What We Are Just Beginning To Know

Now that our faith in efficient and rational markets is largely discredited, new studies are sketching in the multiplicity of ways in which investors make decisions — irrational decisions.  This is all part of a new generation of behavioral economists and psychologists working together to replace the simplistic ideas of the economic orthodoxy that helped bring about our recent economic collapse.

The Wall Street Journal reported on Saturday that investors are prone to believe what they want to believe: “In short,” they conclude, “your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the ‘confirmation bias.’” (See, “How to Ignore the Yes-Man in Your Head.”) “We’ve made tons of errors like this,” says Staley Cates, president of Southeastern Asset Management, and, according to The Journal, other professional investors not only agree but actively seek strategies to combat this tendency.

In his book, Predictably Irrational, Dan Ariely has assembled an account of a slew of irrational factors that shape behavior.  He describes, for example, the force of what he calls “anchors,” the initial impressions of value that serve as a reference point for all future valuations. It turns out that coherence is more important to the brain than almost anything else.  It is a simple point, but it strikes at the heart of what economists have called “demand,” what people are willing to pay for what they like and want.  As Arieli explains, what people want turns out to be highly determined by accident and habit, the “anchors” they started with, and not only has little inherent meaning but inevitably differs in different situations.

In How We Decide, Jonah Lehrer stresses how recent research shows that emotions are often a more reliable guide in figuring out what to do than our conscious minds.  Emotions are often better able to process clues and discern key differences.  In fact, we often make mistakes in trying to be too rational and systematic.  Jesse Prinz in his book, Gut Reactions, makes a similar point.

Joseph Hallinan addressed a variety of factors that account for biased and distorted decision-making in Why We Make Mistakes.  He points out how often we wear rose-colored glasses without knowing it, and that, moreover, the grass we see on the other side of the fence really does look greener.  We all think we are above average in looks and intelligence – except when our personal tendencies towards distortion move us in the opposite direction.  And so forth.

All of these insights do not make for a coherent psychology of investing, but they certainly drive home the point that the simplistic assumptions about human motivation that guided economists in their thinking about markets just don’t work.

What we really need is a greater understanding of how the unconscious guides us in all our perceptions and responses to reality.  Economic decisions are only a part of that reality – but a big and vital part whose importance we are just beginning to grasp.