Nowadays it's common to hear that the market is not rational. This statement is primarily a reaction to the old rational market paradigm that economists followed for decades. Economists tend to think reality is as nuanced as the mathematical tools they have for measuring it. As the tools improved, it was inevitable that the rational market theory would fall by the wayside.
However, that does not mean that the market is irrational. Leave it to an economist to claim that if the market is not perfectly rational according to the parameters of their model -- such as price, supply, demand -- that it is not rational at all. The market is rational -- it's just that there are hundreds or thousands of factors that go into the rationality. These factors lie far beyond the power of mathematical models. The toolset of economics is indeed powerful, but the complexity of the human mind -- and the collective functioning of many minds -- is practically infinite.
One case of market behavior that appears to be irrational is the panic that went with the Bear Stearns fiasco and is currently affecting Lehman Brothers, other big banks, Fannie Mae and Freddie Mac. The panic may seem like an overreaction to an economist who is simply looking at the book value of the company. But there is a rationality to the individual investor who says "I don't care how low the price goes, as long as no one wants to own the stock, it's too risky for me to hold."
Only an appreciation of human psychology can fully explain the "behavior" of a stock. Quantifying this psychology and putting it in an economic model is difficult if not impossible. An excellent way to learn about economics as it happens in real life is to observe carefully when extraordinary phenomena occur in the markets. Read the news stories, watch the big picture, and try to think of the market as following normal human psychology. You might be surprised by how much you understand the "irrationality" of the market.
Dean Rock is a full-service real estate professional at Coldwell Banker in Lancaster. Dean's professional and volunteer activities are focused on long term health of Lancaster County's economy and society. Dean's areas of interest include historic homes, land preservation, low-income home ownership, education and youth social work. Click here to learn more about Lancaster PA real estate.
