Who cares if investors are rational or irrational?

To some extent this is really an academic argument.  Why does it matter if investors make rational and stupid decisions (as I say) or irrational ones (as everyone else says).  I do think knowledge for knowledge sake is cool and to better understand how people make decisions is cool too.  However I also think there is something very important about the distinction as it relates to policy.

Given today’s economic situation, the irrationality of investors and economic actors is being used to justify hugely significant policy decisions.  Instead we should be focusing on, for example, the horribly wrong incentive structures throughout the finance system that led to (rational) decision making which in turn led to the our current economic woes (much more to come about this under Current Economic Situation category).   We also should be focusing on how to educate people to make smarter decisions (i.e. to understand economic and finance decisions).

It is also important to understand the fallacy of irrationality because it is being used as key evidence of the inherent failure or instability of a free market system.   This couldn’t be further from the truth, as we will also discuss in other posts.