Investing and Behavior: Reasonable vs. Rational

‘Assumption is the mother of all… (I am sure you know the rest of the quote)” - Steven Seagal: Under Siege 2

Rationality is an assumption widely used in micro-economic models in trying to predict human behavior. I deliberately us the word ‘trying’ as we all know that predicting human behavior is exceptionally difficult.

Why then use rationality? The answer is intuitive. It is not absurd to believe that an individual, when presented with choice will choose the one, taking cost into consideration, which will deliver the most benefit.

The one flaw of rationality is the added assumption that each person is alike. When Jack and Jill are faced with the same problem, they will as a rational person, make the same decision.

For example, if Jack and Jill are presented with the same option of receiving R100 today, or R110 in a years’ time, given an inflation rate of 5%, both will choose to delay gratification and receive the R110. The rational thing.

But what if Jack places a higher value on the R100 today? What if the comfort of R100 today is worth more to him than the anxiety of having to wait a year to get R110? Is Jack being irrational, or simply just reasonable?

It is okay to sometimes do the reasonable thing.

When constructing a retirement investment strategy for someone with 40 years left to retirement, the rational asset allocation would be to invest very close to 100% in equities. Equities have shown to outperform listed asset classes over long periods and with such a long-term time horizon, volatility should play little role.

However, would this strategy be reasonable for someone who gets nervous when markets fall by 20% and act emotionally by de-risking at exactly the wrong time?

It is quite rational to get exercise in on a daily basis. Research has clearly shown the benefits. But is it reasonable to assume that each day when you wake up you reason with yourself that ‘research clearly indicates it is good for me to exercise’ so I will put on my shoes and go for a jog?

The mythical rational person might argue that drinking a smoothie containing 90% kale is the healthy way to start your day. The reasonable person, if presented with this daily choice, might choose to rather starve to death.

The rational will always say no to a slice of New York Cheesecake. The reasonable person lives in reality. 

The rational person will measure off his one unit of wine, if any, each night so that he or she only consumes the medical suggested amount. More wine could be bad for you, right? Therefore, the rational person will not pour another glass. The reasonable person would quote Mr. Seagal and proceed to pour after a tough day.

When conducting your finances and constructing an investment strategy I would strongly suggest that you be rational. Consult the data and make realistic assumptions. But, if you want to increase the probability of success, add a bit of reasonability. Your personal reasonability. Each person is so wonderfully uniquely different that the ‘rational person’ is just not applicable. The probability of sticking to your plan will increase considerably if it contains your unique touch of reasonability.

So, every now and then, put on your jogging shoes so that you can comfortably walk past the kale smoothie bar and order a large slice of New York Cheesecake and two glasses of wine.