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Irrational Behavior, In Theory and Practice
But Why Study Theory When "Practice" Is All Around?

By Robert Folsom
Wed, 26 Mar 2008 17:15:00 ET
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Irrational behavior is popular these days, in both theory and practice.

The "theory" part consists of the steady stream of academic research and now best-selling books, mostly by economists of the behavioral finance school. One such book last year The Black Swan: The Impact of the Highly Improbable. It showed how most people (including most Ivory Tower types) go much too far in assuming that past events and trends will follow a linear path into the future, when in fact the future is more often shaped decisively by events that are dismissed or never anticipated because "that can't-won't-shouldn't happen."

Even more recently, Predictably Irrational (by an MIT professor) just hit the best-seller's list. The title is by no means misleading: there seem to be countless ways in which people make predictably irrational choices, from health to career to how to select a mate and beyond. One example in the book involves placeboes and the power of suggestion. The researchers "zapped volunteers with a little painful electricity, then offered fake pain pills costing either 10 cents or $2.50 (all reduced the pain, but the more expensive ones had a far greater effect)."

Alas, research that involves volunteers in a lab setting is still just "theory" that fails to record and verify the actual "practice" of predictably irrational behavior. In fact, it's not clear to me why researchers would even bother with lab studies -- there's no shortage of conspicuous irrationality in the real world of finance and consumption. The history of stock markets amounts in large part to how investors buy the highs and sell the lows. For more than a year, the news headlines have been full of problems that started when lenders did dumb lending to borrowers who did dumb borrowing.

And on the horizon are big problems with the way most of us do most of our consuming, namely credit cards. It seems credit card debt is "securitized" -- and has been rated AAA -- in the same way as mortgage debt. And as the number of bankruptcies skyrockets, credit card companies have started setting aside billions for the anticipated loan losses. Yes, that is exactly the type of story we were reading around this time last year regarding mortgage lenders.

Obviously it's good to shed light on irrational choices, especially in the hope that people will see the behavior for what it is and make fewer bad choices. Maybe, maybe not. What I know for certain is that Elliott wave analysis -- and many methods of technical analysis generally -- assume that the future is non-linear, and expect investors to drive trends that take irrational turns. This has been true for decades. Put bluntly, it's good to see that some academic research is catching up, but "catching up" is precisely what it amounts to. Check out the patterns we see now, via the easy steps below.

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