Are Markets Rational?

Traditional definition of economics is all about the efficiency of markets, "the Price is Right!" (1) , and the optimization of Supply and Demand. Furthermore, it advocates that individuals make rational decisions based on all available information.

That's the theory, but is that necessarily true in real life?

In a simplistic example; when deciding whether to have fruit or a chocolate chip cookie, the rational decision would be to choose the fruit, as it's much healthier. However, when given a choice, many of us would choose the cookie - I know I would!

For a more relevant example, we can easily turn to the current housing crisis. When given the choice between putting no money down for a house, and in addition taking an ARM (adjustable rate mortgage) as opposed to a traditional 20% down payment and fixed interest mortgage rate, we have seen many individuals choosing to go with the first option.

What makes ARMs attractive, initially, is the fact that they usually offer a lower rate than the standard interest rate. However, this is only temporary, and after a set period, the interest rate then fluctuates based on some hybrid or common index of interest rates. The risk is if the interest rates go up, it will significantly increase one's monthly mortgage payments. In addition, many ARMs can be structured by lenders which make it unfavorable to pay off the principle early, in the form of fees.

Unfortunately for many, the rates have gone up, due to the Fed's concern regarding inflation. As a result, many saw their monthly mortgage payments double or triple. Very often, an individual's monthly income does not provide enough flexibility to handle sudden increases in required mortgage payments. When an individual is unable to pay the new mortgage amount in full, what happens is that whatever amount they do submit, first goes towards the interest -- not the principle! This results in negative amortization, whereby the principle (original amount to be paid) increases! This can be exasperated in situations where already the individual did not put any down payment towards the principle. The negative amortization leads to a downward spiral where the interest applied to the principle increases, thereby increasing the monthly mortgage, very often leading to foreclosure.

If interest rates are high and there is some future expectation that rates continue to decline, ARMs may make sense if the individual intends to pay off the mortgage relatively quickly or if they flip the house. However, at some point the rates will go back up, so if the expectation is that you will hold onto your home for 15 or 30 years, this could lead to financial difficulties. So ARMs require very careful assessment, as well as some level of financial savviness - which a majority of Americans do not have according to a recent NY Times blog on Freakonomics.


http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/?scp=1&sq=financial%20Illiteracy&st=cse


So does this imply that we are always doomed to making the wrong choices? Fortunately, the answer is NO! In a recent book, "Nudge: Improving Decisions about Health, Wealth, and Happiness", written by Richard Thaler and Cass R. Sunstein, the authors demonstrate that while individuals have difficulty to make rational decisions, conscious interventions can be applied to ensure that the right decisions are being made. Thaler and Sunstein are Behavioral economists who speak to a different philosophy, which advocates that social, psychological or emotional biases need to be taken into account when explaining or making market decisions.

So we know an individual may not always make rational decisions 100% of the time, but what about organizations - for example Corporations or Wall Street?

(1) http://money.cnn.com/magazines/fortune/fortune_archive/2002/12/09/333473/index.htm