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.

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Paradigm Shifting

I grew up in the investment business in the early 1990s on the ginormous fixed income trading floor at the then Merrill Lynch in the World Financial Center in New York City.  It was a culture of trading and instant gratification. “What have you done for me lately?” covered no more than that day, often less. I frequently argued that we should consider the interests of our customers – among of the biggest investment managers, pension funds and insurance companies in the world – in our dealings so as to build long-term relationships and enhance longer-term profitability even if it meant making a little less in the near-term.

I got nowhere.

We called our accounts “clients” to their faces, and I thought of them that way, but they were customers at best and marks at worst to virtually everyone on the floor, and especially to our managers.  We didn’t call them “muppets” like the guys (and it was almost all guys then) came to at Goldman Sachs, but we may as well have. Our mission was clear.  We were to make as much money for the firm as we could as quickly as we could. Lunch was a long-range plan.  In his first and funniest book, Liar’s Poker, about our counterparts at Salomon Brothers, Michael Lewis got the tone, the approach and the atmosphere precisely right.

Rescue Me

Surgeon, author and MacArthur Fellow Atul Gawande is a particular favorite of mine.  I am working on a broader post that incorporates some of the themes he focuses on in his writing.  In the meantime, I wanted to comment briefly on the commencement address he gave to this year’s graduating class at Williams College. 

In the address, Gawande cites recent research examining why some surgical hospitals have much lower death rates than others. Instead of the intuitive answer — that the better hospitals have better processes such that fewer things go wrong after surgery (the lovely euphemism, to suffer “complications”), these exceptional hospitals actually react better to their problems, failures and mistakes.  It turns out that they are really great at “rescuing people when they had a complication, preventing failures from becoming a catastrophe.”

The key to success therefore, in large measure, is rescuing a bad situation.

In the investment world, it is an obvious fact that we will have “complications” of various sorts. The markets involve more than enough randomness (luck) such that a terrific process and a solid decision can turn out poorly, perhaps very poorly.  As Gawande phrases it, “We talk a lot about ‘risk management’—a nice hygienic phrase. But in the end, risk is necessary. Things can and will go wrong. Yet some have a better capacity to prepare for the possibility, to limit the damage, and to sometimes even retrieve success from failure.”

According to Gawande, “When things go wrong, there seem to be three main pitfalls to avoid, three ways to fail to rescue. You could choose a wrong plan, an inadequate plan, or no plan at all. Say you’re cooking and you inadvertently set a grease pan on fire. Throwing gasoline on the fire would be a completely wrong plan. Trying to blow the fire out would be inadequate. And ignoring it—’Fire? What fire?’—would be no plan at all.”

In the investment world, we see all three types of errors routinely.  For example, when markets tank, some investors see no fire at all.  But the wiser of them have a personal plan in place to deal with the psychological pressure to sell when things are looking grim for the market and may even re-balance to take advantage of cheaper products, but even then many will be ill-equipped to deal with the pressure.  As Barry Ritholtz commented today, simply trying to “stay the course” is contrary to human nature.  “People get tired, annoyed and angry.”  That makes even a “plan” to do nothing when the market tanks almost impossible to follow.  They have — in reality or in effect — “no plan at all.”

Of course, the perfectly human reaction to getting crushed is to pour gasoline on the fire — to panic and sell.  We need a specific plan to deal with our portfolios and ourselves when the markets get ugly, as they necessarily will, especially during secular bear markets (the current one is 12 years old and counting; they average about 17 years).  As noted above, the plan could be to rebalance.  It could be to buy more.  It could be to hedge, perhaps by buying puts. Then again, these responses don’t work very well when the entire plan was ill-conceived. 

Moreover, abject failure is something that is particularly hard to recognize:  “recognizing that your expectations are proving wrong — accepting that you need a new plan — is commonly the hardest thing to do. We have this problem called confidence. To take a risk, you must have confidence in yourself. In surgery, you learn early how essential that is. You are imperfect. Your knowledge is never complete. The science is never certain. Your skills are never infallible. Yet you must act. You cannot let yourself become paralyzed by fear.” 

Confirmation bias and confidence bias make it extremely difficult to see how badly we have screwed up.  We need (relative) objectivity and humility is we are going to succeed in investing and in life unless we are extremely lucky.  It’s a lead-pipe-lock that we’re going to err and err often in the investment world.  Unless you have committed to a carefully crafted rescue plan ahead of time (I recommend a comprehensive, written investment policy that includes regular re-evaluation and a rescue plan in the event of “complications”), you are not likely to succeed over the long-term.  Planning to be lucky is a lovely thought but not remotely realistic.

As I have often told my children, hope is not a strategy and lunch is not a long-range plan.

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I also recommend Tom Brakke’s series on checklists based in large measure on Gawange’s book as well as blog posts from Tadas Viskanta and Mick Weinstein on the commencement address.  In fact, I should point out that Mick and I make some of the same points.