intelligent

An Idea Called Irrationality Why The Earth Is NOT Flat

Sanjeev

Sanjeev

 Since childhood, we have heard our teachers tell us that “man is an intelligent being”, meaning thereby that our species is ‘intelligent’. By way of evidence, it is pointed out that back in the jungles, we were the only species that learned how to handle fire, make tools, and build ‘organizations’ that ensured that the sum of the parts is much greater than the whole.

Declaimer: This article written was originally in September 2008, and some of the data points may be outdated.

Within the limited context of evolutionary biology, man does seem to stand out as ‘intelligent’, in that we did a better job of all this than other species, which is why we are not yet, (global warming notwithstanding) on the brink of extinction.

But we need to use our words carefully and not apply them out of context. In the new jungle of our economic world, there appears no evidence that the previous maxim doth apply. The idea that ‘man is irrational and systematically so’ ranks along with the idea that the world is round, circa 1600 (i.e. the time of Galileo).

Just think about what the flawed belief that the world is flat, did for society. Sea-borne Shipping was minimal, as was world (or inter-continental) trade. This stopped the flow of ideas and the building of one (idea) on another. Perceptions of risk were very different till Galileo pointed out his Heliocentric theory.

In almost the same fashion, the idea that man is intelligent leads us to assume many other beliefs, are equally flawed. This limits our ability to get the correct perspective. For example, we often say that Mathematics gives ‘correct’, i.e. definite answers. Here we confuse correctness with definitiveness, mixing precision (a left-brain thing) with judgment about appropriateness (a right-brain thing). This results in rather strange behavior: GDP and Inflation are treated as mathematically significant, in that 12.63% is lower than 12.84%, and so is a cause for celebration. The current rally in the markets is driven by a ‘drop’ in inflation, it seems. Rational??!

People go to town with the news that ‘the GDP growth rate is dropping’. Tiny decimal points of GDP growth rate get discussed till the cows come home as if lives depend on it. The markets gyrate in step, is it 7.9% or is it now 8.1%? Just plain stupidity, useful only for selling newspapers and filling up TV time.

Just think of the damage this notion (that “man is intelligent/ rational”) is doing. In the first place, we draw no semantic distinction between the two words, confusing rationality with intelligence. Then, as I pointed out above, we transplant the context, confusing biology with economics. Whole industries live on this ‘fatal flaw’, just like the inland river trade (on the Rhine) and overland trade (to Asia) lived on in Europe, in place of sea-borne transcontinental trade, setting back progress by hundreds of years. In modern times, the Insurance industry, one of the most profitable industries of all, lives on the widely-held notion that Insurance is ‘useful’, even as it preys on a singular, terrifyingly secular human irrationality: that under conditions of stress, the human mind is incapable of calculating the probability of any ‘expected’ event, just as it is equally incapable of evaluating the probability of a thinly imagined event. An industry that stands on such flimsy ground, actually lobbies for entry into India as a technology industry. So now foreign companies will make money on Indian fears, all in the name of progress.

I argued in a previous article how man-made computers, often considered more rational, will create even more trouble by widening spreads and increasing volatility in the markets. Spread and strip trading, even in liquid scrips like Infosys, yields returns of 300% per month already. Would you call this rational? Do you think computer programs can catch this?

For a very long time, I have been carrying on this monologue at various Institutes, that mathematically precise Classical Finance is not necessarily either correct or useful in the real world, which is why so many forecasts fail. We explain this away in the name of ‘complexity’ using words like ‘speculation’ to hide our failures. This is not dissimilar to a sailor explaining the failure of his voyage with a reference to the flat earth. I have often bitten back the comment that we hide personal failure and incompetence behind such words.

I use current research on irrationality as a daily filter in almost everything I do. It strikes me just how wide the applications are. If you are sensitive enough to see how people are always prey to hundreds of irrationalities and are basically ‘lemmings’ in human form, you will cease to be surprised by most headlines. If the pink papers had not invested in color printing presses, maybe the markets would not have fallen so badly the last time around. The huge amount of red and blue in their banner headline, discovering Inflation (at >12%), did its bit. Why were people surprised?

My columns in the previous year have talked regularly about Money Supply, oil, trade flows, and the Indian (and American) Current Account deficit. I talked about the real estate bubble, the debt bubble, and whatnot. No doubt, my language was complex, I used too many words, and not enough of them were colored red and pink in one simple banner headline….  but that was the only difference. What must happen, must happen, I sigh; and after writing about it, I just go out and take advantage of those who ignore me.

In hundreds of ways, it will do us well to start with the notion that man (in general) and we in particular, are irrational. Successful economic behavior is therefore a defensive process: once you have located all the hundreds of ways in which we are irrational, we must seek to avoid those patterns (of behavior). Then, we can use those insights to take advantage of the rest of the populace.

It doesn’t stop here. Once you have understood the individual, you must now move on to understand crowds. Goose and geese are two different entities when we are discussing humans in economic form. Predictability increases dramatically when we discuss crowds, and there are almost no exceptions when we move to large crowds, i.e. big companies and markets.

With increasing predictability, these behavior patterns lend themselves to mathematical and statistical analysis, which is where this can become a business. The process of locating human irrationality, predicting it with mathematics/ statistics, finding ways to take advantage of it, and converting the entire skill into a process, can become a business. The actual business entity may be called a Hedge Fund or whatever and may choose to carry on its business in some marketplace or the other,  but the core strategy of most successful businesses is always based on this. Whether this is stated explicitly or not, most long-term business success comes from a process that preys on human irrationality.

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