Can Investment Mistakes Be Considered Rational Decisions?

 |  Includes: DIA, QQQ, SPY
by: James Picerno

There’s a furious debate these days over the efficient market hypothesis and whether recent events support or spurn its implications. Among the criticisms: investors are irrational, meaning that they're prone to chase trends mindlessly. In turn, this leads to speculative manias and crushing selloffs.

It all sounds reasonable on the surface, but the details are tangled. Suffice to say, definitive, all-or-nothing explanations, one way or the other, are far more elusive than a casual discussion on the matter suggests. That includes the issue of distinguishing irrational behavior from genuine but otherwise rational mistakes and miscalculation. Even proponents of EMH concede that the market isn't perfect, at least on an ex-post basis. All's clear in hindsight; it's the ex-ante challenge that's slippery.

Or, as Warren Buffett likes to say, it's only obvious who's swimming naked after the tide goes out. Speaking of Buffett—widely hailed as the uber-investor par excellence—Investopedia's Financial Edge published a story last week that reviews "Buffett's Biggest Mistakes." It comes as no shock to learn that the master is fallible. He may be the world's greatest investor, but he's only human.

That brings up the subject of irrational behavior, or what appears to be so. No one would call Buffett an irrational investor. That implies that he's making rational investment decisions. Perhaps he's an anomaly in an otherwise irrational world. But here's the thing. If a rational investor can make mistakes when it comes to valuing securities (e.g., paying too much, selling too early), how does one distinguish that from similarly flawed decisions by so-called irrational investors?

Yes, it's easy to say, Well, he's Warren Buffett, ergo, his investment decisions are rational. But what about the average mutual fund manager? Or the guy down the street trading from his bedroom? Could you tell if one's irrational and the other's rational? Clearly, it's no quick clue to simply declare that someone paid too much, or sold too early. We need something more than that. But what?

Alas, there are no easy answers, if any. There are no econometric tools that separate rational investors who make mistakes from irrational types who stumble. On the other hand, there's no shortage of subjective opinion, rules of thumb, and a truckload of hyperbole.

Meanwhile, the market may collectively be irrational at times, if not continually. Or maybe not. Could the market (and individual investors) be making rational decisions that are sometimes wrong? Or is it a matter of degree? Does irrational behavior equate with making really big mistakes, vs. relatively modest ones? Okay, how do we define big and modest? Is that determined solely by, say, price relative to earnings? Is a 15 p/e too high? Or is it 16? And do we need to adjust that for inflation, interest rates, the outlook for economic growth, the possibility of war, etc.? Or does the mere presence of mistakes (defined after the fact, of course) constitute irrational investing, regardless of valuation?

As you can see, deciding if the EMH is reasonable or not isn't quite so easy. At least not if you have to write down the rules. Then again, there are those pesky index funds, which generally perform as EMH predicts. But even that's debatable, as we'll discuss in a future post. It's not an entirely persuasive argument, but that doesn't slow the debate.

If you're looking for quick, definitive answers, debating EMH isn't likely to offer satisfaction. By comparison, you'll probably have better luck with religion or politics.