Against the Gods: The Remarkable Story of Risk (55 page)

People who play dart games, for example, would rather play darts
than games of chance, although the probability of success at darts is
vague while the probability of success at games of chance is mathematically predetermined. People knowledgeable about politics and ignorant
about football prefer betting on political events to betting on games of
chance set at the same odds, but they will choose games of chance over
sports events under the same conditions.

In a 1992 paper that summarized advances in Prospect Theory,
Kahneman and Tversky made the following observation: "Theories of
choice are at best approximate and incomplete ... Choice is a constructive and contingent process. When faced with a complex problem,
people ... use computational shortcuts and editing operations."23 The
evidence in this chapter, which summarizes only a tiny sample of a huge
body of literature, reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions
and choices when faced with uncertainty.

Must we then abandon the theories of Bernoulli, Bentham, Jevons,
and von Neumann? No. There is no reason to conclude that the frequent absence of rationality, as originally defined, must yield the point to
Macbeth that life is a story told by an idiot.

The judgment of humanity implicit in Prospect Theory is not necessarily a pessimistic one. Kahneman and Tversky take issue with the
assumption that "only rational behavior can survive in a competitive
environment, and the fear that any treatment that abandons rationality
will be chaotic and intractable." Instead, they report that most people
can survive in a competitive environment even while succumbing to
the quirks that make their behavior less than rational by Bernoulli's
standards. "[P]erhaps more important," Tversky and Kahneman suggest, "the evidence indicates that human choices are orderly, although
not always rational in the traditional sense of the word."24 Thaler adds:
"Quasi-rationality is neither fatal nor immediately self-defeating."25
Since orderly decisions are predictable, there is no basis for the argument that behavior is going to be random and erratic merely because it
fails to provide a perfect match with rigid theoretical assumptions.

Thaler makes the same point in another context. If we were always
rational in making decisions, we would not need the elaborate mechanisms we employ to bolster our self-control, ranging all the way from
dieting resorts, to having our income taxes withheld, to betting a few
bucks on the horses but not to the point where we need to take out a
second mortgage. We accept the certain loss we incur when buying
insurance, which is an explicit recognition of uncertainty. We employ
those mechanisms, and they work. Few people end up in either the
poorhouse or the nuthouse as a result of their own decision-making.

Still, the true believers in rational behavior raise another question.
With so much of this damaging evidence generated in psychology laboratories, in experiments with young students, in hypothetical situations where the penalties for error are minimal, how can we have any
confidence that the findings are realistic, reliable, or relevant to the way
people behave when they have to make decisions?

The question is an important one. There is a sharp contrast between generalizations based on theory and generalizations based on
experiments. De Moivre first conceived of the bell curve by writing
equations on a piece of paper, not, like Quetelet, by measuring the
dimensions of soldiers. But Galton conceived of regression to the
mean-a powerful concept that makes the bell curve operational in
many instances-by studying sweetpeas and generational change in
human beings; he came up with the theory after looking at the facts.

Alvin Roth, an expert on experimental economics, has observed that Nicholas Bernoulli conducted the first known psychological experiment more than 250 years ago: he proposed the coin-tossing game between Peter and Paul that guided his uncle Daniel to the discovery of utility.26 Experiments conducted by von Neumann and Morgenstern led them to conclude that the results "are not so good as might be hoped, but their general direction is correct."'-' The progression from experiment to theory has a distinguished and respectable history.

It is not easy to design experiments that overcome the artificiality of the classroom and the tendency of respondents to lie or to harbor disruptive biases-especially when they have little at stake. But we must be impressed by the remarkable consistency evident in the wide variety of experiments that tested the hypothesis of rational choice. Experimental research has developed into a high art.*

Studies of investor behavior in the capital markets reveal that most of what Kahneman and Tversky and their associates hypothesized in the laboratory is played out by the behavior of investors who produce the avalanche of numbers that fill the financial pages of the daily paper. Far away from laboratory of the classroom, this empirical research confirms a great deal of what experimental methods have suggested about decisionmaking, not just among investors, but among human beings in general.

As we shall see, the analysis will raise another question, a tantalizing one. If people are so dumb, how come more of us smart people don't get rich?

nvestors must expect to lose occasionally on the risks they take. Any
other assumption would be foolish. But theory predicts that the
expectations of rational investors will be unbiased, to use the technical expression: a rational investor will overestimate part of the time
and underestimate part of the time but will not overestimate or underestimate all of the time-or even most of the time. Rational investors
are not among the people who always see the glass as either half empty
or half full.

Nobody really believes that the real-life facts fit that stylized
description of investors always rationally trading off risk and return.
Uncertainty is scary. Hard as we try to behave rationally, our emotions
often push us to seek shelter from unpleasant surprises. We resort to all
sorts of tricks and dodges that lead us to violate the rational prescriptions. As Daniel Kahneman points out, "The failure of the rational
model is not in its logic but in the human brain it requires. Who could
design a brain that could perform the way this model mandates? Every
single one of us would have to know and understand everything, completely and at once."' Kahneman was not the first to recognize the rigid
constraints of the rational model, but he was one of the first to explain
the consequences of that rigidity and the manner in which perfectly
normal human beings regularly violate it.

If investors have a tendency to violate the rational model, that
model may not be a very reliable description of how the capital mar kets behave. In that case, new measures of investment risk would be in
order.

Consider the following scenario. Last week, after weeks of indecision, you finally liquidated your long-standing IBM position at $80
share. This morning you check your paper and discover that IBM is
selling at $90. The stock you bought to replace IBM is down a little.
How do you react to this disappointing news?

Your first thought might be whether you should tell your spouse
about what has happened. Or you might curse yourself for being impatient. You will surely resolve to move more slowly in the future before
scrapping a long-term investment, no matter how good an idea it seems.
You might even wish that IBM had disappeared from the market the
instant you sold it, so that you would never learn how it performed
afterward.

The psychologist David Bell has suggested that "decision regret" is
the result of focusing on the assets you might have had if you had made
the right decision.2 Bell poses the choice between a lottery that pays
$10,000 if you win and nothing if you lose versus $4,000 for certain. If
you choose to play the lottery and lose, you tell yourself that you were
greedy and were punished by fate, but then you go on about your business. But suppose you choose the $4,000 certain, the more conservative
choice, and then find out that the lottery paid off at $10,000. How
much would you pay never to learn the outcome?

Decision regret is not limited to the situation in which you sell a
stock and then watch it go through the roof. What about all those stocks
you never bought, many of which are performing better than the stocks
you did buy? Even though everyone knows it is impossible to choose
only top performers, many investors suffer decision regret over those forgone assets. I believe that this kind of emotional insecurity has a lot more
to do with decisions to diversify than all of Harry Markowitz's most elegant intellectual perorations on the subject-the more stocks you own,
the greater the chance of holding the big winners!

A similar motivation prompts investors to turn their trading over to
active portfolio managers, despite evidence that most of them fail to
outperform the major market indexes over the long run. The few who
do succeed on occasion tend to show little consistency from year to
year; we have already seen how difficult it was to distinguish between
luck and skill in the cases of American Mutual and AIM Constellation.*
Yet the law of averages predicts that about half the active managers will beat the market this year. Shouldn't your manager be among them? Somebody is going to win out, after all.

The temptations generated by thoughts of forgone assets are irresistible to some people. Take Barbara Kenworthy, who was manager of a $600 million bond portfolio at Prudential Investment Advisors in May 1995. The Wall Street journal quoted Ms. Kenworthy as saying, "We're all creatures of what burned us most recently."' To explain what she meant, the Journal commented, "Ms. Kenworthy is plunging into long-term bonds again despite her reckoning that value isn't quite there, because not to invest would be to momentarily lag behind the pack." The reporter, with a sense of the ironic, then remarked, "This is an intriguing time horizon for an investor in 30-year bonds."

Imagine yourself as an investment adviser trying to decide whether to recommend Johnson & Johnson or a start-up biogenetic company to a client. If all goes well, the prospects for the start-up company are dazzling; Johnson & Johnson, though a lot less exciting, is a good value at its current price. And Johnson & Johnson is also a "fine" company with a widely respected management team. What will you do if you make the wrong choice? The day after you recommend the start-up company, its most promising new drug turns out to be a wash-out. Or right after you recommend Johnson & Johnson, another pharmaceutical company issues a new product to compete with its biggest-selling drug. Which outcome will generate less decision regret and make it easier to go on working with a disgruntled client?