I know what you are thinking. Did I make a typo here? Don’t most economists believe in perfect rationality? So isn’t the myth that people are rational? No and No.
It is true that up until 10 or 20 years ago, the assumption of mainstream economics was of rationality. Yet thanks (or no thanks) to the explosion of the (sub)field of behavioral economics, mainstream economists today operate with the assumption that individuals make all sorts of “irrational” decisions. And economics use this assumption of irrationality to explain all sorts of so called “market failures” (see Myth #2) and to justify all sorts of government intervention to counteract these irrationally fueled market failures.
The truth is that individuals are indeed rational, yet neither the economists of yesteryear nor the economists of today get it right because they both are using a poor definition of the word “rational.” The correct definition of a rational decision is one that you believe will make you best off (to be technical, that you believe will maximize the present value of your future utility). It is not necessarily the decision that you believe will maximize your income or wealth. It is not necessarily the decision that you believe will maximize your current utility or happiness. It is not necessarily the decision that will actually make you best off. You may make a poor decision for lack of information, due to miscalculation, stupidity or any other reason, but as long as you believe you are making the best decision for you, you are acting rationality.
Virtually all of the so-called “anomalies” to rational behavior that behavioral economics have “discovered” in recent decades are not truly “anomalies” if you use the proper (and colloquial) definition of rationality. In other words, behavioral economics, though sometimes mildly interesting, is hardly worthy of the attention it has received.
And by the way, financial bubbles (which can and do exist) have absolutely nothing to do with investor irrationality. I’ll have a lot more to say about the subjects of utility and rationality in a future post, but in the meantime remember to be skeptical whenever you hear economists justify government intervention in markets due to “irrational behavior.”