Perfect rationality, an indispensable component of modern portfolio theory, suffered an intellectual tsunami in 2008-2009, after having been battered by extreme stress in the real estate markets in 2007.  Modern portfolio theory is the financial theory that has guided much of the academic financial world and the financial media . . .  as well as Wall Street . . . since that land of ill-repute last lay in smoldering ruins in late 1974.  Without perfect rationality, modern portfolio theory is a hollow shell, bereft of its key feature. 

Rational Math, Irrational People
Math is the language of science; it uses short-hand-like symbols to describe natural phenomena.  One of Einstein’s best known theories, summarized by the short-hand, E=mc², asserts that, if matter contains mass, it contains energy. This theory is strongly supported by empirical data; and most importantly, it has not been discredited by actual events. Unlike descriptions about naturally occuring phenomena, asset markets represent nothing more and nothing less than the daily decisions of  a collection of people.  And many asset market participants, professional and amateur, have been routinely guilty of taking actions in markets that reflect fear, pessimism, shock, dread, anguish, and outright fright.  Charles Kindleberger chronicled a multi-century history of financial panics in his book Manias, Panics, and Crashes (2000).  The bottom line to Kindleberger's chronology is that people suffer from multiple emotional afflictions when it comes to money; and those afflictions, including wanton greed and mammalian flight, are fully integrated into the actions by both professional and amateur capital market participants.   

Certain financial theories purport to be scientific (they rely on advanced math to assert their scientific grounding); however, among such theories, modern portfolio theory is compelled by its required assumptions to actively ignore human frailties.  The cornerstone of the theory is an indispensable assumption,  the assumption of "perfect rationality."  That is, before the mathematics of the theory can work properly, all aspects of human fear, panic, or despair must be ignored. If the assumption is valid, the theory looks like a masterpiece of art.  However, if this one assumption is wrong, then the entire edifice collapses.    

As a rough illustration of perfect rationallity, imagine that only people totally devoid of emotion participate in asset markets.  The same actors also have exceptional second-by-second math skills; they will always price an asset correctly, and it will only be re-valued when new information emerges. That is, the stock of Company X, trading at $42.20 per share at 10:00 a.m, is priced neither too high nor too low.  Only emotionless traders have either asked or bidded for that stock; and the settled price perfectly reflects the value of a stock at that moment.  News received in the afternoon, like a quarterly profit report, may then change the perfectly rational view of value.  Keep in mind, no one is excitable, no one ever ponders getting rich overnight, being promoted within his or her Wall Street firm for exceptional acumen in their speculations, and nobody, ever fears for their Wall Street positions, reputations at the country club, or their very livelihoods.

The Case Against Perfect Rationality

Is it Rational to Buy a Home that You Cannot Possibly Afford? 
Asset markets in the United States include such areas as real estate, commodities, bonds, and the like.  Some of these other asset markets, not just stock markets, can be considered when thinking about perfect rationality.  From an economics perspective, it would appear to stretch the bounds of credulity to assert that market actors could be both perfectly rational and also perfectly ignorant of fundamental financial principles.  The validity of perfect rationality might reasonably be questioned if it could be demonstrated that many hundreds of thousands (if not a few million) residential real estate market participants knowingly took out loans that they could not possibly afford between 2003-2007.  Proponents of perfect rationality would be hard-pressed to explain away so many market participants who did so much to damage so many regional real estate markets.  Anyone accepting a loan that required no down payment, charged interest-only (no pay-down of the principal), and was given the opportunity to choose negative amortization (the loan balance actually grows over time) cannot be considered rational, perfect or otherwise, under any educated person's definition (unless perfect financial ignorance squares with perfect rationality).

Stated differently, the national real estate calamity that has befallen the United States cannot be dismissed as a result of mass ignorance without also dismissing a key ingredient that underlay perfect rationality: market participants are fully informed and fully rational at all times. 

How Rational are those Bank Depositors?

Commercial and Investment Banking is central to the proper functioning of real estate markets, money markets, and our ultimate target, capital markets.   Provided that asset markets behave with perfect rationality, it is perfectly reasonable to believe at the dawn of the 21st Century that bank runs would have been an artifact of the Pre-World War II era.  That is, no perfectly rational actor, being clothed with all publicly-available knowledge¹ (including the specific knowledge of the power of the United States Government's pledge of  "the full faith and credit of the United States" in the global financial arena) would ever panic and participate in a bank run.  Unfortunately, perfect rationality gave an extremely poor showing when it came to bank runs in 2008.


Stock Prices in 2008-2009: The Crowning Anti-achievement of Perfect Rationality 

In evaluating the performance of handsomely-paid Wall Street market participants during the critical period of September 2008 through March 2009, it is exceptionally difficult to distinguish their actions from woefully ill-educated hacks who were filled with self-doubt, and who ran around the room asking others what they thought should be done.  That is, there was nothing rational, perfect or otherwise, about the actions of stock market participants, particularly many of the professionals, during this critical period.  The actions that were taken, panicked selling and hand-wringing, reflected a very large group of market participants who feared looking bad far more than they appreciated an opportunity of a lifetime.  After the broader market indexes had already fallen from a high of 1481 in October 2007 to a much lower mark of 1166 in September 2008, the dread-filled selling of stocks from September 2008 through March 2009 led to an additional loss of 40 percent in the broader equities market (the index eventually fell to 679 on 3/10/2009).  It would be laughable to assert that "perfectly rational" participants brought about this type of financial carnage.  In fact, perfect rationality, appears to have taken a long holiday during the most essential moments that it was needed in the past 75 years.

Cooler heads eventually prevailed (as usual); the broader stock market has risen strongly since March 2009 . . .  mostly because some peopel recognized the unbeatable deals in the aftermath of perfect rationality's abject failure.  However, the devastation wrought by irrational actions was already done to milions of peoples' retirement portfolios by the time that the market participants found their will again.

The critical understanding to take away from the recent three-headed debacle in real estate, banking, and stock markets discussed above is this: had the capital markets been populated by the mythical actors of perfect rationality, then the world-wide financial meltdown witnessed in 2008-2009 would never have been possible.  However, if we were to substitute human actors , replete with fear, shock, dread, anxiety, and remorse in place of modern portfolio theory's perfectly rational actor, then the events that unfolded between September 2008 and March 2009 do not look all that different than what one might reasonably expect from the aftermath of a grotesquely inflated credit bubble's implosion.

 
^{1  Title 12, U.S. Code, specifically section 1828(a)(1)(B), The National Bank Act, Regulations governing insured depository institutions.}