Market Cycles as an Informational Cascade - The Arrogance of Rationality

Abstract

Most literature that labels certain behavior as “irrational” ignores the etymology of the word “rational.” To be “rational” is to be proportionate (i.e., in a ratio). The question is, “proportionate to what?” To label behavior as irrational is to assert that the behavior is not proportionate to what the one doing the labeling considers appropriate. Perhaps the one being labeled as irrational has a different perspective or world-view than the one doing the labeling. Who is to say the one doing the labeling is the arbitrator of what is or is not proportionate? This is especially evident in claims that investor behavior is “irrational.” Perhaps it is “irrational” relative to the valuation model of the researcher, but it is clearly consistent - or rational - relative to the beliefs and preferences of the one engaged in the putatively irrational behavior. A classic illustration is in “momentum investing strategies” where an investor extrapolates from the recent price movements future price movements. This could be an entirely efficient use of information and is consistent with a belief that what happened in the near past will continue into the near future. To label this as “irrational” is nothing but arrogance.