We Are Less Than Rational

Investment Belief #3: We aren’t nearly as rational as we assume

Traditional economic theory insists that we humans are rational actors making rational decisions amidst uncertainty in order to maximize our marginal utility. Sometimes we even try to believe it.  But we aren’t nearly as rational as we tend to assume. We frequently delude ourselves and are readily manipulated – a fact that the advertising industry is eager to exploit.¹

Watch Mad Men‘s Don Draper (Jon Hamm) use the emotional power of words to sell a couple of Kodak executives on himself and his firm while turning what they perceive to be a technological achievement (the “wheel”) into something much richer and more compelling – the “carousel.”

Those Kodak guys will hire Draper, of course, but their decision-making will hardly be rational. Homo economicus is thus a myth. But, of course, we already knew that. Even young and inexperienced investors can recognize that after just a brief exposure to the real world markets. The “rational man” is as non-existent as the Loch Ness Monster, Bigfoot and (perhaps) moderate Republicans.  Yet the idea that we’re essentially rational creatures is a very seductive myth, especially as and when we relate the concept to ourselves (few lose money preying on another’s ego). We love to think that we’re rational actors carefully examining and weighing the available evidence in order to reach the best possible conclusions.

Oh that it were so. If we aren’t really careful, we will remain deluded that we see things as they really are. The truth is that we see things the way we really are. I frequently note that investing successfully is very difficult. And so it is. But the reasons why that is so go well beyond the technical aspects of investing. Sometimes it is retaining honesty, lucidity and simplicity – seeing what is really there – that is what’s so hard.

In 2006, researchers randomly mixed and labeled news stories from a single, separate news source as coming from four different outlets – Fox, CNN, NPR and the BBC – and showed them to a random sampling of readers. Significantly, the very same news story attracted a substantially different audience depending upon the network label. Thus, for example, conservatives chose to read stories labeled as being from Fox while liberals ignored them, no matter their actual source and content. In other words, the exact same story with the exact same headline was deemed readable or not solely based upon its apparent source. The conclusion is obvious and unsurprising: “people prefer to encounter information that they find supportive or consistent with their existing beliefs.” Therefore, people generally “wall themselves off from topics and opinions that they would prefer to avoid.”

This research result isn’t particularly noteworthy overall in that it’s hardly surprising for anyone who has looked at decision-making, especially with respect to investing. It shows classic confirmation bias, our tendency to see what we want to see and look only to sources that agree with our preconceived notions. Add in a bit of optimism bias and we jump to conclusions that we think are right far more often than they really are. That’s why bleachers all over America are full of parents who are certain that their child is a prospective Hall-of-Famer (or a least a prospective college scholarship winner) – all evidence to the contrary – and why venture capitalists are wildly overconfident in their estimates of how likely their schemes are to succeed.

Perhaps worst of all, because of our bias blindness, it is extremely difficult for us to see that there might be something wrong with our own analyses, perspectives and processes. Everybody else may be biased, but we remain convinced that we routinely come to a careful and objective conclusions for ourselves.²

In related news, what Nobel laureate Daniel Kahneman calls the “planning fallacy“ is our tendency to underestimate the time, costs, and risks of future actions while at the same time to overestimate the benefits of those actions. It’s one reason why nearly every building project tends to have cost overruns. It’s also why my week-end chores take at least twice as long as I expect and require three trips to Home Depot. It’s why the end results aren’t nearly as good as I expect. In a finding that is particularly dangerous for investors, we tend to think we can control events and thus the future to a much greater extent than is truly possible.

These behavioral and cognitive biases (plus many more) constantly conspire to limit our ability to make good investment decisions. Fortunately, behavioral economics has done a terrific job at providing an outline as to what these risks look like. But it is one thing to recognize these cognitive difficulties, of course, and quite another actually to do something about them, as Kahneman concedes. Recent evidence even suggests that being smarter, more aware or more educated doesn’t seem to help us deal with these cognitive difficulties more effectively.  Indeed, they may actually make things worse. For example, a new study suggests that, in many instances, smarter people are more vulnerable to thinking errors, even basic ones.  Moreover, “people who were aware of their own biases were not better able to overcome them.” Indeed, we even know from neurobiology that when presented with evidence that our worldviews are patently false, we tend to refuse to engage the prefrontal cortex, the very part of the brain we need most to make sense of the new.

Accordingly, if we’re to have any chance of making good investment decisions consistently, we need help. We need to construct personal and corporate investment processes that are robust to the various behavioral and cognitive foibles that beset us.

There are a number of possible ways to do that, although none is anything close to fail-safe. Among the possibilities are

• making sure every decision-maker has positive and negative skin in the game;
• focusing more on what goes wrong and why than upon what works (what Harvard Medical School’s Atul Gawande calls “the power of negative thinking”);
• making sure your investment process is data-driven at every point;
• moving and reading outside your own circles and interests;
• focusing on process more than results;
• collaborating – especially with people who have very different ideas (what Kahneman calls “adversarial collaboration”);
• building in robust accountability mechanisms for yourself and your overall process; and
• slowing down and going through every aspect of the decision again.

One additional (and related) suggestion worth special focus is that in order to improve our chances of success, we need both outside input and an “outside view.” As Kahneman noted during a presentation I attended, our best chance of overcoming our inherent biases is for us to ask the best and smartest people we know to tear our ideas apart. In other words, the best advice is to “[s]low down, sleep on it, and ask your most brutal and least empathetic close friends for their advice.” We also need what Michael Mauboussin calls the “outside view.” It requires that we expand the reference class beyond our comfort zone and our personal experience. We need a much bigger sample size from which to acquire data. In essence, we need an empowered devil’s advocate.

Per Kahneman, organizations are more likely to succeed at overcoming bias than individuals. That’s partly on account of resources, and partly because self-criticism is so difficult. The best check on bad decision-making we have is when someone (or, when possible, an empowered team) we respect systematically sets out to show us where and how we are wrong. Within organizations that means making sure that everyone can be challenged without fear of reprisal and that everyone (and especially anyone in charge) is accountable (so, obviously, we’re not talking about PIMCO).

But it doesn’t happen very often away from PIMCO either. Kahneman routinely asks groups how committed they are to better decision-making and if they are even willing to spend just one percent of their budgets on doing so. Sadly, he hasn’t had any takers yet.

The bottom line here is that the way we’re built makes it really hard for us to make good decisions. To have a reasonable opportunity to do so, we need actively to consider and test opposing viewpoints. We don’t like to think that we’re wrong, but we are – a lot. As Jeff Bezos of Amazon insightfully expresses it, people who are right a lot of the time are people who change their minds a lot. Information may be cheap, but meaning is expensive and elusive. If we are going to make better decisions in the markets and elsewhere, we need a much broader perspective and we need to be constantly refining and updating our viewpoints. More than that, we need really talented people actively empowered to try to discover where we are going and have gone wrong.

We may not be all that rational, but it’s also a myth to assert or assume that we need to take emotion out of our decision-making process in order to make it better. That myth has a reasonable underpinning – we inherently prefer words to numbers and narrative to data, often to the immense detriment of our understanding. As Nate Silver put it in an interesting interview, “our brains are wired to build stories around essentially random data.” But we don’t need to be like Dr. Spock to make good decisions. In fact, that wouldn’t likely help. Investing like Spock would leave us devoid of phronesis – the subtle, embodied, practical wisdom that comes from combining learning with judgment born of experience, and that which used to be the goal of education in the Renaissance. It would also leave us cold and thus less likely to follow through with our plans.

Consider the Mad Men clip again. Draper uses his depiction of the carousel not to tout its newness and efficiency, but rather to conjure memories that allow us to circle back towards home, security and presumed truth, despite the chaos and uncertainty that seem to overwhelm us. We may even tear up in the process. Notice how psychiatrist Steven Schlozman of the Harvard Medical School describes it.

“We remember what we remember not just for the facts but also for the feelings that go along with the facts, and the ability to balance feeling with fact is what keeps us out of trouble.  The converse, however, is also true. The inability to balance feelings with facts allows all hell to break loose.”

Unrelated emotions can hurt our ability to make good decisions. But more intense feelings can actually aid investment decision-making.

Narratives are crucial to how we make sense of reality. They help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts we take them to represent. As reported last year in The Atlantic in the context of sports and political analytics, “[d]ata is an incredibly valuable resource for organizations, but you must be able to communicate its value to stakeholders making decisions.” We all recognize that value judgments are often powerfully and dangerously emotional. Thus we need both reason and emotion to make good decisions.

As I noted previously in another context, this idea is consistent with research showing that in order to help people understand the implications of various findings and conclusions – and to change behavior – we often need to do more than lay out a data-driven, logical argument. Instead (or, better yet, in addition), we need to provide a sort of emotional charge. Thus, for example, instead of simply showing people the numerical consequences of a certain action, we need to find a way to load the results with aversive emotion. “Load” is obviously a – well – loaded word.  But I chose it to emphasize the size of the stakes. Similarly, we can help ourselves think longer-term by actively considering what our future might be like (or even what successful people do in similar situations) and how better planning will make that future better.

In the context Draper created, the carousel seems to sell itself.  I have watched this scene many times, and I always feel (more than think) that the “wheel” is not worthy of the talent that sells it. Moreover, the line between being sold and being inspired is blurred to the point of disappearance. Yet utter rationality alone – without emotion to provide a kick to make the experience stick – makes it much harder for us to make tough decisions. For example, notice the power that a fear of regret (“Maybe not today, maybe not tomorrow, but soon and for the rest of your life”) provides both Rick (Humphrey Bogart) and Ilsa (Ingrid Bergman), forced to choose between “love and virtue,” at the conclusion of the brilliant Michael Curtiz film, Casablanca.

Great communicators evoke images and emotions through the use of compelling narrative that can be used to incite a strong response. During the 1984 election campaign, for example, Ronald Reagan talked about our future in outer space and the importance of our going there and conquering the unknown while his soon-to-be-vanquished opponent, Walter Mondale, kept talking about how much doing so was going to cost. It isn’t hard to guess who captured people’s imaginations. Better still, watch this address from the 40th anniversary of D-Day and feel the evocative power of Reagan’s words. I dare you to try not to be stirred.

If we are best to commemorate those who began the rescue of Europe, “the boys of Pointe du Hoc,” like Reagan we won’t focus upon a factual recitation of their amazing accomplishments. Instead, we will inspire images that seem to put things in proper perspective. In the words of the poet Stephen Spender, they are men who in their “lives fought for life and left the vivid air singed with honor.”

Or consider the emotional power of Dr. Martin Luther King Jr. as he calls on all Americans, indeed, “all God’s children” to aspire to, to work for and to demand his dream – based upon self-evident truths. It’s a bit easier for us today to hope for a world where children will be judged “not by the color of their skin but by the content of their character.” But the heroism of Dr. King and others in fighting for freedom would not and could not have happened without an undergirding of emotional rightness. Data did not enlighten a generation and transform a nation.

Developing an investment process that can overcome our irrational tendencies and to stick to its commitments is, quite obviously, extremely difficult. It requires measured rationality and emotional stick-to-it-iveness. It requires the fortitude to act the fool by allowing commitments and beliefs to be challenged fairly and aggressively.

None of us likes to be challenged and corrected. Few of us are willing to accept such an approach even in theory. And most people doing the challenging don’t do it in the right spirit and for the right reasons. But invest in our processes we must if we are to succeed. Our irrationalities will necessarily overwhelm us unless we do everything we can personally so as consistently to check our work and have it challenged by smart and talented people we encourage to “tear it apart.” That’s because we are consistently and dangerously much less rational than we assume.

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¹ Obviously, I recognize that the Mad Men clip is fiction, but it illustrates the point beautifully and is entirely consistent with what the advertising industry does.

² Of course, a few people (like this guy) claim to be utterly and completely rational. “I must admit, I don’t have much empathy for people who struggle with irrational beliefs. I’ve of course had mistaken beliefs and I’ve had lazily constructed beliefs, but I’ve never had an irrational belief. Not one.” (Emphasis in original). But it’s a claim that’s impossible to treat seriously. The evidence simply doesn’t allow it.

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This post is the fourth in a series on Investment Beliefs. Such stated beliefs can suggest a framework for decision-making amidst uncertainty. More specifically, one’s beliefs can provide a basis for strategic investment management, inform priorities, and be used to ensure an alignment of interests among all relevant stakeholders.