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Rational Choice Theory



In a speech to the annual Allen & Company investor conference in 2001, Warren Buffett once relayed this stock market insight:

"To refer to a personal taste of mine, I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the 'Hallelujah Chorus' in the Buffett household. When hamburgers go up, we weep. For most people, it's the same way with everything in life they will be buying--except stocks. When stocks go down and you can get more for your money, people don't like them anymore...that type of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizons of any investors."

The idea that human beings would react differently to price changes in one set of goods versus another speaks directly to the fact that human beings are not purely rational creatures. Indeed, the data is very clear in support of Buffett's contention with respect to stocks. Whether one uses such measures as cash as a percentage of total mutual funds assets or measures of reported bullish or bearish sentiment, the conclusion is very clear. The vast majority of investors become bullish at peaks and bearish at bottoms: the price record from 1900 to present proves it at every extreme. The crowd then is doing precisely the opposite of Wall Street's golden rule of 'buy low, sell high'.

So why do the vast majority of investors buy high and sell low? Why do they become bearish when stocks decline and bullish when stocks advance? The short answer is physiology.

At times of rational calculation, it is theorized that human beings largely use their cortex, the upper part of their brain where reason and logic dominate. At times of emotional calculation, however, humans largely use their limbic systems, that part of their brains where emotion and instinct govern. Aaron Sloman is a proponent of this physiologically-based view of decision making: rational decisions are made in one part of the brain, emotional decisions are made in another. Is it this critical difference that allows for the hamburger vs. stocks dichotomy that Buffett explained above. Understand that current biomedical research strongly supports the idea that different regions of the human brain are active under differing circumstances.

What are those circumstances? We have written in the past about rational choice theory. We said that the conditions that need be present in order for the rational choice theory to be operative are: (1) there is precise and sufficient information available about what will occur under each decision (or at least a probability distribution of such outcomes); (2) there is sufficient time and ability to weigh each choice against each other choice and; (3) all of the available choices are known. For decisions in which such conditions are present, test subjects have shown that, by and large, they employ their cortex to "maximize real or perceived benefit or minimize real or perceived cost".

When confronted by the purchase of hamburger, a consumer can easily perform the rational calculation necessary to optimize self-interest. If the price of the hamburger is too high, a smaller amount will be purchased or perhaps even none will be purchased if substitution (chicken) takes place. He will maximize his desires as a function of his means. If the price of hamburger is low relative to resource maximization calculation, he will buy even more. In this regard, where information about resources, desires, and relative price differentials exist, the use of the cortex, the rational part of the brain, takes precedence.

These rational processes produce the laws of supply and demand. How? With hamburger prices high relative to other similar goods, a rational consumer wishing to maximize his resources (money) will purchase less or purchase none (as in the chicken substitution example). As a result, demand will naturally be lower and prices will come down to reflect this new level of demand. In the opposite case, if the price of hamburger is too low relative to other similar goods, a rational consumer will maximize his resources by purchasing more. This increased level of demand will then, all other things being equal, drive prices up. In this regard, the immutable laws of supply and demand are created. We can view goods for which the laws of supply and demand hold as markets in which the bulk of buyers and sellers are using rational, resource-maximization goals - and thus their cortices - to make buying and selling decisions. The price of any good then mediates the opposing goals of buyer and seller: to maximize their respective resources. The law of supply and demand results.

But the laws of supply and demand seemingly do not operate when it comes to stocks. At least not most of the time. What forces are operating? How do those forces 'work' and 'behave'? We'll explore those questions hopefully in a later article. But understanding that rational choice theory is incomplete and thus incapable of fully explaning the history of asset prices is a very important observation.

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