100 Ways To Leave Your Lucre

Irrationality, The Enemy Within, by Stuart Sutherland

For those of us interested in how people manage to behave oddly in the face of anything to do with finance, these recent years have been good, as a range of intelligent books have been published on the topic. From Freakonomics and Predictably Irrational to The Undercover Economist and Nudge, plus a whole host of imitative single word follow-ons, we’ve been treated to real economists demonstrating a hitherto unforeseen talent for communicating with the unwashed masses. Nonetheless, despite this, there is still no better introduction to the subject of behavioral psychology than Irrationality, by Stuart Sutherland, even though it originally dates from 1992. 

Unsurpisingly, although the world has moved on, people haven’t; and the mistakes they made twenty years ago they still make today. We are still the enemy within.

Prize Senility

Sutherland takes us on a glorious, whirlwind tour of irrationality. He covers over a hundred different examples of ways in which we depart from what a rational observer would expect of us, with relevant psychological research, personal anecdote and wry sideswipes, at almost everyone who comes within reach, thrown in. So, in discussing the problems caused by irrational institutions when they create prizes, he remarks:

“The experimental evidence … suggests that people who are trying to gain a prize will do less imaginative and less flexible work than those of equal talent who are not. In addition they may come to work less hard after winning the prize. There have been no studies on the effects of Nobel Prizes, but one has the impression that many Nobel Laureates deteriorate markedly, though in some cases allowance must be made for senility”.

This is a book that’s about far more than the financial markets, even though it’s riddled with examples taken from the subject. As an example, he manages to attack the organisational folly behind both fundamental analysis and chartism in a refined two page diatribe which ends:

“The continued resort to investment analysts both by the general public and by large firms with money to invest is a puzzle, since they are known to be worse than useless. It is though a doctor were to be paid for prescribing drugs that were worse for the patient than ones selected at random”.

Explain, Don't Predict

In fact perhaps the biggest problem with Irrationality is that it covers such a vast range of behavioral issues  that it’s pretty much impossible to digest the whole thing. It's not a book to be read in a single sitting.  To be fair, this is more an issue with the topic under examination than the writer because the glue of the book is in its title: Irrationality itself is the guiding theme and this exposes one of the problems with the whole subject, that there’s no single theory that explains how all of these strange twitches and quirks fit together.

So we will, for instance, manage to find a reason for anything we do but we’re usually mistaken about that reason. We do things to conform or because we’re attracted by a halo or because we’re emotionally biased or we’re justifying a large investment or simply because we have strongly held prior beliefs and we’re twisting the evidence to fit our vision of the world. And presumably sometimes these reasons conflict with each other: there’s simply no easy way of determining which will decide what we do under what circumstances. So although behavioral psychology can explain behaviour it can’t predict it, which is why markets sawtooth around without any of the researchers in the area being able to predict anything useful.  Of course, explanation is a valuable scientific outcome, but it doesn't help us directly make any money.

What Sutherland develops, though, is an argument that takes us from what we experience – the irrationality that is the enemy within – to what we ought to do if we want to try and avoid these problems. And to do so surprisingly he moves us beyond the explanatory power of behavioral psychology into the rationalising power of economics. This isn't the path we’re used to experiencing, so it takes a bit of thought to understand what he's trying to do.

Information Overload

As an example, when the book moves onto the question of false inferences (e.g. the crow of the rooster causes the sun to rise, aka Rooster Syndrome) it touches on the problem of information overload – how do we actually deal with a surfeit of information? The rough answer is that we, following the work of Herb Simon, satisfice – we find a ‘good enough’ solution and follow it. And this is not really irrational, it’s just a limitation of our brain’s bandwidth.

So, when people have to consider lots of information in order to make a decision – as in, say, when they’re doing detailed analysis of some stock – they generally make bad decisions because they focus on a very few – often only one – salient point. Our satisficing mechanism doesn’t work very well in these conditions. As Sutherland shows, we all too often fail to see that anything that outperforms on one occasion is likely to revert to the mean on the next.

Moreover, people tend to spend about the same amount of time in making decisions – regardless of whether these are minor and rather unimportant ones or major and very important ones. Regardless of how you twist it, taking the same amount of time to decide to have a baby as in choosing which brand of coffee to buy is pretty darned irrational.  Which leads to the question of how we should go about making important decisions if our standard approach is almost guaranteed to be biased?

Actuarial Methods and Utility Models

Sutherland outlines two methods, dependent on the type of decision being made. Firstly, there’s the actuarial method, which relies on the same type of prediction being made using the same kinds of knowledge about a large number of similar cases. Here, invariably, mathematical models work better than human intuition: a finding which applies over a vast range of examples from medical diagnosis to job candidate selection.  It even covers predicting happiness in marriage. You simply take the number of times a couple makes love a week, subtract the number of arguments they have each week and if the number’s a negative one you advise them to find a divorce lawyer.

The second method is one we’ve met before: the much derided idea of utility theory. In fact, utility theory as applied to how people really behave is pretty much nonsense but it actually originated in an idea of how they ought to behave if they were rational – so if we’re trying to make an important decision it’s not a bad place to start, although as the book demonstrates using it isn’t a task for those of us lacking courage and initiative. Moreover utility can’t answer all our problems because, as Sutherland puts it:

“Don’t value everything in terms of money unless you’re an accountant”.

The Origin of Irrationality

The book ends by analysing where this vast range of irrational behaviors originate. Although it’s partly speculation Sutherland suggests a range of causes – evolutionary pressures towards group conformity and other similar effects, neurological randomness caused by sloppy neural networks, the use of heuristics to take mental shortcuts and avoid hard thinking, ignorance of statistical methods and, finally, self-serving bias: we blame others for our failures and attribute our success to personal skill, no matter what luck or randomness is involved.

To finish Sutherland suggests that if we want to improve our rationality we need to follow Aristotle’s dictum: if we want to be good we need to resist being bad because practising good habits leads to them becoming automated. Well, maybe, but either way Irrationality is an essential part of any investor’s toolkit.  We all ought to want to practice rationality in markets – unless, of course, we simply want to let the securities industry take our profits in order to fund its next round of profligacy. Now that would be genuinely irrational.

See more from the Psy-Fi Blog's Book Review page or the Psy-Fi Blog on Irrationality:

The Halo Effect: The Halo Effect: What's In A Company Name?
Emotional Bias: Risk, Stone Age Economics and the Affect Heuristic
Confirmation Bias: Disconfirm, Disconfirm, Disconfirm
Commitment Bias: Herd of Investors
Satisficing: Satisficing Stockpicking
Utility: Utility, The Deus Ex Machina of Economics
Evolutionary Investing: Capitalism Evolving: Be a Cockroach, not a Dinosaur
Group Confirmity: Contrarianism
Neural Processing: O Investor, Why Art Thou Rational?
Heuristics and Biases: Behavioral Finance's Smoking Gun
Statistics: Regression to the Mean: Of Nazis and Investment Analysts
Self Serving Bias: Disposed to Lose Money