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The failure of ratonal choice theory. November 1, 2008

Posted by shaferfinancial in Uncategorized.
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There is a theory is social science that started within economics called rational choice theory.  In the 1990s it spread to sociology and psychology.  These folks concentrate on how humans make choices.  Specifically, they concentrate on the decision making part of the decision process.   The decision process goes more or less like this; One perceives a situation, you think of possible actions, your make a decision, and then take action.  For the rational choice theorist, the decision making is a rational choice where people measure the likely costs and benefits and pick the plan of action that maximizes their chance of gain and minimizes their cost.  In this way we are all rational actors constantly measuring our choices and making rational decisions.  Sociologist and psychologist have always known this was a part of the decision making, but recognized other habitual or emotional action as important too.  Economics, on the other hand generally looked down upon their sister social sciences for this belief.  No, economist thought, rational action, once understood, was the key to predicting human behavior.  And their rational choice peers in sociology and psychology were generally push to the “poor” side of their disciplines, and for the most part ignored (unless they got hired into Wall Street).

Funny thing happened the other day.  Greenspan, a leader of the rational choice crowd, admitted that rational choice failed to predict the behavior of Wall Street and the banks.  “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms,” said Greenspan at the congressional hearings last week.  In fact, rational choice has been demonstrated to be a very poor predictor of behavior.

The  behavioral economist and other social scientist who look at decision making are now starting to shift their attention to the full process.  Perception, stage 1 in the process, is started to be looked at strongly.  Interestingly, it is the sociologist who have done the most work in this area.  So now, hat in hand, the economist are coming to the sociologist way of thinking.  Emotion and habit limits your perception of a problem.  And there are social structures like norms that create the lenses through which we see the world.  Now these ideas are generally accepted in the sociology world, but are just getting through to the economist that design public policy like the Federal Reserve Actions.  Its a whole new world for the central bankers, no all bankers, to deal with.  Its a whole new world that the folks working for hedge funds and other Wall Street investment organizations must think about.  Frankly, it has been obvious for a while now if you really looked at it.  How many “bubbles” have we gone through lately?  How many bear markets where stocks get beat down well past any rational point?

Any “financial advisor” or investor that does not try to figure out these issues of non-rational actors and/or habitual actors is going to be very confused.  No longer can they hold on to their beliefs in a rational actor making investment decisions.  All this adds up to a very chaotic environment in which to invest in and tells us we will have “unintended consequences” from every decision or non-decision made as an individual or by groups like the Federal Reserve.  Frankly, this means that there is little choice but to use our intelligence, get knowledgeable, and learn to be active.  Not that this should surprise regular readers, but the time you could sit back and depend upon “the market” or “a pension” to do it for you are long gone.  Evolve or die!

Now the other idea sociologist have been pushing around for a while now, is the intrinsic ability for most folks to think creatively.  Evidence of this is widespread.  But of course, the ability and the willingness to use the ability are two different things.  That is where the habitual behavior comes in.  The momentum of old habits have to be overcome.  And that is no mean feat!

On this Halloween eve, where monsters will be crawling around our neighborhoods, remember the monsters in Wall Street, are no more real than the ones in your neighborhood tonight!

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