The myth of the rational investor

One aspect of my job I love best is reading to broaden my horizons. I recently finished a book by Dan Arielly called Predictably Irrational: The Hidden Forces That Shape Our Decisions. It was an eye-opening look into how real humans make decisions and what traps to avoid.

This may sound like heady stuff, but it’s quite useful to a professional investor like me. You see, I happen to be human, and knowing the errors that humans frequently make can help me avoid mistakes and become a more successful investor over time. Quite practical, really.

Arielly highlights that most economic theory, up until the pioneering research done by behavioral economists, tended to assume that humans make fully rational decisions, especially when it comes to spending money. On the contrary, research has shown that we humans make all kinds of silly mistakes.

For example, we tend to over-value what we own. Before we buy a car, say a VW bug, we want to pay as little as possible for it. But, once we’ve bought it, we suddenly value it much more than we did before ownership. We won’t sell it unless we can get top-dollar, even though we didn’t think it was worth top-dollar when we bought it. And, the longer we own it, the more attached we can become, especially if we put a lot of work into ownership. I’ll think about that the next time I go to sell a stock. I may want a price no one’s willing to pay simply because once I’ve owned it for a while. Using objective value measures like price to earnings or price to book value give me an objective reference point to avoid this trap.

Another problem for humans is we want to keep our options open. Keeping options open makes sense in many contexts, but not when economic costs outweigh benefits. Arielly and crew showed how people generally over-weigh the benefit of keeping options open, literally to the degree of putting a higher price on keeping options open than the benefit derived. By trying to keep our options open, we frequently get distracted from the true objective. I’ll remember this the next time I go to make an investment decision. When considering investment options, I know that wanting to keep my options open may distract me from making a good decision. Instead, I’ll make the best decision given the facts and move on.

We humans are also greatly impacted by our expectations, and we may never change our minds even when confronted with contrary evidence. Arielly and his colleagues demonstrated through several experiments how people’s pre-conceived notions literally impact their experiences. This is easy to find with investing, too. Once we buy an investment with the vision of great wealth pouring down on us, we hold on to that vision long after the facts have shown the vision to be faulty. This is a great thing to keep in mind when making investment decisions. Am I ignoring evidence? Am I looking for opinions different than my own? Can I dig for dis-confirming evidence instead of just looking for proof that backs my pre-conceived notion?

Being human has many wonderful benefits, but being rational decision makers, in the economic sense, is not one of them. This doesn’t mean we should throw in the towel, it just means we have to be very objective when making investment decisions. This book helps me ask myself: 1) am I over-valuing something simply because I own it? 2) am I losing economic benefits because I want to keep options open? 3) am I looking for dis-confirming evidence to contradict my pre-conceived notions? Such questions lead to better decision making and better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.