We Are Less Than Rational

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

InvestmentBeliefssm2 (2)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. Continue reading

Examined Rationality

urnsAs illustrated (left), you are faced with three urns, each containing 2000 balls. A has 2 reds and the rest black; B has 20 blues and the rest black; C contains 1 red, 10 blues and the rest black. You may reach into the urn of your choice and remove a ball at random. If you draw red, you get $1000; if you draw blue, you get $100; if you draw black, you get nothing. 

Which urn do you pick and why?

Source: The Big Questions (from a paper by Armen Alchian, with the exercise attributed to Harry Markowitz)  Continue reading