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.

Advertisement

Mean Reversion Wins Again

Right after his terrific Super Bowl winning performance, Joe Flacco was deemed the best quarterback in the NFL by ESPN “expert” Merril Hoge.

During presentations on cognitive biases and their impact on investment decision-making throughout this year, I have been using this claim as a great example of recency bias and of a likely failure to understand mean reversion. Flacco’s performance so far this season makes the point.

Flacco was fantastic in the play-offs last season, leading the Baltimore Ravens to a title by throwing 11 touchdowns with no interceptions over that time and averaging a terrific 9.05 yards per attempt. His QBR was 84.4 and his QB Rating was 117.2.  However, in the 80 regular-season games before that, and through the 2013 season to this point, Flacco has been and remains an average NFL quarterback {115 TDs to 74 interceptions (13/13 this year); 7.01 yards per attempt (6.55 this year); 51.7 QBR; 84.9 QB Rating (48.3/75.3 this year)}. Despite the four play-off games that suggested he might be an emerging superstar, I argued, beginning last winter, that his performance would likely revert to his mean, long-term performance. And so it did.

It is possible that near-term aberrations in performance reflect a major change in long-term norms that can be continued going forward. But that’s not usually the case. As Dennis Green (then coach of the Arizona Cardinals) famously expressed it, “They are who we thought they were” most of the time and that doesn’t tend to change all that much.

The market corollary to this idea is that when prices are very high they will tend to decline and when they are very low they will tend to rise. Since our objective generally is to buy low and sell high, making good investment decisions in this regard should be pretty easy then, right? Sadly, the answer is a clear no.

Recency bias is our tendency to put too much emphasis upon the recent past to the exclusion of the full data set and to extrapolate recent events into the future indefinitely. Professionals are no less prone to its effects as anyone else. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weightings of stocks, bonds and cash.  The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommeded weighting came just after the lows of the financial crisis. Obviously, following that advice would have been a big mistake and had an investor sold stocks at the peak stock weighting and bought at the rock-bottom weighting – doing the opposite of what the experts said – s/he would have done exceptionally well.

Emotionally, we get afraid when markets tank and euphoric (greedy) when markets are hot. No matter how quick we are to agree with Warren Buffet conceptually (“Be fearful when others are greedy, and greedy when others are fearful”), it’s really hard to do. The financial markets are the only places I know where people want to pay top dollar and resist buying anything on sale. Where else do people want to wait for prices to go up before they buy? That’s largely on account of recency bias and our emotions. Ravens fans were angry when mean reversion was discussed in connection with Joe Flacco’s play-off performance last season. But the numbers don’t lie. He’s still who we thought he was.