Tuesday, May 3, 2011

Are People Rational?

Economists argue that people are rational. Rational people make decisions or judgement using reasoned thinking, based on facts, applying rules; and those decisions are consistent over time. How far is this true? Do you spend time in analysing mundane simple task such as what to eat, where to shop or what to wear? Very often we make these simple decisions based on intuition or “gut feeling”. But when it comes to investment or children’s education, we will spend more time to gather information, do some analysis and then make a decision. Hence, decision making is a complex process, involving both analysis and intuition: analysis involves computation and more “rational” thought, but is slower; intuition, by contrast, is much faster, less accurate, and relying on intuitions or “gut feeling”.

A study conducted in United Kingdom shows that people with autism related disorders are less likely to make irrational decisions, and are less influenced by gut instincts. This is because of the tiny brain tissue called “amygdala” which is involved in processing human emotions. And according to research, people with autism-related disorders have a different density of amygdale in their brains than others.

Further research done by a Nobel Prize winner, Professor Kahneman, the founder of behavioural finance found that this “amygdale” trigger the fear factor in our brain causing us to feel “risk”, which can gets in the way of successful investing.

What is amygdale?

Deep in the center of your brain, level with the top of your two ears, lie two small, almond-shaped knobs of tissue called the amygdala (ah-mig-dah-lah). When you confront a potential risk, you will trigger this hot button of the brain that acts as an alarm system – shooting signals up to the reflective brain like warning flares. Because the amygdale is so attuned to big changes, a sudden crash of the stock market tends to be more upsetting than longer, slower decline, even if it is greater in total.

On October 19th, 1987, the U.S. stock market plunged 23%, so sparking the amygdala and disrupting the behaviour of millions of people for years. Anyone who has ever been a teenager knows that peer pressure can make you do things as part of a group that you might never do on your own. When the fear factor strikes, people tend to follow the herd; not because you want to but because it hurts not to. Neuroscientist Gregory Berns says: “Social isolation activates some of the same areas in the brain that are triggered by physical pain”. Hence, being part of a large group of investors can make you feel safer and less painful.

Neuroscientists discovered that amygdala is responsible for our fear, emotional responses, and social behaviour. As a result, during the event of a stock market crash, our bio-instinct will tell us to be part of the larger community by following the crowd’s action.

In Professor Kahneman’s research, he got together a group of people whose brains had been damaged due to tumour removal or accident, and let them play a little game with the other group of normal people. Starting with $20, each one flipped a coin and called it: heads or tails. If the participant called it correctly, he won $2.50. If he called it incorrectly, he would lose only $1. If he was feeling unlucky, he could pass.

Given the odds of winning were tilted to participants favour, any player who wanted to maximise his or her returns would never pass. But the result showed that the “normal” group passed more than the “damaged head” group. Does that mean the best investors are mental defective? No, the conclusion was that emotions get in the way of successful investing. Emotions cause participants to react to “illogical” ways by refusing to bet, even when the odds were clearly in their favour. The un-emotional players, by contrast, did the “rational” thing more often and won more money.

However, another study published recently claims the opposite view. It says “adding emotions to decision-making process can enhance creativity, engagement and decision efficiency”. This is contrary to the popular belief that level headed people are more rational and make better decisions.

No matter whether we are cool headed or hot headed, rationality depends on how we see things and in whose perspective. If we apply our own reasoning to the event, we can come up with different results. I believe most people are rational in their own minds, even if we may think otherwise. Some investors would rather feel ‘safe’ than ‘risky’. Others enjoy playing for short term gains even though it costs them more time and money. Some do not even realise they have made the wrong decision simply because they have made the wrong assumptions or are given the wrong information.

By Pauline Yong
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1 comment:

yauwenchin said...

People are less rational when it comes to financial markets. They move in herd. Those who thought they are rational, following a set of fundamental measurement still got it wrong because the measurement they rely on is ineffective.

Hence, you can see, it is the majority who loss tonnes of money during the 2006 housing crisis, 2008 commodities crash, and 2009 stock market nightmare.

The majority never learn because they are driven by herd mentality unknowingly. It will continue for century to come, because, they don't realise it themselves.

It may be most rationale at a point, but become irrational on the hindsight because the yardstick they uses is WRONG. Sometime they are right for the wrong reason.

So, when it comes to financial matter, it is usually driven by EMOTION.