Tuesday, December 31, 2013

Making Rational Decisions

Are rational and irrational the new right and wrong?

Most people would believe that the rational thing is the right thing, but it is also true that one person’s rational decision is another person’s error. It might be rational to do one thing in one’s own self-interest, but it might be rational to do another thing because it is best for one’s family. Surely, altruistic actions can also be rational.

And, of course, who is to decide what is or is not rational, and for whom? Doing the right thing might feel automatic, as though rational reflection has not entered the decisions making process.

After all, there are good habits and bad habits. All of them are often performed as though without reflection. They might promote your best interest, but you need not be doing them because you made a rational decision. For all we know people develop good habits because they are brought up that way, because their parents encourage them or because they don't know any better.

Recently, behavioral economists have addressed the problem of human decision-making. They have tried to answer this question: Are human beings fundamentally rational animals who make decisions based on their self-interest, or are they buffeted hither and yon, making irrational, and presumably wrong decisions, for reasons that have nothing to do with their self-interest?

Angela Chen summarized the research in the Wall Street Journal:

Behavioral economics, which has gained ground among academic economists over the past several decades, departs from traditional notions by assuming that individuals don't always behave rationally and act in their own best interests. Thus we have market bubbles in which investors inflate stocks or homes way above their rational value.

Of course, we can ask what the rational value is, and who decides it. If the rational value involves a stock’s future earnings, we should recognize that predicting the future is a notoriously difficult task. We may understand the probabilities and the probabilities may point in one direction, but what if instinct says otherwise? And what if Warren Buffet’s instinct leads him to a different conclusion?

Market bubbles are much easier to identify retrospectively. If there were a human being who could predict the future with perfect or even near-perfect accuracy, he would not be teaching in a university.

People who invest at the top of market bubbles are following what has been called the madness of crowds. But, is it rational or irrational to participate in an activity that has netted many people vast sums of money? After all, some people exit a bubble market before the collapse; some don’t.

And let us not imagine that scientists have a monopoly on good investment advice. No less than Isaac Newton was ruined by investing in the South Seas Company in the early eighteenth century.

In the past, before behavioral economics, at a time when we left ethical issues to the non-scientists, people would have said that those who get caught in a market bubble have been done in by their greed. They would have committed one of the seven deadly sins, the sin of avarice.

But then, the man who was so avaricious that he kept his money hidden in a vault, thus, who refused to chase a market bubble might also be considered as having committed a deadly sin.

In ethics, the difference between wise investment decisions and greed is one of degree, not of kind. The same is true of most of the deadly sins.

To take another problem: procrastination. How do you know when you are procrastinating and when you are working on making a judicious decision? Some situations require quick, decisive actions. Others demand more sober reflection. How do you know which is which?

Keep in mind, one person’s snap decision might be spot on while another’s might be folly. The difference, of course, lies in experience.

Behavioral economists have approached these problems by looking at the  inner workings of the human brain. They want to be able to observe what the brain does when decision-making takes place.

Chen summarizes:

Psychologist Dr. Kahneman, who won a Nobel Prize in economics for research into decision-making in 2002, says it is very difficult to overcome our split-second irrational reactions. "Much of it is automatic," he says. "Preferences come to mind and emotions arise, and we're not aware that we're making [decisions and assumptions] and therefore cannot control them."

Of course, it is not at all self-evident that the mind (really, the brain) under observation functions as it does when it is not being observed... by being hooked up to electrodes of being subjected to a PET scan?

Thinking that feels automatic is not necessarily irrational. An experienced baseball player will know much quicker than you or I whether the pitch that is coming at him is a fastball or a slider. He will be using intuitive and instinctive knowledge, knowledge that he has gained from experience. He can surely be tricked, but less often than you or I.

When it comes to moral responsibility, the inner process is far less important than the outward behavior. You are known for what you do, not for what you were or were not thinking before you did it. As I was arguing yesterday, the concept of free will means that you are responsible for your actions, regardless of your motives or of the temptations you faced.

John Horgan made the same point recently on the Scientific American blog:

The concept of free will underpins all our ethics and morality; it forces us to take responsibility for ourselves rather than consigning our fate to our genes or a divine plan. 

Whatever our reservations about behavioral economics and its forays into decision-making and ethics, it is important to note that, until recently, the conventional wisdom, foisted on us by the therapy culture, did not concern itself with how people go about making good decisions or with how they make and implement plans.

Similarly, where the therapy culture, thanks to Dr. Freud, taught people to look back into their past, the new techniques of decision making involve projecting oneself into the future.

Therapists have been more obsessed with telling people to figure out how they really feel than what is the right thing to do. If they offer advice, then tend to follow mindless mantras, like: follow your bliss.

You don’t think that those who invest in bubble markets are not following their bliss?

Surely, it is better to manage your emotions and to think through  your decisions, even to follow through on them, than to follow your instinct when it is leading you over the cliff.

And yet, when you are involved in a conversation, for example, you do not think through everything you say before you say it. A good conversation does not feel that it is being directed by an inner genie. It feels like it has a life of its own.

There is, as the scientists have pointed out and as I have argued often on this blog, nothing wrong with talking about feelings. Emotion is information in a different form.

People run into trouble when they start believing that their emotions are key to understanding a situation.  Behavioral economists are correct when they tell people to step back from their feelings, to consider them objectively as though they were someone else’s. Then again, this does not feel like an original thought.

How do you learn how to do it? Perhaps the behavioral economists have invented some new mental exercises, but the old way, taking advice from someone who is wiser and more experienced, has a pretty good track record, too.


vancount said...

My understanding is that 90% of individuals who attempt to trade the markets with an online trading account lose money.

Ares Olympus said...

re: "You don’t think that those who invest in bubble markets are not following their bliss?"

Actually no, unless being dependent upon other people's unlimited greed is bliss.

The advice "Follow your bliss" comes from Mythologist Joseph Campbell, and he wasn't looking at materialistic gains.

I admit I'm skeptical of the advice, just as I'm skeptical of "Prosperty gospel" which says the more generous you are, the more you'll get back. But I can see generosity is the key - how do you experience generosity when you feel resentment? So if you give resentfully, you're doing it wrong, and everyone pays for that.

Here's a direct quote from Power of Myth:

MOYERS: And yet we all have lived a life that had a purpose. Do you believe that?

CAMPBELL: Wait a minute. Just sheer life cannot be said to have a purpose, because look at all the different purposes it has all over the place. But each incarnation, you might say, has a potentiality, and the mission of life is to live that potentiality. How do you do it,’ My answer is, "Follow your bliss." There’s something inside you that knows when you’re in the center, that knows when you’re on the beam or off the beam, And if you get off the beam to earn money, you’ve lost your life. And if you stay in the center and don’t get any money, you still have your bliss.

Unknown said...

"... taking advice from someone who is wiser and more experienced, has a pretty good track record, too."

Yep, and I wish I had taken that advise seriously many years ago before losing quite a bit of money trading the market.

Chapter 2 of the book Psychology of Intelligence Analysis by Richards J. Heuer, Jr., is appropriately titled "Perception: Why Can't We See What Is There To Be Seen?"

Two of the principles of perception that he discusses are

"We tend to perceive what we expect to perceive," and "Mind-sets tend to be quick to form but resistant to change."

Those like myself who go long at market tops develop a perception that the market should continue to go up. Being wrong with this perception is not the fatal trading flaw, but refusing to change our minds about our perception of market opportunity is the fatal flaw that loses money in the markets.

This flaw can be overcome by learning the culture of the markets from a successful and seasoned market professional. First you have to accept the fact that market culture is totally different from any other professional culture that most of us are exposed to. Then and only then can we be successful in the markets.

Heuer makes this same point at the end of the book concerning CIA analysis of foreign cultures:

"Consultation with outside experts is especially important as a means
of avoiding what Adm. David Jeremiah called the “everybody-thinkslike-
us mindset” when making significant judgments that depend upon
knowledge of a foreign culture. Intelligence analysts have often spent less
time living in and absorbing the culture of the countries they are working
on than outside experts on those countries. If analysts fail to understand
the foreign culture, they will not see issues as the foreign government sees
them. Instead, they may be inclined to mirror-image—that is, to assume
that the other country’s leaders think like we do. The analyst assumes that
the other country will do what we would do if we were in their shoes."