Wednesday, April 2, 2008

Predictably Irrational

One of the central tenets of economics is that people are rational actors. A slight problem with this assumption, however, is that it is blatantly untrue (as detailed entertainingly by MIT Professor Dan Ariely's new book, Predictably Irrational). A result of this assumption is that, when we see large numbers of people acting in the same way, we believe that there has to be some explanation, leading to rationalizations of phenomena that may be entirely random.

As a prominent example, Freakanomics co-author Stephen Dubner points out the comically useless explanations offered daily by newspapers for the stock markets swings. He notes an article from Yahoo News yesterday declared:
“Stocks Surge to Start Q2″
Wall Street began the second quarter with a big rally Tuesday as investors rushed back into stocks amid optimism that the worst of the credit crisis has passed and that the economy is faring better than expected.

The problem being that the headlines appearing alongside this newsbrief seem to contradict the thoughts assigned to investors:
  • "Celent: 200,000 US Banking Jobs at Risk"
  • "Manufacturing, Construction Weaken"
  • "Ford, Toyota U.S. Sales Down in March"
  • "Congress Has Big Questions for Big Oil"
  • "U.B.S. Will Write Down $19 Billion"
All of this leaves me wondering why, exactly, the author thought that this signaled investors' belief that the worst was over and the financial crisis had passed.

Instead, Dubner suggests two headlines for the stock markets movements that are probably much more accurate:
"Stocks Surge, Reasons Unknown; May Be Nothing More Than the Random Fluctuation of a Complex System"
"Stocks Dive: Three First-Movers Sold Hard and Then Everyone Else Inexplicably Followed."

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