Rational or Behavioral Economics?

[Wonk]

I'm curious to see what others tend to think is the most credible theory of economics: rational or behavioral.  Rational economics is closely tied with the Chicago school and efficient market hypothesis.  Behavioral economics believes that people don't always act rationally and therefore create more mispricing of the markets--creating opportunity for profit.

In another post, I mentioned the documentary "Mind over money" that I watched on Netflix.  You can stream it directly from PBS here:

http://video.pbs.org/video/1479100777/

It contrasts the two schools of thought and it's very interesting.  So, what do you think?

[MediumTex]

I would say behavioral economics gets closer to the truth, but it is still probably not sufficiently humble to grasp the true unpredictability of the world.

As far as rational economics, how many times does it need to be shown that people are not rational for people to accept that we are not rational?  It's almost like people have an irrational belief in human rationality.

[Wonk]

As far as rational economics, how many times does it need to be shown that people are not rational for people to accept that we are not rational?  It's almost like people have an irrational belief in human rationality.

There's a segment in "Mind over money" where Eugene Fama says "I don't believe in the existence of bubbles anymore."  To me it seemed akin to a respected meteorologist saying "the sky isn't blue, actually."

[LifestyleFreedom]

This is an excellent video.  Thank you for the link.

I'm in the behavioral economics camp.  We are herd animals with lizard brains and react to the stimuli from our environment.  When the crowd goes mad, each of us tends to go mad along with it.  It takes great strength to go against the crowd.

But we also have a higher-order rational mind (when we want to use it).  I'm studying Dr. Van Tharp's books right now (Tharp is in the business of training traders and is the author of titles such as Supertrader and Safe Strategies for Financial Freedom).  Tharp makes the point that we don't trade the markets; rather, we trade our beliefs about the market.  He believes that people can be trained to trade the markets successfully by working on their beliefs.

In Tharp's world, all investors are traders.  He says Warren Buffett (the buy-and-hold investor) is really a trader who believes in a holding period of forever, along with an entry strategy (pay 50 cents for a dollar bill) and an exit strategy (sell when the price Mr. Market offers you is equal to the intrinsic value, or sell whenever the wonderful business you bought is no longer wonderful).

Harry Browne is also a trader.  Browne believes in buying the four asset classes (stocks, bonds, cash, and gold) at any time in equal 25% proportions and rebalancing whenever an asset class falls outside the 15%/35% band.  Hold these assets forever and never sell (unless you need to money for personal reasons).

Buffett and Browne appear to be rational, but they also have a well-trained behavior of following their inner thoughts rather than the behavior of the external crowd.  This confidence to march to the beat of their own drummers is what give them their respective edges in the markets.

[MediumTex]

I think it's also true that when we are calm, rested, have no stake in a matter, and have access to accurate information, we can be highly rational.

However, when we are tired, frustrated, impatient, annoyed, or have preconceived notions about a matter, we can be incredibly irrational.

I think that part of the reason the PP can work so well for real investors is that it helps keep the investor from emotionally taxing market experiences that make irrational decisions tempting.

[LifestyleFreedom]

I think it's also true that when we are calm, rested, have no stake in a matter, and have access to accurate information, we can be highly rational.

I agree with this approach -- remain calm, rested, have no stake in the matter, and have access to accurate information.  The challenge, of course, is that most of us have to be trained to be rational and even then, the temptations to be irrational are high.

For example, Buffett once mentioned than when he worked on Wall Street, the fact that deals were being discussed and done by those around him made him feel pressured to do deals also.  It was only when he went back to Omaha that he was able to make investment decisions in a completely cool and rational manner.  Retail investors feel this same pressure from their friends at the office or at a cocktail party, where everyone except them is making a lot of money in the investment fad of the day.

I remember learning in high school that the U.S. Army once believed the best sharpshooters in target practice made the best soldiers in combat.  But when the targets started shooting back, many of these sharpshooters lost their aim and the Army had to rethink its approach to training soldiers.

It's easy to read Fail-Safe Investing and see the merits of the permanent portfolio.  But it's not necessarily easy for many investors to subsequently pull the trigger.  For proof, just read the many posts elsewhere on this forum about whether now is the right time to buy bonds, stocks, gold, or stay in cash.  It's human nature to have these fears, and as emotions go, it's probably better to be trigger-reluctant rather than trigger-happy.

I handle my fear of pulling the trigger by buying the PRPFX.  I have a very small percentage of my investable assets in this fund and I depend on the fund manager to do the right thing with regards to managing the rebalancing.  As I gain confidence with this approach, I may put a larger percentage of my money in this style and do the managing myself.  In the meantime, nothing focuses attention as well as having money at risk in an investment.

I did the same thing with my other investments.  I started out using money managers (mutual funds and then managed accounts).  I've since put 20% of my money into a dividend growth portfolio I'm managing myself because I now have the confidence I know what I'm doing with that strategy.  I'll get there eventually with the permanent portfolio also.