, the last part is the key. In the real world we deal (and evaluate and act) with incomplete information sets, not encompassing all relevant information but distinct and different sets. The same information is not available to every player.
Furthermore, the evaluation of each subset of information will follow rules that are based on many factors unique to each actor (past experience, cultural background, etc) and could be very difficult if not impossible to replicate. As a matter of fact, people have been trying to build Expert Systems for a long time… without much success…
The second point has to do with your statement that ”Humans are capable of denying themselves monetary or other gains in order to spite adversaries with greater losses, or to punish a class of people based on perceived injustices”.
The key here is the unique definition that each actor has of “reward” or “goals”. The reward does not have to be monetary nor have to necessarily represent a direct benefit resulting from a specific action or decision. Do we judge the rationality of specific isolated actions or we consider them only as part of a larger strategy with longer term goals and rewards?
A tactical loss can also be a significant strategic gain.
And part of the definition of the “Scope” includes a time factor. What is the timeframe that we use to evaluate a good/bad or rational/irrational decision? In the West we deal with days, weeks, sometime months, and rarely years. But not every culture is so narrow-minded…
Sometime in the 1950s a French journalist interviewing Mao Zedong asked for his opinion on the impact of the French Revolution, and Mao answered that it was too early to tell….
And sometimes a change in perspective, a look at the Big Picture, is enough to reveal that sacrificing that bishop was not necessarily a bad idea…
Enough for now,
I’m going back to work…
Regards,
Carlos