Don’t believe the psychologists about investing

Don’t believe the psychologists about investing

The Russian psychologist Alexander Luria decided to go to Uzbekistan in 1931 to study people in the remotest part of the Soviet empire. Some tribes there had no experience of education or the outside world.

Luria wanted to compare their thought patterns to the new socialist man, who’d been educated in the newly collectivised farming projects.

It sounds like a good idea. But Luria made a big mistake. He brought a team of psychologists with him.

Luria and his team started studying people living in both conditions. The educated ones and those who’d lived their lives isolated. And what he found was pretty odd.

Can you find the odd one out?

Isolated people simply couldn’t buy the theoretical premises of his experiments. They couldn’t generalise or hold abstract concepts in their mind. They could only base their thinking and decision making on past experiences they had themselves. On real things, not assumptions.

When asked which shape was the odd one out, they didn’t see circles and a line. They saw real items like watches and coins, which those shapes supposedly represented.

The abstract concept of a shape, devoid of any useful meaning to an Uzbekistani nomad, didn’t exist to someone living in that sort of isolation. And so they couldn’t pick out the odd shape, or object, as they saw it.

Russ Roberts from the EconTalk podcasts recalls another theoretical question Luria asked:

The one I found so striking was the three adults and a child were shown, and the question was: Which one is different? What doesn’t belong here?

And supposedly the person couldn’t answer it. And they said, “But don’t you see that the child doesn’t belong?”

“No,” says the respondent, “the adults are working; they need the child to help them get stuff when they don’t have it, and run errands.” So, you can’t take the child out.

Reality and context put abstract concepts out of isolated and uneducated people’s reach. Education allows us to think in abstract and generalised ways.

The more interesting example is a little simpler. The Soviet psychologist tells the survey participant something like the following:

Cotton only grows in warm climates. The climate of Scotland is cold. Can cotton grow in Scotland?

The educated man says, ‘No.’ The uneducated man says, ‘Dunno, I’ve never been to Scotland.’

The psychologist gets annoyed with the uneducated idiot. And repeats the question.

But the uneducated man, in the Soviet experiments, often refused to budge. Even under pressure.

Why?

Perhaps education just makes us more intelligent. More able to think logically using premises and assumptions.

Assuming the following lies are true…

But, as Russ Roberts put it, perhaps there’s some wisdom to the uneducated man’s stubbornness. I think it’s the same sort of wisdom you need to be a successful investor today. But back to that in a moment.

How is refusing to accept the abstract and theoretical wise?

First of all, trial and error is a rather beneficial way of discovering things like penicillin. You don’t just learn things — you also learn when the assumptions you made were wrong, too.

Then there’s the hard evidence. Because, in practice and reality, theories and abstract ideas rarely hold.

Not believing the Soviet intelligentsia probably served people in remote areas of Uzbekistan well. Collectivised farming was a spectacular failure. The mass starvation turned some of the most theoretically committed commies against their own party.

Try telling a Japanese person that stocks go up in the long run. Or that QE generates inflation. Or that property is a safe investment. Or that signal failures are a valid excuse for late trains. They’ll laugh at your ignorance of reality.

Assumptions and the context of the real world clash quite badly. Being aware of this is a wise thing. Being ignorant of assumptions and abstract ideas is almost as good.

Another example of all this comes from a jungle tribe. I can’t remember where they’re based, but they supposedly can’t count past about five. Show them a number of arrowheads and they’ll count them. But after a certain number, they start to give answers like ‘several’, ‘a bunch’ and ‘a pile’.

Are they stupid? Or do they just adapt to the reality of their situation?

Hint: Put a Harvard-educated psychologist in a jungle with nothing but an arrowhead and see what happens.

Back to stock markets and investing. Because investors are supposedly irrational too. According to psychologists.

When the academics start chuckling about reality, you know there’s a problem. And it’s become fashionable to laugh at ‘irrational investors’ and their biases. Bookstore shelves are full of these sorts of criticisms.

Recency bias is the tendency of people to pay more attention to recent events. They expect the future to look like the recent past. And forget the crashes or booms of the more distant past.

Normalcy bias is the tendency of people not to expect something unusual. Then, when it happens, they expect it to continue for longer than it does.

There are plenty more diagnoses you can add to the list of investor ailments. Psychologists have identified them in peer-reviewed journals and all.

The trouble is, the theoretical world from which psychologists derive their theories is devoid of context. They propose theoretical experiments that make assumptions about reality, which do not hold in reality, and then call people irrational for not believing those theoretical assumptions.

All they’ve really proven is the flaw of their scientific method.

Lies, assumptions and markets

A psychologist professor might tell a survey participant to assume that a coin is evenly weighted. It has come up heads 37 times in a row. What is the probability of it coming up heads again?

The correct answer, to the psychologist, is 50/50. The coin is evenly weighted, after all. Because the psychologist said so.

But no normal person is that stupid.

They’ll refuse to believe the coin is evenly weighted given the past results. And they’ll answer that heads is far more likely. Thus, the psychologist describes them as ‘irrational’.

But the psychologist and the survey participant operate in completely different worlds. One in which theoretical assumptions hold, and one in which people lie.

As one around-the-world sailor told me a little too often, ‘Don’t assume!’ And I’d rather believe him than a psychologist when it comes to anything important and real.

Now, which mindset serves you better in financial markets?

Well, when a bunch of academics decided to run a hedge fund based on their theories, the Long-Term Capital Management fund blew up in spectacular fashion.

A statistically nigh impossible event happened to come along and undermine all the assumptions that their models had made. (Obviously, reality was flawed, not their models.) The failure of the fund almost took major financial markets with it.

Those academics’ theories are now taught at universities instead…

Enough criticism of psychologists and academics though. It’s a bit hypocritical to expect those who don’t live in the real world to learn real-world lessons.

What’s the alternative?

Well, real financial market participants who are stuck with having to make real decisions in a real world tend to behave very differently to what psychologists’ models consider rational.

They take unlikely but high-impact events seriously, for example. Which is what LTCM’s managers got wrong.

If you lose your wealth during a financial crisis, it doesn’t matter that the stock market will eventually recover. You might have to sell all your shares at rock-bottom prices to pay for your retirement in the meantime. The difference between theory and reality.

That’s what one of our strategists is worried about right now.

He’s warning people of an imminent recession in Australia, which would take financial markets down with it.

And given he saw the collapse of LTCM from the inside, you need to take his warnings seriously.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia