Rational Versus Intelligent Investing
Rational Versus Intelligent Investing
This article is intended to help investors understand their own rationality while drawing a distinction between intelligence and rationality. We can judge our own intelligence, but then we must also evaluate and improve our individual rationality based on the effectiveness and appropriateness of our past behaviors and decisions.
An article in the Sunday 9/18/2016, New York Times, entitled “The Difference between Rationality and Intelligence” by David Hambrick and Alexander Burgoyne of the Michigan State University Psychology Department, included in its entirety at the end of this current piece, articulates a key distinction in the thought processes of people. To summarize, the healthy brain appears to be both a focused analytical machine (intelligence), but also an integrative mechanism (rationality), enabling people to evaluate many different situations and problems in detail, find similarities or dissimilarities, meld them into a coherent vision of reality for an individual, and ultimately dictate a behavioral response. Thus conceptions of reality for the individual are based on assumptions, experience, interpersonal communication, emotion and innate triggers that have some stability but also fluidity, as conflicts and tensions arise in a changing world with imperfect information. Our various intelligences manipulate these inputs into useful sub-structures or patterns, while our rationality prioritizes these diverse sub-structures according to values or probabilities driving action or inaction. According to the authors, there is significant divergence in the population between people who are highly rational, and others that exhibit much lower rationality of decision-making. Interestingly, rationality is not highly correlated with intelligence, contrary to common assumption. The authors indicate that various intelligences by and large cannot be modified for most individuals, while rationality can be taught and improved by “brain training”, whereby people develop selectivity skills regarding validation of input information, personal and collective value determination and prioritization, estimated outcome probabilities and impulse control.
Economic Behavior and Investing
Economic and investment decisions are an important subset of individual and group behaviors, as they frequently have sustenance, class, standard of living and life-span implications for individuals and sub-groups. Much of our time is spent in economic behaviors or the pursuit of economic well-being. Yet we are challenged as individuals and groups to be both intelligent and rational in this behavior. This occurs for a number of reasons, some articulated below:
We are bombarded by messages in the media to buy or behave in certain ways that promise to improve our lives, our society, our status, or our values. Many messages are laden with assumptions or biases that channel our behavior toward specific outcomes that may or may not be optimal for individuals or society.
Human behavior in large part relies on reinforcement from other key human relationships or trends. Thus parental or spousal advice, the behavior or ideas of key opinion leaders in society, the collective movement of markets, fashion or politics, all play a role in personal economic decision-making. These influences may or may not be in our best interests.
Much of our economic decision-making is influenced by innate emotional biases that we carry from our ancestors. For instance, the impulse to sell when the market goes down and buy when the market goes up is most likely an innate response reinforced by millennia of human reaction to stress. Our innate or default reactions may not be the optimal reaction in our current circumstances.
Economic outcomes are in fact probabilistic, heavily influenced by random chance, as well as by cause and effect relationships. Thus we are never 100% sure of an outcome, and we never can rule out rare occurrence possibilities, what the writer Nassim Nicholas Taleb calls “Black Swan Events”. Thus we are frequently caught blaming or congratulating ourselves for our failure or success, or excusing ourselves from responsibility for losing based on “the luck of the draw” analogy to card games. These conclusions we make may not be consistent with the facts.
Society confers status to individuals with wealth, and this association often is construed to mean that a wealthy person also has special skills, talents and capacities to generate more wealth or to be a political leader. Conversely, a poor person is frequently denigrated, for instance by the phrase, “If he is so smart, why isn’t he rich?”
This inherent bias has many dysfunctional implications in politics and business including corruption, dynasties, and miscommunication between the top and bottom of institutions. In fact, we often ask ourselves, “How could such a prominent, often wealthy, person make such an irrational decision?” Thus investors or businesspeople sometime become the victim of their own success, or fall in love with specific investments that previously outperformed, oblivious to the possibility that the environment has changed. Because we so frequently fall victim to this misconception, securities regulators continue to remind us, “Past performance is no guarantee of future results.”
Our economic and investment rationality probably follows a maturity curve, whereby our judgement and decision-making improves during our formative and adolescent periods, somewhat stabilizes in adulthood, and gradually declines with age.
How Can We Improve Our Rationality in Investing?
We can improve our rationality in investing by admitting to and focusing on countering specific biases that we hold. These biases are either innate predispositions, implanted by repetitive inputs, based on unrealistic outcome probability assumptions, overtly emotional or reactionary responses, socially accepted biases, or “significant other” biases. For instance, the following are ways of countering inherent biases:
Recognize that our society has significant biases regarding wealth, power, gender, race, ethnicity that show up in advertising. Just as advertising attempts to access a broad swath of the population with its message, the probability that its message is appropriate to a given recipient is exceedingly low. Yet advertising continues to elicit outsized sales and has the potential to influence all message recipients.
Fear or greed may begin driving your decisions irrationally especially during market turbulence. Benjamin Graham, the investment sage, famously referred to the stock market as “Bipolar Mr. Market, who is either depressed or ebullient”. At such times, it is often best to back off and take time to clear your mind. Then address the question if anything substantively has changed that would recommend a particular investment decision. If not, then perhaps no action is better than a reflexive or emotional reaction. This capability is known as impulse control.
There is evidence that there are truly rational and effective investors such as Warren Buffett, Peter Lynch or John Templeton, who outperform the market averages. However, there is also evidence that most investors are less rational in their decision-making. Thus a vast majority of active mutual funds do not outperform their benchmark indexes in any given year. Every investor should analyze their performance and decisions and make the difficult but objective assessment of the quality of their investing. Those with low rationality skills can either work to improve their skills, seek an active portfolio manager who is rational, or invest through passive index investments.
Benjamin Graham also advised, “Investing is best when it is most businesslike.” By this he means that it should be data driven, knowing as best you can that the probability of the investment making money is in the investors favor. Thus trading in and out of the market, having certain sell orders such as “stop-loss”, becoming emotional about a particular company, celebrity CEO or famous trader, or not using the financial data that is available to make good decisions- all of these practices lead people to make investment decisions that have lower probability of success.
Take responsibility for the performance of your investments but also recognize that you still have opportunity to make money in the future but also vulnerability to fall victim to chance or irrationality in your own investment decisions. One can never be too vigilant about the quality of one’s personal decisions. The primary agent navigating between financial opportunity and vulnerability is you, the investor.
SundayReview New York Times, September 18, 2016 Gray Matter
The Difference Between Rationality and Intelligence
ARE you intelligent — or rational? The question may sound redundant, but in recent years researchers have demonstrated just how distinct those two cognitive attributes actually are.
It all started in the early 1970s, when the psychologists Daniel Kahneman and Amos Tversky conducted an influential series of experiments showing that all of us, even highly intelligent people, are prone to irrationality. Across a wide range of scenarios, the experiments revealed, people tend to make decisions based on intuition rather than reason.
In one study, Professors Kahneman and Tversky had people read the following personality sketch for a woman named Linda: “Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.” Then they asked the subjects which was more probable: (A) Linda is a bank teller or (B) Linda is a bank teller and is active in the feminist movement. Eighty-five percent of the subjects chose B, even though logically speaking, A is more probable. (All feminist bank tellers are bank tellers, though some bank tellers may not be feminists.)
In the Linda problem, we fall prey to the conjunction fallacy — the belief that the co-occurrence of two events is more likely than the occurrence of one of the events. In other cases, we ignore information about the prevalence of events when judging their likelihood. We fail to consider alternative explanations. We evaluate evidence in a manner consistent with our prior beliefs. And so on. Humans, it seems, are fundamentally irrational.
But starting in the late 1990s, researchers began to add a significant wrinkle to that view. As the psychologist Keith Stanovich and others observed, even the Kahneman and Tversky data show that some people are highly rational. In other words, there are individual differences in rationality, even if we all face cognitive challenges in being rational. So who are these more rational people? Presumably, the more intelligent people, right?
Wrong. In a series of studies, Professor Stanovich and colleagues had large samples of subjects (usually several hundred) complete judgment tests like the Linda problem, as well as an I.Q. test. The major finding was that irrationality — or what Professor Stanovich called “dysrationalia” — correlates relatively weakly with I.Q. A person with a high I.Q. is about as likely to suffer from dysrationalia as a person with a low I.Q. In a 2008 study, Professor Stanovich and colleagues gave subjects the Linda problem and found that those with a high I.Q. were, if anything, more prone to the conjunction fallacy.
Based on this evidence, Professor Stanovich and colleagues have introduced the concept of the rationality quotient, or R.Q. If an I.Q. test measures something like raw intellectual horsepower (abstract reasoning and verbal ability), a test of R.Q. would measure the propensity for reflective thought — stepping back from your own thinking and correcting its faulty tendencies.
There is also now evidence that rationality, unlike intelligence, can be improved through training. In a pair of studies published last year in Policy Insights From the Behavioral and Brain Sciences, the psychologist Carey Morewedge and colleagues had subjects (more than 200 in each study) complete a test to assess their susceptibility to various decision-making biases. Then, some of the subjects watched a video about decision-making bias, while others played an interactive computer game designed to decrease bias via simulations of real-world decision making.
In the interactive games, following each simulation, a review gave the subjects instruction on specific decision-making biases and individualized feedback on their performance. Immediately after watching the video or receiving the computer training, and then again after two months, the subjects took a different version of the decision-making test.
Professor Morewedge and colleagues found that the computer training led to statistically large and enduring decreases in decision-making bias. In other words, the subjects were considerably less biased after training, even after two months. The decreases were larger for the subjects who received the computer training than for those who received the video training (though decreases were also sizable for the latter group). While there is scant evidence that any sort of “brain training” has any real-world impact on intelligence, it may well be possible to train people to be more rational in their decision making.
It is, of course, unrealistic to think that we will ever live in a world where everyone is completely rational. But by developing tests to identify the most rational among us, and by offering training programs to decrease irrationality in the rest of us, scientific researchers can nudge society in that direction.
David Z. Hambrick is a professor in the psychology department at Michigan State University, where Alexander P. Burgoyne is a graduate student.