Rational Expectations

About 20 years ago in an 8 a.m. economics class in Oxford, Ohio, a teacher on loan from the University of Chicago pitched the concept of rational expectations to a group of less than eager students. By less than eager, I mean to say that it was too early in the day for college students to be fully awake and the topic was not anticipated to be very stimulating. And yet of the handful of individual lectures I still remember, this one was right up there at the top of the list for me.

In economics, the theory of rational expectations is a relatively simple concept to grasp — people make business and personal finance decisions based on what they expect to happen in the future. If two high school seniors both earn minimum wage working at McDonalds but one spends all of his money on clothes, cars and music while the other deposits his earnings in the bank, is it possible that both are responding rationally to their expectations for future earnings? The answer is yes. If the latter student is expecting to study four more years at college, he knows that his income will be low and thus decides to save. As for the first student, he’s a star basketball player and is expected to skip college and get drafted in the first round to the National Basketball Association, a guarantee of a seven-figure income. Both students are making reasonable spending decisions based on what they expect to happen in the future.

Consider your business today. In your heart of hearts, what do you rationally expect to happen in the future? Because of all of the external economic uncertainty and all of the vagaries of each local employment market, etc., this is a much tougher question to answer right now than it was 12 months ago, before the banking crisis hit. Is a remodeler in Houston making rational decisions about his or her business by adding staff while a remodeling firm just across the Gulf of Mexico in Naples, Fla., is still cutting its ranks? Absolutely.

The same thing can be asked about the consumer side of the economy. After the initial “shock and awe” of the financial events of last fall, are consumers now settling on a new reality that can allow them to make purchasing decisions again? It is too soon to tell, but let’s assume that smaller purchases are easier to make than big ones.

A good prescription for running a remodeling business in the next six months is to focus like a laser beam on your local market. That is the only way for your expectations to be truly rational. Don’t pay a lot of attention to the national news media, which focuses on national numbers for house prices, existing-home sales, and other economic data. It can only distort your reality at this point.

Remodelers need to create for themselves a track to run on for the next six to 12 months. It needs to be a track that they can reasonably run assuming hard work and possibly longer hours. For example, if your firm needs to hit $750,000 in revenue in 2009 and you know that job sizes are smaller, you need to find a marketing model that will drive enough leads to help you close the number of jobs you’ll need in order to hit that number. Right now, remodelers can, among other things, focus on what aging homes need. People will spend money if they think they need to do it.

In any event, it is incumbent upon you, in these uncertain times, to build your own set of rational expectations and to execute a plan based on your reality.