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The Fallacy of Rational Behavior! December 7, 2009

Posted by shaferfinancial in Finance.
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I have never met a person that thinks that their decisions are not rational.  Yet, the latest in neuropsychology research definitively answers the question of which parts of the brain [and what order] are involved in decision making.  The most recent understanding in brain research indicates the more uncertainty is involved in a decision the more the part of the brain that houses our emotions is dominant.

What does this mean to investing/saving for retirement?  It means that the dominant paradigm of investing, that of efficient market hypothesis, is just a mind game played by mathematicians, and not a model for investing decisions.  More specifically, EMH believers almost always end up suggesting that indexed mutual funds is the best place for folks to invest [usually with some form of asset allocation] because EMH makes it impossible for people to beat the market over any length of time because the market is an accumulation of rational decisions.

But, now we understand that people employ their emotions more so than any rational analysis and that means their is often inefficiencies available for the astute investor to access.  Of course, several top investors, including Buffett, have been telling us this for years.  So, for those who think in terms of doom and gloom [Adam, this is for you!], you are going to make decisions based on that dominant emotion and overlook evidence of companies with good metrics and bright futures, just as those who are hopeful in a BULL market overlook the extraordinary overpricing of stocks during that time.  Hence the real results of investing for the masses is in buying high and selling low instead of what Buffett does, buy fairly and reap the long term cash flow rewards or as others try to do, buy low and sell high.

All this is the result of some academicians whom had to make some [bad] assumptions to create mathematical models of human behavior in an attempt to use their talents [in math] to model human decision making.

Ever wonder why so many people make such a bad decision in marrying?  Ever wonder why people don’t get better at choosing intimates?  I mean theoretically you should learn from your mistakes and  get better, right?  But, we find that people who get married and then divorce are much more likely to repeat the divorce compared to the population as a whole.  Love and marriage is an emotional decision, and seems to be impervious to improvement.  Ever wonder why women who were abused by their fathers are far more likely to be in abusive relationships?  Same deal.

Back to investing; the siren call of indexed mutual funds as the ultimate investing vehicle is similar.  Yes, you can take the risk out of investing, take the thinking out of investing; all you have to do is keep putting money in month after month, ignore price, make yearly adjustments and you will be successful!  For those that have a FEAR of losing their hard earned dollars, the simplicity and the confidence it is sold to them calls out, UNTIL the reality of a market bears reignites their fears.

Same can be said about real estate investing or bond investing or anything else; ignore the reality of emotional guided decisions until a bear market overcomes your ability to ignore market losses!

Can anyone really look at the actual behavior of investors and possibly conclude their decisions were rational?

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