Why Irrational Can be Rational

The market is up though global economic indicators are anything but rosy. Italy is paying more than 7% for its debt; other PIGS (Portugal, Italy, Greece and Spain) are in the same sty. This international situation will (short of a miracle) almost certainly negatively affect the U.S., putting us in a pigpen as well. The question is whether it will be sooner or later.

In spite of these facts, which suggest conservative investment behavior would be prudent, the market started going up again after a recent short drop; this is apparently irrational.

Humans are complex: though we think we are rational, we can be irrational. Is it rational to be irrational?

Part of this phenomenon might be the “feel good” season. Americans want to participate in Thanksgiving and the Santa Claus joy. Buying stock is part and parcel of the frenzy. Additionally, it also might be our national economic sentiment; after-Thanksgiving spending was better than expected.

But, way down deep, there is another much more basic reason, human nature. It is protective to be optimistic even in the face of less than favorable odds. This is because the reverse, to give up, can only promise defeat. It makes us feel rotten. Therefore we often act irrationally in the face of rationality.

One important reason why is that we can justify this behavior to ourselves. According to Dr. Michael Gazzaniga, professor of psychology at the University of California, Santa Barbara, in his book entitled, The Mind’s Past, the rationalization is fed by an inner spin doctor. His opinion is based on solid scientific research (see Financial History Repeats Itself: Part II: My Brain Did This?).

My interpretation of Gazzaniga’s work is that the spin doctor fills in details for self-image protection, which may be in conflict with accuracy. In other words, it is why irrational can be rational, at least to us individually. Though this may be protective in many areas of our life because it shelters our egos, it can be disastrous when investment decisions are made. This is because a disconnect between what we tell ourselves and the financial facts can lead to unwise monetary decisions.

Unfortunately, there isn’t any certain cure. But, knowledge about why the irrational can be rational is powerful in itself. We then just need the courage to reverse it.

Further Reading

Financial History Repeats Itself: Part I - My Brain Did This?

Financial History Repeats Itself: Part II: My Brain Did This?