"The Irrational We!"
I graduated with a degree in A.B. Economics in the mid 80s and the very premise of all my Economics subjects is that human beings are rational. We make our choices based on a rational decision process that maximizes utility, minimizes costs and risks, based on available data. And because of this, our institutions are also designed to aid the rational individual to make optimum decisions.
However, taking a closer look at how we actually make our decisions makes us realize that most of the time, we make irrational decisions.
I first got myself interested in the Behavioral Economics (B.E. - the field that acknowledges the human irrationality in decision-making) in 2010 when I read the book of Dan Ariely entitled Predictably Irrational. It’s very informative yet light and funny that you won’t notice you’re already taking up a course on B.E. I got hooked and read his succeeding books entitled The Upside of Irrationality and The Honest Truth About Dishonesty (How we lie to everyone especially to ourselves). I even took up his online course on irrationality. I also read the book of Daniel Kahneman (the father of B.E.) entitled Thinking, Fast and Slow (be ready for loads of readings on experiments), the book of Richard Thaler and Cuss Sustein entitled Nudge (a book recommended for all policy makers!), and The Little Book on Behavioral Investing by James Montier.
I’ve written to some of the writers and they have responded, which thrilled the fan-reader in me.
B.E. is a very helpful field that helps us make the right decisions in every aspect of our life that I encourage you to read up on them. If you don’t want to buy any of the books, you can download some of their studies for free from their respective universities. However, based on my experience, digesting the concepts is easier when you read their books instead of their studies, which include all the details on their experiments.
Last month I attended a one-day course on Behavioral Finance by Bruno Curnier sponsored by, among others, COL Financial.
Here are some insights I wish to share with you:
1. The C system and the X system –Matthew Lieberman (UCLA) discussed the C and X Systems in his paper entitled The Neural Basis of Automatic and Controlled Social Cognition. The C-system (C for refleCtive) is the rational way of thinking and coming up with a decision. It follows a process of logic and takes longer to use. The X-System (X for refleXive) is the automatic and spontaneous way of reacting and bases conclusions on past experiences, without much effort. If you want a lighter read, you may check out an article I wrote during the showing of the movie Star Trek. It’s by no means as comprehensive as the Lieberman paper but discusses these two systems also - Star Trek Lessons: Are You Mr. Spock or Captain Kirk?
2. Let’s do an exercise to test your C and X systems.
In making decisions on money, we are better off using our C-System. Shane Frederick of Yale (formerly from MIT) designed this test with just 3 questions which may be a better gauge than SAT or other IQ tests. I read this from one of the books I mentioned above and it was given during the course I took up in Behavioral Finance, and yet I still didn’t answer all questions correctly. So when you try to answer the questions in under 30 seconds, do not be intimidated.
a. A baseball bat and a ball together cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?
b. If it takes 5 minutes for 5 machines to make 5 widgets, how long would it take 100 machines to make 100 widgets?
c. In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take for the patch to cover half the lake?
After you’ve answered the above questions, check your answers with the answer key below:
a. If you used your X-system you might have answered $0.10, the most common answer. However, if the ball is $0.10 then the bat would have to be $1.10 for it to be $1.00 more than the ball, in which case the total of the two would be $1.20, not $1.10. The ball cost = $0.05
b. The immediate reaction in answer to question b is 100. However, if you reflect deeper into the data, you will realize that it takes 5 minutes to produce 1 widget per machine. So faced with 100 machines and 100 widgets, the amount of time should still be 5 minutes per widget.
c. The most common answer to question c is 24 days (48 divided by 2). However, if the patch doubles in size each day, then the day before it covers the entire lake is the day it covers half of the lake, so the answer is 47.
How well did you do? Again, do not let your self-confidence go down too much just because of this. Just a little bit of humility is okay. Anyway, you’re not alone! Even the MIT students had a hard time answering these questions.
3. Beware of the X-System taking over. In view of the fact that the X-system easily takes over in our decision-making, let’s guard ourselves. Do not make important life-altering decisions under pressure. Despite being a romantic, I tell my sons not to ask their future fiancés to marry them in a staged proposal. It’s okay to do so for prom dates like this one "Promposal," it will just be for a night anyway. But not for life-long commitments. The same is true for buying big-ticket items like appliances, luxury items, investments, etc. Never be pressured by “you only have until today†for this special price. For expos like travel, wedding, etc. which really offer discounts if you purchase on the spot, do your homework before going there.
4. The X-System is not altogether negative. We developed this system ahead of the C-System for survival. This is the gut feel or the intuitive feeling or response. In cases of emergency, we are better off listening to this system. I read before that many victims of rape and other crimes would have escaped had they acted immediately on their gut feel. Just a friendly reminder, a sale beckoning you to purchase those marked down items for today only is not an emergency!
5. The need to belong. We’re all still like teenagers who need approval from our peers. We need to feel that we’re “in.†We don’t want to feel like the outsider most of the time. So let’s watch out for the decisions that we make just so we please our peers. Are you buying that car, bag, dress, just because all your friends seem to have them? If you’re an investor, are you buying that stock just because everybody seems to have it even if you feel uneasy with the management team or its financials? We know that in investing, following the mob is the wrong way to go. However, we cannot deny the comfort of following the mob, especially for fund managers. If they follow the mob and don’t register a good return, they’re fine because their performance is always compared with the market. However, if one wants to be the best, one has to be a contrarian. Uncle Warren Buffett has always been quoted about his mantra on this so let me use that of Sir John Templeton’s, “ It is impossible to produce a superior performance unless you do something different from the majority. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.†By the way, Templeton who first intended to be a missionary before he became one of the greatest investors also said this in his Time Tested Maxims of the Templeton Touch, “If you begin with prayer, you can think more clearly and make fewer stupid mistakes!†Whatever your religious beliefs are, I think starting with a prayer clears our minds and ironic as it may sound, prayer somehow activates our C-System or our rational brain!
6. Focus on the Process. Because of the noise we have to contend with, we usually end up making decisions affected by too many external factors. A good broker’s magical spell may entice you to buy or sell something not in agreement with the tenets in value investing. Short-term results muddle up your decisions that may not be good for your long-term goals. Most of the time we are too focused on the short-term outcomes that we do not have control of anyway. However, we should realize that the thing we can control is the process we follow in investing and other aspects of our life. So let’s focus on the process. Let’s put systems that will make it easy for us to make the right decisions. Do you know that managing money is very much like baking? Just follow the steps and measurements in the recipe and you will be fine. This reminds me, maybe this is the reason why The Honey who manages the country’s largest fund, likes to bake his bread. The problem among the younger breed of fund managers may be their need to be in the heat of action. They have to be always doing something – buying here, selling there. To them the process of value investing is not sexy at all and could be boringly systematic!
7. Too much loss aversion. I’ve discussed this a few times in previous articles. It is the greater emotion we feel over the loss of something as compared to the gain on something. This is the reason why we hold on to losing stocks and readily sell our winning stocks. This is also the reason why some insist on putting all their money in savings and time deposits even if they know that they are not beating inflation by doing this.
8. Over-optimism and Over-confidence. We always see this in surveys. I discussed the results of Filipinos optimism in their financial literacy versus their actual knowledge last week (see "Let The Sunshine In!"). Moreover, this over-confidence among stock investors, especially the ones who would initially benefit from “beginner’s luck†usually end up over-trading and losing money.
There are many more concepts in Behavioral Economics and Behavioral Finance aside from the eight discussed above. I will discuss them in future articles.
For the meantime, let’s not worry too much about our irrational selves. A world full of Mr. Spock would be a boring world, don’t you think? Let’s just be aware of this side of ours. It’s in acknowledging and embracing our irrationality that we are able to make rational decisions that would lead us to better lives!
