My latest Research magazine column is now available. Here’s a snippet:
The point here is that the highly improbable happens all the time but is always unexpected. This math explains why we shouldn’t be surprised when the market remains “irrational” far longer than seems possible. But we are. Randomness is difficult for us to deal with. Instead of dealing appropriately with probability, we look for patterns to convince ourselves that the numbers don’t really say what they clearly do. In this regard, we are dumber than rats—literally.
In multiple studies (most prominently those by Edwards and Estes, as reported by Philip Tetlock in his book Expert Political Judgment), subjects were asked to predict which side of a “T-maze” held food for a rat. The maze was rigged such that the food was randomly placed (no pattern), but 60% of the time on one side and 40% on the other. The rat quickly “gets it” and waits at the “60% side” every time and is thus correct 60% of the time. Human observers keep looking for patterns and choose sides in rough proportion to recent results. As a consequence, the humans were right only 52% of the time—they (we!) are much dumber than rats. We routinely misinterpret probabilistic strategies that accept the inevitability of randomness and error.
If we are going to recommend and implement probabilistic retirement planning strategies, we need to prepare for client and advisor difficulty in dealing with such concepts.
Above the Market 