What is rationality?
The basics of behavioral finance is that people do not behave rationally, contrary to what is supposed by traditional economic theories.
Homo sapiens is not Homo oeconomicus.
Our decisions are strongly influenced by emotions, social pressure, logical or memory fallacies. Such cognitive biases are often presented as ”bad things” which prevent us from making the right decision. However, cognitive biases are a very wide and ambiguous term which covers many different cognitive mechanisms. Even what we mean by rationality is not always clear. Is it a deviation from individual profit maximization? From mathematical truth? From wisdom? From reality? From evolutionary optimum?
Risk-taking and rationality
Let’s consider the question of risk-taking. Our behavior depends on loss aversion, greediness and overoptimism. In other words, it depends on how much risk we are willing to take to win more, to lose less and on how we perceive the probabilities of such outcomes.
If our decision is totally neutral, we behave equally in case of low/high and positive/negative outcomes with high/low probabilities. Is such a behavior ”better” than the other ones?
If we are traders, we’d better be aggressive to increase our profit. If we are a medical doctor, we should better be loss averse to save lives.
Risk aversion is then not rational or irrational in absolute. It is more a question of personal preferences and personality.
Optimism and rationality
For optimism, the question is trickier. We do not choose really to overweight small probabilities or underweight large probabilities of winning. The process is unconscious.
We just feel that we can win in a lottery with a 0.001% of success rate. Are we a irrational if we do so? Again, the answer is not straightforward. Yes we are, as we misperceive the reality. Even if we are totally aware of our 0.001% of chance of winning the lottery, we keep gambling as we unconsciously overweight this probability. However, in some cases, they can have a positive impact on our decisions. If we are entrepreneurs or politicians, we’d rather be a bit overoptimistic to motivate investors and electors.
Fallacies and rationality
What about memory or causality fallacies? Is it irrational to remember more the first and last event of a series, to make generalities from our limited past personal experiences,…?
Such biases often make sense from an evolutionary perspective. Focusing on last and past events enables to reconstruct quickly a story. Integrating our past experiences helps us make decisions in uncertainty. Many cognitive biases are heuristics or intuitions which can be very effective in making quick and result-oriented decisions in a complex environment.
I’m biased, is it serious?
So, I’m biased, is it serious? As we have seen, some cognitive biases, like loss aversion or greediness, are related to our personality or personal preferences. They cannot be really classified as good or bad. We can deliberately invest in risky assets because we like risk.
Other biases, like most cognitive fallacies or social biases, make us misperceive the world and are often unconscious. We think that this person has performed the best during the interview while in fact this is because she was from your hometown or because she was the last to be interviewed.
Such biases can be useful heuristics to make quick decisions in complex environments. In this sense, they are optimal under constraints. However, it is better to avoid them if time allows.
Finally, logical fallacies such as base rate fallacy (ignoring when calculating conditional probabilities) or syllogism fallacies are just errors that are false, and, this time, are irrational from a logical point of view, whatever the situation!
Thinking fast and slow, D.Kahneman