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Wednesday, April 15, 2009

Posner Misses the Point

From his blog:

"Bubble behavior is exhibit number 1 to the claim by some behavioral economists that stock market investors often act irrationally. For example, buying in a rising market or selling in a falling one (both illustrating what is called "serial momentum" or "momentum trading") is said to illustrate "herding" behavior."

I disagree with his premise. Behavioral economists do point to herding behavior and momentum to explain bubble formation and collapse, but I don't think many would necessarily deem the behavior at the individual level as "irrational." Many try to avoid such useless terms - behavior is not necessarily rational or irrational, it just is. Nevertheless, the behavior can be deemed to be quite "rational" for precisely the reason Posner cites: uncertainty. In an uncertain environment, people see trends and observe the behavior of the herd and calculate subjectively that they can potentially beat the market provided they can 'exit' in time. I don't think many behavioral economists would say there is anything irrational about that - it's just a gamble. It is long-run inefficient (and 'irrational' if you want to use that word) at the aggregate market level - but since people don't act like the Borg, the term itself is rather useless in this case.

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