Judgement and decision making should not be considered as processes happening in a rational vacuum, removed from both the limitations and constitution of our biology.
A shift in paradigmes
If you've visited a finance conference or flipped through the course catalog of your local business school lately you are, perhaps without knowing it, witnessing a revolution. A slow one, surely, but a revolution nonetheless, the core of which is a shift in the basic model of economics away from mechanics towards ecology - and hence away from modelling economics and finance on physics but instead modelling it on biology.
The key term to look for is 'Behavioural', which is shorthand for 'Empirical' and long-hand for 'what people actually do in the real world when given an economic choice'.
The basic model of economics the past few hundred years has been the Newtonian mechanic universe: opposing forces are pulling on something until an equilibrium is established. For Newton that was the movement of the stars by gravity and momentum, for Adam Smith it was the setting of prices by the invisible hand of supply and demand.
Economics then added the assumption that market agents where rational and seeking to optimise personal utility based on a series of mathematical arguments culminating with Eugene Fama and the efficient market hypothesis, that says that all prices are in equilibrium.
The problem for economics has been twofold: First, it has had a really hard time predicting anything, unlike Newton who could predict pretty much anything that was within the boundaries of his theory. Secondly, it appeared rather obvious to anyone who wasn't seeking tenure at the local economics department that the notion of a market place consisting of rational agents wasn't anywhere close to reality.
Enter Daniel Kahnemann and Amos Tversky: two Israeli psychologists who spent the latter half of the twentieth century demonstrating through a long series of ingenious, fun and enlightening experiments that agents are not rational. We dislike risk more than we like gain. We get obsessed with our own ideas. We hate being wrong. We get attached to things we own. We are too optimistic with regards to what we can achieve and by when. All things that are perfectly obvious to anyone who's ever had a job involving other people or been the one half of a marriage. Kahnemann and Tversky presented their theories with such demonstrable certainty and backed up with their ingenious experimental approach, that Kahnemann was awarded the Nobel price in ecnomics (Tversky unfortunately died before he could get it).
The notion that we are shifting from a basic model of mechanics to a basic model of ecology and self-organising and unpredictable systems is not Kahnemanns invention but the killing of the rational agent is a key component in his thinking and one that holds particular interest to us as investors, since knowing how we are, in fact, equipped to make decisions will help us in structuring how we should, in practice, make decisions.
Three notions of irrationality
The first step in building a solid investment process that handles the four elements of risk is to realise that your judgement and the decisions you make on the basis on that judgement is not as infallible as you think. And even when you truly realise that, humbly, you should still be highly and systematically suspicious of your own judgement calls.
But first let me unpack three distinct ways in which we are irrational. Even understanding this distinction will put you ahead of 95% of everyone out there who deals with behavioural finance.
The first source of irrationality is Scarcity: Biological evolution is a process of adaptation under pressure. Food is scarce, so we have to use the calories we can get in an optimal way. When a lion jumps at you time is scarce, so you can't spend it pondering the existential ramifications of mortality. And so on: evolution had to design us (and every other living being for that matter) in order to optimise our chances of reproduction given what we had. That is why we don't see everything, but only what we focus on. And why our faculties of pattern recognition tend to gauge a trend rather quickly and try to verify it instead of - scientifically appropriate - to falsify it. We make decisions faster and with higher degrees of loss aversion if we are tired. The key term is scarcity and the key insight is that thinking is hard.
If you need convincing then take a look at this murder riddle.
The second source of irrationality is Misadaptation or the fact that we are in fact very well adapted to living on the African savannah some 100.000 years ago. So not a matter of limited biological ressources in terms of interacting with our environment, but rather a function of our environment having changed quite dramatically.
The two key differences of which are:
First: Stability in society and a lot of technological advances gives the consequences of our decisions a far longer time horizon. Biologically we are very 'Now'-focused and we discount the future heavily. Eat it now, before it rots. Survive today and let tomorrow take care of itself. This was good back when we didn't have refrigerators and survival was a daily issue. Today it is bad because we save less, eat ourselves fat and in other ways act as if there is no tomorrow - simply because, on an evolutionary average, there rarely wasn't.
Second: Our social networks are much larger, less determinate and far less crucial to our survival than they used to be. We are biologically geared to handle only a few handfuls of people in our entire lifetime - and to treat the opinions, actions and relationships of other people as crucial to our survival. Today this creates herd mentality in the markets and fear of shame and abandonment when our stocks drop in value, because we sense that other 'other people' are disagreeing with us. We also get blinded by authoritative news anchors and experts - which are often hired more for their ability to sound confident than for their ability to be right.
The third source of irrationality is what I call The Gene & Me-Problem.
Most people think that Darwinism is about the survival of the fittest, strongest, fastest and cleverest individual. That the better you are, in your given environment, the better your chances of 'spreading your genes' to the next generation. This view is subtly wrong. It has the relationship between you and your genes screwed on backwards: you are not trying to spread your genes - your genes are trying to spread versions of you. Or rather: genes are collaborating with other genes to spread versions of themselves.
This is important because your genes doesn't care about your survival in particular : they care about their overall ability to spread in a broader sense. They are selfish and they use you as the vehicle to spread through. As such they care about the group. The survival of the individual agents is of course a necessity to some extend, but there exits a horde of various behaviours and mental patterns where it makes sense for the genes to produce individuals that doesn't have their own interests at heart first, but instead would be willing to sacrifice themselves for the group.
Extreme overoptimism in the face of danger is one such effect: Just think about how often - compared to cool statistics - soldiers believe they are going to make it back alive and unhurt?
We are, in other words, genetically programmed to 'take one for the team' far more often than makes sense for us as individuals. This kicks in as over optimism and overconfidence and it should give you great pause next time you 'feel it in your gut'.