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A Few Notes on Predictably Irrational

July 2, 2008 • Posted in Animal Spirits

In his 2008 book, Predictably Irrational: The Hidden Forces That Shape Our Decisions, behavioral economist Dan Ariely “refutes the common assumption that we behave in fundamentally rational ways.” Many of his observations have implications for investing and trading from the perspectives of avoiding irrationality as individuals and exploiting the systematic irrationalities of others. Based on his past studies of irrational behaviors, he concludes that:

In Chapter 1, “The Truth About Relativity”:

“…[W]e not only tend to compare things with one another [as a valuation method] but also tend to focus on comparing things that are easily comparable–and avoid comparing things that cannot be compared easily.”

Do investors/traders avoid unusual opportunities because of the difficulty of valuing them?

In Chapter 2, “The Fallacy of Supply and Demand”:

“…[W]e anchor ourselves to initial prices. …[O]ur first decisions resonate over a long sequence of decisions. …[T]he power of the first decision can have such a long-lasting effect that it will percolate into our future decisions for years to come. Given this effect, the first decision is crucial, and we should give it an appropriate amount of attention.”

Do investors/traders become irrationally anchored to position entry prices as permanent valuation benchmarks?

In Chapter 5, “The Influence of Arousal”:

“Even the most brilliant and rational person, in the heat of passion, seems to be absolutely and completely divorced from the person he thought he was. Moreover, it is not just that people make wrong predictions about themselves–their predictions are wrong by a wide margin.”

Does euphoria/depression-inducing volatility make investors/traders abandon discipline in trading?

In Chapter 6, “The Problem of Procrastination and Self-Control”:

“The struggle for [self-]control is all around us. …And yet…we find ourselves…failing over and over again to reach our long-term goals. Why? Because without precommitments, we keep on falling for temptation.”

Can target prices (or target conditions) and stop-losses help investors/traders inhibit irrationality?

In Chapter 7, “The High Price of Ownership”:

“The first quirk…is that we fall in love with what we already have. …The second quirk is that we focus on what we may lose [in divesting], rather than what we may gain. …The third quirk is that we assume other people will see the transaction from the same perspective we do.”

Do investors/traders systematically switch from analysis mode to self-justification mode after entering positions?

In Chapter 8, “Keeping Doors Open”:

“We have an irrational compulsion to keep doors [options] open. It’s just the way we’re wired.”

Do investors/traders overtrade out of indecisiveness, fear that they will miss some opportunity?

In Chapter 13, “Beer and Free Lunches”:

“Standard economics assumes that we are rational–that we know all the pertinent information about our decisions, that we can calculate the value of the different options we face, and that we are cognitively unhindered in weighing the ramifications of each choice. The result is that we are presumed to be making logical and sensible decisions. And even if we make a wrong decision from time to time, the standard economics perspective suggests that we will learn quickly from our mistakes either on our own or with the help of ‘market forces.’ …But…we are all far less rational in our decision making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless–they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring or our brains.”

“…[W]e are pawns in a game whose forces we largely fail to comprehend. We usually think of ourselves as in the driver’s seat, with ultimate control over the decisions we make…but, alas this perception has more to do with our desires–with how we want to view ourselves–than with reality. …[A]lthough irrationality is commonplace, it does not necessarily mean that we are helpless. Once we understand when and where we may make erroneous decisions, we can try to be more vigilant, force ourselves to think differently about these decisions, or use technology to overcome our inherent shortcomings.”

In other words, investors/traders are often, though not hopelessly, irrational and mostly unaware of their irrationality. Rationality is very hard work.

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