Why We’re Not as Rational as We’d Like to Think
There’s an old story about an economist who walks by a $20 bill on the street. When asked why he didn’t pick it up, he replies, “it can’t really be there, if it was, someone would have already taken it.”
That, in a nutshell, is the theory of rational expectations, which proposes that a market of rational actors will value things correctly. The price, therefore, represents the proper value for everything at any given time.
However, the overwhelming evidence shows that we have lots of reasons for believing things, many of them decidedly irrational. We were wired by evolution to survive, not to make economic transactions. The result is that price and value often become uncoupled by fashion and zeitgeist, leaving much more than $20 on the ground.
Is Amazon Worth 10 Times Apple, Google and Microsoft?
Personally, I believe that Amazon is a great company and that Jeff Bezos is one of the visionary geniuses of the digital age. They’ve prospered through good times and bad and innovated like few others have. From e-commerce to e-readers, personal publishing to cloud computing, this is a company that can seemingly do it all.
I’m not the only one, either. Just look at what their stock price has done over the past five years:
Who could argue with success like that? With the exception of a brief dip during the financial crises, Amazon just goes up and up. Who wouldn’t want a piece of that?
Well, in fact, I wouldn’t. When you take into account that Amazon trades at 133 times its earnings, while Apple, Google and Microsoft trade 14, 20, and 10 times their earnings, respectively, it’s hard to see how anyone would buy it.
Why would anyone pay ten times as much for a dollar of Amazon earnings as they would for Apple? For that matter, why would you pay 50% more for Google than Apple? How, by any stretch of the imagination, are these values are rational?
What Everybody “Knows”
In March 2000, the dot-com boom was at its height and everybody “knew” that we were witnessing the dawn of a new economic reality. That is, everybody but professor Robert Shiller of Yale , who published his book, Irrational Exuberance, in which he predicted that the stock market had nowhere to go but down.
When the market crashed, he was hailed as a visionary and a prophet, certainly someone to be taken seriously. When he published a new edition in 2005 and included a chapter on home prices, there should have been some concern. He applied the very same logic as he did to stock prices. Alas, no. Everybody “knew” that housing prices always go up.
The point, of course is that crowds are often stupid, not rational as many economic models assume. They tend to run away with a particular notion, drive up prices far past what is rational and then crash when the bubble pops. This is nothing new, John Maynard Keynes called it the work of Animal Spirits and it happens so often that it seems inevitable.
The question, then, is why does it happen?
The Availability Heuristic
One answer lies in what Daniel Kahneman, in his book Thinking, Fast and Slow, calls the availability heuristic. We tend to make decisions not on the strength of the evidence, but by the ease with which some facts come to mind. In effect, we substitute hard questions of fact for easier ones of familiarity. Kahneman writes:
The world in our heads is not a precise replica of reality; our expectations about the frequency of events are distorted by the prevalence and emotional intensity of the messages to which we have been exposed.
For instance, when we hear of a car accident, we will drive more carefully, even though the roads haven’t become any more dangerous.
The availability heuristic also affects how we perceive events. When the financial crisis hit in 2008 and 2009, media companies were hit hard. At the same time, social media just started hitting its stride. Many thought that the two sets of events were linked and that meant that traditional media companies were doomed.
However, behind the headlines, hard data pointed to a much different story.
In actuality, the enormous red ink and massive layoffs we were reading about in the press had very little to do with operations and very much to do with bad investments. Those investment decisions, ironically, were made because all the talk about “new media” encouraged executives to push up the value of risky companies.
That’s what makes the winner’s curse is so pervasive. In the heat of the moment, we put a more weight towards the information put in front of us than that which seems more abstract.
In the early 70’s, a young MBA student named Michael Milken noticed that debt that was considered below investment grade could provide higher risk adjusted returns than other investments. He decided to make a market in the so-called junk bonds and, by the 80’s, was making a ton of money
Then everybody else piled on and the value of the bonds increased so much that they became a very bad investment. Nevertheless, investors continued to rush in. Inevitably, the bubble popped and billions were lost. The market crashed as the crowds rushed for the exit. Fortunes were then made by those few who bought for pennies on the dollar.
That’s what George Soros calls reflexivity. Expectations aren’t formed in a vacuum, but in the context of other’s expectations. If many believe that the stock market will go up, we’re more likely to believe it too. Moreover, the data will show that stocks are indeed going up, encouraging others. When panic sets in, the reverse happens.
Markets are made up of crowds and crowds can go haywire. We shouldn’t assume that cognitive biases will cancel out in larger numbers. In fact, they often serve to feedback and reinforce false notions, driving the price of Amazon, junk bonds, mortgage bonds and even tulips far past any semblance of rationality.
Life is, as Shakespeare wrote, indeed a tale told by an idiot. We have nearly unlimited access to data, but our judgments remain all too human. So how, in the midst of conflicting information, reflexive feedback loops and our own irrational neurological wiring can we make better decisions?
Kahneman gives us some guidance in his discussion of two thinking systems. The first is intuitive, much like Malcolm Gladwell described in his book Blink. The second is rational and deliberative. It weighs facts in order to deduce reasonable conclusions.
The problem is that the second system is slow and takes effort, so we all have a tendency to substitute a second system question for a first system question. What investment will provide the best value? Which medium will best promote our business? Which candidate will best serve our country? We transform these difficult questions into easier ones such as, “what excites me?”
The crux of the problem, then, is to be honest with ourselves about what we know and what we don’t. Our intuition serves us well in matters that are familiar to us, but will lead us astray in areas that are not. Our instincts evolved to keep us alive, not to make us rich.
Rationality may be distinctly human, but that doesn’t make it natural or easy.