Irrationally rational or rationally irrational?
I remember first being introduced to the concept of market efficiency during business school. At the time, I was working for a large Wall Street firm in close proximity to the equity trading floor. As I thought about the precision with which market efficiency was being described in class and contrasted that with the controlled chaos of the trading desk, I couldn’t quite reconcile the two.
As the years have passed, I’ve had more opportunities to learn about financial theory, as well as observe how people make financial decisions in general, and investment decisions in particular. I still struggle with how markets can be efficient when people are involved!
As it turns out, two new books address this very conflict. The first, Thinking, Fast and Slow by Daniel Kahneman, suggests that humans are irrational. Kahneman, a psychologist by training, won the Nobel Prize in economics in 2002. He challenges one of the key tenets of economics—that humans are essentially rational. The book’s premise is that we, as humans, have two minds: One that is quick and intuitive (System 1), and one that is deliberative and rational (System 2). According to Kahneman, we rely on System 1 more often than not. This, of course, has interesting implications for how we “interpret” the world around us and ultimately make decisions.
The second book addresses our tendency to put too much faith in quantitative financial models. Models Behaving Badly is written by Emanuel Derman, the former head of quantitative analysis at Goldman Sachs. Derman’s premise addresses our tendency to put the same amount of faith in financial models as those based on the laws of science. Whereas the latter are good measures of reality, the former are less so. According to Derman, most financial models “fail to reflect the complex reality of the world around them.” It’s intriguing to think about the role financial models have played in the markets over the past five years. They work until they don’t work (remember subprime mortgages?). To be honest, we do employ several models at Vanguard when we think about measuring risk in a portfolio or forecasting future capital market returns. We always do so, however, with a healthy dose of humility about what they can—and cannot do.
If there are other books or articles you’ve found of interest on this topic, please feel free to share.
It’s clear that there isn’t a single System 1, there is a constellation of Systems 1a, 1b, etc. all competing for attention, and usually not all working together. Humans clearly are often conflicted, especially in the face of complex situations.
So the problem actually might be that System 1 puts too much faith & trust in System 2. When a sophisticated model offers rational and deliberate recommendations based on the data, System 1c and 1d suppress System 1a’s doubts and questions, and 1b’s fears.
Or maybe a simpler explanation is sufficient: in the contest between fear and greed, greed often wins, especially when you’re playing with other people’s money.
Excellent points about the rationality and irrationality of the process of investing. Cold, rational and impartial evaluation of the facts rewards investors more often than the irrational ‘follow the herd’ investing ever has. I would also add the element of emotional entanglement when evaluating ones own portfolio and it’s performance. It is difficult to separate emotion from rational thought when things seem to be going ‘to hell in a hand basket’.
Fortunately for us Vanguard investors, we have little worry that the Vanguard crew will become ‘emotionally invested’ in one model over another, since they don’t actually actively ‘sell’ anything … subsequently, the choices are ours to make…rationally, irrationally or emotionally…and as usual, our individual results will differ based upon our own choices.
By the way, wasn’t it Greenspan who coined the term “Irrational Exuberance” to describe the then market circumstances? Since the term joins rationality with emotionality, I still wonder if he was referring to rational or emotional investing.
Although I have not read the first book, it seems System 1 is the subject of “Blink” by Malcolm Gladwell and quite rational at the adaptive subconscious level. As to the second book, I have no interest in theories from Goldman Sachs.
Catherine,
Your post reminds me of a quote, which I think is attributable to F. Scott Fitzgerald, that pinpoints the thesis of your blog: “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” Wow, that is good…wish I could exhibit and manifest this type of wisdom in the majority of my financial and relational matters!
I thank you for expressing the idea that, while much of the philosophy of Vanguard is built upon the idea of the efficient market theory, Vanguard also has the flexibility of validating the insights that behavioral finance has taught us within our investing decisions over the last 25 years or so.
Wise post for us to analyze within our System 1 and System 2 thinkings Caps on our noggins’! Take care…
good
Given the title of your piece, shouldn’t you have mentioned Dan Ariely’s Predictably Irrational?
“…Daniel Kahneman, suggests that humans are irrational.”
Since you ask for other books on human irrationality, I suggest you google Sigmund Freud, the discoverer of the unconscious. Over 100 years ago Freud talked about how irrational “rational man” was.
I love the idea that economists are just discovering what psychoanalysts have known for over a century.
If we are rational beings, would we be investors?
I guess I’m irrational irrational. I just made some changes to my Vanguard accounts and an objective observer might say that I’ve made some rookie mistakes. I transferred some $ from my international accounts (perhaps near a bottom [mistake one]) and bought some bond funds (perhaps at tops [mistake two]). Yet, as a retiree, I feel a need to adjust my asset allocation to a slightly more conservative allocation yearly. Further, given the problems in the Euro Zone, international funds may not have reached a bottom. So, the objective observer, without the benefit of my rationale and only the data to review may have concluded that this investor has made a “quick and intuitive mistake”. Yet, the reality is that my actions were based on very rational reasons and were well thought out in advance. My take is to cast a wary eye on the “psychology” of investing and investors.
If you want to be a successful investor, learn all that you can about the art and science of investing and then apply that knowledge objectively. Rationally or irrationally is a relative state of mind. knowledge is power!
I teach an undergraduate behavioral economics/behavior finance class that deals with the issues you discussed. Classical economic theory teaches that we are all supposed to behave like “economic man,” who is rational, selfish, self-serving, learns from his mistakes, etc. Economists have developed elaborate mathematical models to predict the behavior of this ideal person, even though they acknowledge there are a lot of times that “real” people don’t always behave this way. As noted in the post about Dan’s book, Predictably Irrational (he has a second one out as well), it’s clear that people often make inappropriate economic decisions over and over, and don’t often learn from their mistakes. Real people are much more complicated and nuanced that the robot man that neoclassical economics envisions. New developments in neuroeconomics and other areas indicates that we probably aren’t likely to get much better at decision making, either. I think that Kahneman’s new book is a great intro into the System 1/System 2 decision making process and I’d recommend it highly. To paraphrase the classic quote ffomr the physicist Max Planck, new theories often don’t get accepted until the naysayers die off, and a new generation grow up believing in it. Considering that behavioral econ dates to K&T’s Prospect Theory published in 1979, it’s about time. I guess it took a bunch of psychologists to share up the economic theory tree.