ECONOMICS is a fascinating field of study that helps us make sense of many facets of life in finance and beyond.
When doing their work, economists first construct worldviews; they then build manipulable and predictive models that hinge on people ALWAYS being logical and rational.
But as you have noticed in real life there are countless instances of illogical and irrational human behaviour all around us and, frankly, within us. That's just part and parcel of our wonderfully flawed species, which has nonetheless gained apex predator status on our planet.
Human beings are at the absolute top of Earth's food chain because we are the most intelligent and versatile species on Sol 3. Furthermore, our omnivorous nature allows us to eat all sorts of plants and animals, and yet we are not eaten, consistently anyway, by any other lifeform.
Over hundreds of thousands of years, throughout our societal evolution from foragers, hunters, gatherers, and farmers, we saw varied dominant skill sets rise to the fore. Today, as we live in the Age of Homo Economicus, those who best understand, use, and multiply money end up as the biggest winners in life.
ECONOMIC MAN
The 19th century English philosopher, politician and economist John Stuart Mill coined the phrase "economic man" in 1861. It was a useful way of viewing human beings as being always rational and logical — steadfastly focused on personal profit, benefit, and advancement.
So, as a concept for better understanding our money-driven modern world, the idea of Homo Economicus or "economic man" has some predictive value. Yet it is flawed because it is incomplete.
Each of us has observed irrational behaviour in others and, obviously, within ourselves. In recent decades, the mounting body of proof about humanity's widespread irrationality has helped curious academics seek to better explain the world of finance and our ongoing reactions to money in a manner that moves away from the old idea of expecting people to always behave logically and rationally, to the more accurate model of identifying how we are all sometimes logical and sometimes illogical, sometimes rational and sometimes irrational.
As I've written before in Money Thoughts, two new rewarding fields of academic study, behavioural economics (BE) and behavioural finance (BF), help us identify the ways most of us sometimes abandon the path of rational action despite massive amounts of proof that irrationality hurts our long-term wealth building plans.
For instance:
We all know the best way to make profits in business and within our investment portfolios is to "buy low and sell high". It doesn't matter if we're talking about buying raw materials cheaply, and selling, say, cooked chicken rice or assembled cendol or manufactured cars or constructed condominiums; or if we're focused on portfolios of shares or real estate investment trusts (REITs) or unit trust funds encompassing, say, fixed income, equities, investment real estate, or perhaps commodities.
The way we make money is to buy low and sell high. And, conversely, the way we lose money is to buy high and sell low.
It is rational to remain courageous as capital and real estate markets fall and to stay patient as we wait for prices to recover and sometimes even surge to dangerously high levels. Unfortunately, few people do the right things through these price cycles, while too many do the wrong things.
PROFITABLE SENSE
The study of such confounding irrational yet commonplace behaviour, as mentioned, birthed two related fields of study, BE and BF.
BE is the broader subject containing within it the narrower subject of BF. (If you remember that alphabetically "E" comes before "F", it might make it easier for you to remember BE is the encompassing superset, and BF the contained subset.)
Traditional economists constructed their economic models on two assumptions:
1.People are always rational; and
2.People never make mistakes as they pursue their goals in a wholly rational fashion.
BE and BF are academia's commendable attempts to better understand the world of money as it actually is, and not as it has long been modelled.
From the perspective of regular savers and investors like you and me, it makes profitable sense for us to arrange our affairs — by first amassing financially and emotionally stabilising cash savings — to allow us to invest profitably through rationality (buy low and sell high) when most people allow fear and greed to cause them to buy at the wrong (high) time and sell at the wrong (low) time.
The world's greatest investor, Warren Buffett, advises, "Be fearful when others are greedy and greedy when others are fearful."
That's easier said than done. It's how the wealthy get that way, and why the poor outnumber the rich. Buffett's mentor, the Father of Security Analysis, Benjamin Graham, penned this observation:
"The investor's chief problem — and even his worst enemy — is likely to be himself."
Buffett studied under Graham at Columbia University in Manhattan; the future billionaire later worked for Graham in his stockbroking firm. Consider now this Buffettism:
"The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable."
© 2024 Rajen Devadason
Rajen Devadason, CFP, is a securities commission-licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via rajen@RajenDevadason.com. You may also follow him on Twitter @Rajen Devadason and on YouTube (Rajen Devadason).