Cognitive Bias Series #2: Debunking the Myth of “Rational Economic Man”

By TradeSmith Research Team

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Imagine the following scenario: You meet your new neighbor at a barbecue and say “So, what do you do?” as you hand him a beer. He tells you that he studies Bigfoot.

“But I thought Bigfoot was a myth,” you say. “Have you ever seen Bigfoot?”

Your neighbor says no, he’s never seen Bigfoot. He further admits, with a shrug, that Bigfoot is just a figment of imagination — an idea that is completely made up.

But still, he studies Bigfoot for a living.

“Why would you study a made-up creature that isn’t real?” you ask.

Your neighbor says that studying real wildlife is too hard … and he’s got this collection of elegant math equations he really enjoys using … and the easiest thing was just to pick a mythical creature to use the math equations on.

So, he studies Bigfoot … knowing full well Bigfoot isn’t real … and somehow makes a living doing this.

You smile politely and walk away, wondering if your new neighbor is nuts.

That sounds like an implausible story, but the real story is even weirder. For more than 150 years, academic economists have studied a fairy-tale creature that never existed. (Many of them still study the creature to this day.)

Though they know this fairy-tale creature isn’t real, they pretend it’s real for modeling purposes … and build all kinds of equations around this made-up creature’s behavior … and then demand that their equations be taken seriously in the real world. (Yes, that’s just as bizarre as it sounds.)

The fairy-tale creature the economists study isn’t Bigfoot or the Yeti or the Loch Ness Monster, but something known as Homo Economicus, aka “Rational Economic Man.”

The term “economic man” first showed up in the 19th century. Around this time, the intellectual community in Europe was impressed by the scientific might of the industrial revolution.

This power of the industrial revolution, and the rise of steam engines, factory floors and so on led to a hypothesis: With all of these wonderful machines, what if whole economies worked like machines too?

William Stanley Jevons, an English son of an iron merchant, wrote a book called “A General Mathematical Theory of Political Economy” in 1862.

From that point forward, the field of economics became dominated by mathematical equations. The economic thinkers of the day did everything they could to turn economics into a scientific discipline, like a cross between engineering and physics.

They did this by turning everything into math — neat, tidy equations that fit into perfect models.
There was just one problem, though. Actual human behavior is too messy and hard to model. People make choices for reasons that have nothing to do with logic (always have and always will).

This tended to mess up the economists’ elegant and beautiful equations. So the human behavior was thrown out, and the elegant equations stayed in.

In the early 20th century, economists took it even further with something called “rational choice theory,” which assumes that all economic decisions are perfectly rational.

In practical terms this meant assuming that, whenever a human being makes an economic decision, the person first weighs all of the available evidence piece by piece … then does a risk-reward cost-benefit calculation down to the decimal point … and then behaves with perfect rationality in “maximizing” their optimal choice as determined by standard economic theory.

There’s just one huge problem. This perfectly rational choice maximizer — Homo Economicus, aka Rational Economic Man — has never existed! There is no such thing as a perfectly rational human being who decides everything like a walking spreadsheet. Never has been, never will be.

Homo Economicus is, literally, a fairy-tale mythical creature that economists invented out of thin air so they would have something to justify their equations.

It’s as if they said: “Studying humans is too hard, so we’re going to study this robot over here, and then draw all kinds of conclusions from the robot about how real humans behave.”

It seems ridiculous, but this is the thinking that dominated without pushback for more than a century. Until the 1970s, that is, when two brilliant thinkers named Daniel Kahneman and Amos Tversky changed economics forever.

Kahneman and Tversky were Israeli academics who met in the late 1960s. In the spring of 1969, Kahneman invited Tversky to speak at a seminar. Tversky talked about some experiments (cutting edge at the time) that seemed to imply humans were rational and thought like “intuitive statisticians.”

Kahneman thought these experiments were terrible, and that human judgment was hugely prone to error — and he told Tversky so. That started a big debate, which Kahneman won.
After the debate, Kahneman and Tversky became “The Odd Couple.” Their personalities were as different as night and day, but they became incredibly close friends.

And their groundbreaking work in the 1970s, demonstrating the countless ways in which human behavior is deeply irrational, exploded the myth of “Rational Economic Man” forever.

Kahneman and Tversky ushered in the era of “Behavioral Economics,” which Wikipedia defines like this:

Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.

Behavioral economics is focused on studying the behavior and habits of actual human beings (rather than fairy-tale creatures or robots). It is rooted in data drawn from human behavior in the real world, rather than rigid mathematical equations applied to a creature (Homo Economicus, aka Rational Economic Man) that doesn’t exist.

The work of Kahneman and Tversky, and the path of economic thought, is relevant to you and me as investors for two reasons.

First, because Kahneman and Tversky discovered useful and universal truths about human behavior — the “cognitive biases” and habits of flawed thinking that all humans possess, because these biases and flaws are based on the structure of how the brain works.

And second because the ghost of “Rational Economic Man” still exists — in the sense there is still a popular assumption that investors are naturally rational and logical, even though they
not … and this flawed assumption is dangerous.

Daniel Kahneman won a Nobel Prize for his work proving that human beings are irrational in certain predictable ways. (Amos Tversky would have won one too, but he died before the prize was awarded.)

Kahneman’s work applies to you, me and everyone because, once again, these are not personality flaws we are talking about — they are built into the blueprint of the brain.

Your perception (and everyone’s) is flawed in ways you cannot easily control. As an investor, you have certain biases built right into your brain that can hurt your performance in markets, and possibly even destroy your performance completely and block you from becoming a successful investor.

That’s the bad news. The good news is these flaws and biases can be corrected.

The answer to the problem that challenges all investors is what we call “behavior modification.” If you can modify your behavior via science and technology, in a simple and painless way, you can correct and eliminate the flawed perceptions that are holding you back in markets.

Imagine behavior modification technology as eyeglasses for your brain.

When your eyesight is fuzzy, you go to the eye doctor and get your glasses prescription updated. Then you get a new pair of lenses, and suddenly the world is sharp and clear again.

The same kind of lens correction can change the way you perceive markets and investing — not in terms of perception with your eyes, but mental perception of how you see markets. Changing the way you perceive then changes the way you think, which changes the way you behave — from patterns of frustration and failure to patterns of investing and success.

But in order to fix a problem, there first has to be awareness that the problem exists … and then there has to be an accurate diagnosis, and steps taken to correct the issue.

That’s why the “rational economic man” myth is still dangerous even today.

While behavioral economics has mostly replaced the old rigid models of economic thought, there’s still a widespread assumption that investors are supposed to be “rational” automatically, on their own, without any correction of mental perception or behavior modification help.

But this idea (that investors can be rational by default) is dangerous. Investors cannot be rational on their own unless they recognize their natural built-in biases and flaws and take steps to correct them with behavior modification. Some investors have figured out how to do this on their own … but the vast majority have not.

That is where TradeSmith comes in: You might say it’s our goal to give 20/20 investment vision to every investor we can find, thus helping them find success in markets … showing them how to “win” in markets and make big strides toward their retirement goals … possibly for the first time.

And the way we do this is not with literal prescription glasses, but with software specifically designed to help you “see” market opportunities and risks with more accurate perception — correcting the flaws Kahneman and Tversky identified that all humans possess — to help you naturally and painlessly make better decisions for investment success.

TradeSmith Research Team

Cognitive Bias Series