'Logically speaking...' How often do we say this simple phrase? There is a presumption that logic is not only good, but that the human mind can easily calculate the pros and cons of most decisions. However, the human brain did not evolve to naturally gravitate to an emotion-free, Spock-like way of evaluating options. "When people face an uncertain situation, they don't carefully evaluate the information or look up relevant statistics. Instead, their decisions depend on mental short cuts, which often lead them to make foolish decisions. The short cuts aren't a faster way of doing the math; they're a way of skipping the math altogether" (Lehrer 2011). The sooner we admit this, the better we can cope with the challenges with which life presents us; the sooner a business organization admits this, the better it can guard against irrationality, or at least plan for the mishaps irrationality may generate.
The illogic of thinking as applies to commerce was perhaps last, most fatefully manifested in the recent recession. Consumers assumed that housing values would continue to go up, and they ignored or simply did not understand the consequences of taking out adjustable rate mortgages they could ill-afford to pay when interest rates increased. Even at the time, Fed Chairman Alan Greenspan used the world 'irrational exuberance' to describe the faith placed in the housing market by homeowners, investors, and bankers alike. Economic bubbles have risen to the surface of the economy, swelled and burst since time immemorial. Every time, otherwise intelligent investors assume that current prosperity can somehow continue indefinitely, even when they know the assets in question are overvalued. Understanding how emotions can influence economic decision-making in a negative fashion is essential to protect one's self against risk and to learn how to take intelligent risks and is the subject of the following memo...
Memo: Logical fallacies in business
Common fallacy 1: A lack of appreciation for the art of doing nothing
A common cliche is that it 'is better to do something than nothing.' But that is often not the case in business. In fact, according to the Princeton psychologist Daniel Kahneman, when comparing the success rates of traders on Wall Street: "the most active traders had the poorest results, while those who traded the least earned the highest returns [and] men act on their useless ideas significantly more often than women do, and that as a result women achieve better investment results than men" (Kahneman 2011). Simply looking busy and being engaged in frenetic activity does not generate value. Making moves for the sake of moving can result in the loss of valuable stocks that accrue value slowly over time and the acquisition of less valuable stocks that eventually go bankrupt. One central tenant that must be observed in business is the need for all actions to have a purpose. The idea that a shark dies when it is standing still does not mean that darting everywhere will lead one to prosperity. It essential that when individuals businesses embark upon any ventures there must be a clear, underlying long-term strategy rather than a desire to make an empty, purposeless display of motion. All too often that 'motion' is simply following the crowd and following other investors down the path of another bubble.
Quite often it is the slow-building, long-term investment strategy that succeeds. Investment guru Warren Buffet famously avoided both the dot.com bubble and housing bubble of recent years because of his belief in blue-chip stock and companies that make products rather than sell their image. 'Slow and steady wins the race' is not a sexy investment strategy, but it is a good way to avoid one of the common pitfalls investors find themselves falling into -- constantly chasing the next new thing. "Like bargain hunters, value investors seek products that are beneficial and of high quality but underpriced. In other words, the value investor searches for stocks that he or she believes are undervalued by the market. Like the bargain hunter, the value investor tries to find those items that are valuable but not recognized as such by the majority of other buyers" ("Warren Buffet: How he does it," Investopedia, 2005). Most investors, however, do the opposite of Buffet, however unintentionally -- they follow what others are doing and end up buying overpriced stocks.
Common fallacy 2: WYSIATI, "What you see is all there is"
When evaluating the fitness of employees, many executives pride themselves on being able to know based on a hunch whether the employee 'fits into' the organization -- hence the brevity of so many job interviews and scans of resumes. However, such superficial attributes and constructed 'tests' of employee fitness are often very poor predictors of actual performance. Despite frequent complaints about a poor mesh between employee and organizational attitudes, these 'gut feeling' attempts persist as a way of measuring employee fitness and the fitness of decisions regarding the overall management if the organization. This has to do with stereotyping and common 'mental shorthand' used to justify actions: "the exaggerated expectation of consistency is a common error. We are prone to think that the world is more regular and predictable than it really is, because our memory automatically and continuously maintains a story about what is going on, and because the rules of memory tend to make that story as coherent as possible and to suppress alternatives" (Kahneman 2011).
The assumption that desired patterns would replicate themselves indefinitely was seen in the recent housing crisis. "Too often, homeowners make the damaging error of assuming recent price performance will continue into the future" ("Why housing market bubbles pop," Investopedia, 2010). This assumption was compounded by historically low interest rates, which gave investors false confidence about their ability to afford homes with adjustable rate mortgages. When the rates went up and their incomes did not, many home owners could not pay their mortgage. And when the 'bottom fell out' on the market, owners were left with homes 'under water' -- on which they owed more than the homes were worth. Our economy is proliferating with economic instruments that take advantage of built-in irrational ways of thinking. Given the way cognitive structures operate, it is almost impossible for people to truly apprehend the consequences of something like an adjustable rate mortgage. Electronic trading on Wall Street, which allow for split-second decisions seemingly invite such errors of cognition because they are based on false gut instincts.
Common fallacy 3: Over-confidence
Daniel Kahneman states that people tend to overrate their ability to make economic decisions. They minimize the influences of change and instead place too much confidence in their ability to control the future. This also makes people reluctant to admit that they are wrong -- they hang on to bad stocks and try to sell upwardly mobile stocks to nervously lock in their profits. "Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year" (Kahneman 2011).
However, according to some critics of Kahneman, what is needed is not more rationality, but that economics is already an overly rationalistic discipline. One of Kahneman's critics, Deidre McCloskey, states that the types of logical fallacies presented by Kahneman cannot be rationalized out of human nature. Instead, we must find better ways to hope with our human irrationality. "Professor McCloskey calls for a return to the more nuanced Smithian view of capitalism -- one that incorporates the S-values (s for…