One of the most preciously held (and arguably irrational) ideas in finance is that markets are rational.
They are rational, say economists, because people act rationally – at least when it comes to their money and investments. To make this theory work, economists assume that people carefully and objectively weigh the risks and rewards of various opportunities and choose only those that are in their best interest. Or, to use the jargon, people seek to "optimize" their personal financial situations.
This principle of rational behavior is held so strongly that in 1996 when former Federal Reserve Chairman Alan Greenspan wanted to warn against what he saw as troubling personal economic behavior – too many people buying too many overvalued assets – he used words that every good economist would hear as a damning epithet. He called it "irrational exuberance."
But if you're not an economist, that rational argument sounds wrong. Nassim Nicholas Taleb, author of a book called The Black Swan, The Impact of the Highly Improbable, explains that if you believe in free will, you can't also believe in the sort of social science and economic projections that depend on prior actions to predict the future. That's because it's impossible to predict how people with free wills will act.
"Except, of course, if there is a trick," he writes, "and that trick is the cord on which neoclassical economics is suspended. You simply assume that individuals will be rational in the future and thus act predictably."
Since Taleb's thesis is that we are most affected by unpredictable and irrational events, then, it's easy to see why he calls rationality a "straitjacket for orthodox economics."
Most of us who aren't economists don't wear that straitjacket. Neither do we buy that rational behavior model, because we know that people act irrationally all the time – even when it comes to their own money.
Be truthful, now: Have you left your money in a 401k with a company you used to work for two jobs ago? That's simply irrational, because it's too easy to lose track of your money even when you continue to get the quarterly mailings. But I'm willing to bet that I'm not the only one who can say 'yes' to this question.
Some Irrational Exuberance at Work
To confuse matters even more, the same behavior that looks rational from one point of view sometimes looks irrational from another. For instance, it seems rational to buy a house to create equity rather than to rent and throw money away every month, but it seems quite irrational to buy a house that you can't afford. That's one reason why we have a full-scale housing implosion on our hands: many people took out mortgages they can no longer afford now that interest rates are resetting from the low teaser level to a higher rate after two years.
Similarly, it seems rational to buy collateralized debt obligations (CDOs) when they are rated AAA or AAA-. But that behavior changes to irrational once you learn that the rating agencies have downgraded the debt securities backed by subprime mortgages, and you find out that your CDOs are really junk bonds. It looks more and more as if Moody's and Standard & Poor's got caught up in the spirit of exuberance.
But what it comes down to is this: It's easy to think people are rational when financial markets are going up. Greed, in that sense, seems rational. That is, it seems rational to take the money and run while you can. It's not nearly so easy to act rationally when fear takes over as markets turn from bullish to bearish. These summer months have given us a taste of what crazy volatility and steep declines in the markets feel like. And they have made people fearful.
When fear replaces greed, things that once seemed so rational – veritable Dr. Jekylls – now look like frightening Mr. Hydes. Thus, people who once bought slices of securitized subprime loans to get the high yield now kick themselves as they take losses. As they watch the rising number of foreclosures across the nation, here's the thought that hits them upside the head: How could I have been so stupid as to take a risk on other people's irrational mortgage-buying behavior?
Now that investors fear losing money on their investments, they demand higher returns, and many also demand their collateral. That behavior – rational on one level – causes some ugly consequences as hedge funds and investment banks must sell their assets to cover their debts. Here's how financial forecaster Bob Prechter of Elliott Wave International describes the situation:
"It is beginning to dawn upon people how a deflationary spiral works. To satisfy creditors, debtors will sell all they can, even their best assets, to raise cash. That's one reason why gold and silver are not going up…. Even if most of the recent price declines are due to forced sales, those sales in turn are decreasing the total value of investments, which in turn will curtail individuals' and companies' economic activity, which will lead to an economic contraction, which will stress the issuers of such bonds to the point that they will be unable to make interest payments or return principal." [Elliott Wave Theorist, August 26, 2007]
Whether we see Dr. Jekyll or Mr. Hyde in the markets, it doesn't matter. What really matters is to realize that rational behavior doesn't rule the markets. Especially once a financial market starts shooting up or shooting down, it's not the mind that decides what one's next move will be. It's the emotions.
Everyone else who is invested in the markets is likewise driven by emotion, which results in herding behavior. And when the herd takes over and the markets turn bearish, say good-bye to any semblance of rational behavior. That's when wise heads suggest that the most rational behavior is to put your money in the safest cash equivalents, particularly since, as Prechter points out, the nearly riskless Treasury bills have outperformed the S&P 500 for the past seven years.
[Editor's note: According to Elliott Wave analysis, herds of investors may seem to act irrationally, but they move in certain wave patterns that you can track in the movements on price charts. But that's another story, one you can learn more about at www.elliottwave.com.]
Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She is a graduate of Stanford University.