Ed Lotterman: Exploring questions of rationality

February 28, 2014 

The very name "George Soros" induces fear and loathing for some conservatives, but one has to admit that he has been a successful speculator.

Recently released numbers show that his Quantum Fund netted $5.5 billion in 2013, the most in the sector. Industry pundits say this puts it at about $40 billion in profits since it was instituted in 1973, the highest dollar figure of any such fund. But is Soros really a brilliant investor? Or is he just lucky?

The answer to that is pregnant with implications. If you think he is not brilliant, just lucky, then limit your own investing exposure to passive index funds that foreswear picking corporate winners. And support whichever candidate strongly opposes government action to influence the economy. Write the president telling him to appoint only Federal Reserve governors who oppose similarly using monetary policy to smooth economic fluctuations.

If, however, you are convinced that Soros, or longer-horizon money managers such as Warren Buffett and Peter Lynch (who guided Fidelity's Magellan Fund to average annual returns of 29 percent for 13 years), really are successful because of their skill, then subscribe to investor newsletters, put hours into research and buy and sell stocks or bonds vigorously. On the political side, support candidates who favor strong action by Congress and the Fed alike to dampen economic fluctuations.

How does this all follow from the question of whether Soros' success stems from ability or chance?

The answer is that the economics discipline is now divided between those who think strict rationality is the dominant factor in human decision-making and those who believe this is wrong, that irrational mental processes and impulses frequently trump reason.

This split exists in microeconomics - the study of how humans choose to allocate resources at the individual level or that of a family or a company. It also exists in macroeconomics, which looks at such decisions on national and international levels.

The assumption of rationality has been the dominant approach for nearly two centuries now. And no economist argues that human reason is unimportant. Assuming human reason allowed economists to construct logically rigorous theories of how the world works. But these rigorously coherent theories did not always predict outcomes in the real world very well. And research in psychology, neurophysiology and other disciplines increasingly has demonstrated how important nonrational factors are in human decisions of all types. So the discipline is in a healthy state of ferment right now.

Taken to its logical conclusion, largely by Eugene Fama, the finance theorist who got a Nobel Prize in the fall, a strong assumption of rationality leads to belief in "efficient markets." These accurately incorporate all available information into the prices of things, be it a share of stock, a bond, an acre of Minnesota farmland or an ounce of gold.

Events may not always prove that price to be "correct," but any variations from that will be random. No one will be able to consistently make money by outguessing the market.

Does that mean Soros or Buffett or Lynch really cannot exist? They obviously do. But their apparent success would therefore be due to random factors, or so the theory implies. They represent cases of "survivorship bias:" Assume many equally sharp people set out following the same strategy, but most fail, and no one pays attention to them. A very few succeed, and we incorrectly attribute that success to their brains or nerve when it really is random.

Now, anything can be taken to a caricature. Fama probably despises Soros' liberal political stances, but I doubt he would dismiss Soros' speculator success as just that of a lucky clueless monkey. And even those who disagree with Fama's theories, including his co-Nobelist Robert Shiller, acknowledge that markets are powerful social institutions to digest available information. It is a question of nuance and degree.

Most people ascribe the success of famous investors like Buffett or speculators like Soros to their abilities, not to pure luck. In doing so, they implicitly reject economic theory that assumes strict rationality.

But that implies a rejection of such theory at the macro level as well as the micro one. And the macro camp with the intellectually strongest anti-Keynesian position is the one that depends the most on assumptions of strong rationality. Indeed, its core theory is one of "rational expectations."

Three decades ago, its architects argued that the Keynesian theories then in vogue were flawed because the collective reactions of millions of rational individuals would counteract the sort of economic micromanagement Keynes' followers prescribed. For a time, they were winning the intellectual argument hands down. But as micro increasingly discards rationality as an overarching assumption, its utility on the macro side erodes as well.

Just because one rejects the assumption of rationality that underpins the strongest intellectual case against Keynes and his followers, it doesn't mean one must become an advocate of activist fiscal and monetary policy for the sake of logical consistency. But you should understand that this leaves you in the intellectual company of libertarians - or, as Greg Mankiw, economic adviser to George W. Bush, put it: "cranks and charlatans" of supply-side economics.

Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at boise@edlotterman.com.

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