Sleep Your Way to a Better Portfolio*

Non-economists, when they’re giving economists a hard time, tend to reach for a couple of standard barbs. The most annoying has to be, “Sure, that works fine in theory,” but a close second is the complaint that economists rely far too much on individual rationality. That’s not, people will readily tell you, how we make decisions. Maybe there are some economists out there that believe people are perfectly rational. I certainly don’t know any. I do know that economists assume rationality, knowing full well that it’s not literally true for everyone all the time, so that they can arrive at a reasonable approximation of reality. And while such an approach has served the field well, there’s also been a growing realization that there are often systematic departures from “rationality,” at least in the maximizing average payout sense, based on lots and lots of repeated games and studies that in no way involve medical devices.

Still, this week’s New Yorker piece on neuroeconomics, on how some academics are now conducting those economic studies with the assistance of an MRI machine, is an interesting read. The results seem to show that when confronted with some economic dilemmas, the emotional parts of our brain are more active and either interact or override the rational bits of our brain to produce choices that are too risk-averse or which value immediate gratification too much. This kind of decision making, where emotions guide or trump common sense, is no doubt familiar to us all, but I imagine we don’t often consider the neural context of the process or its evolutionary history. Given ambiguity, people become sharply more risk-averse, a rather unsurprising feature of our biology given the fact that in the harsh natural world, the unfamiliar can very easily kill you. In interactions with others, including strangers we aren’t likely to see again, people sometimes make decisions in ways designed to build reputations or trust, because for most of our history we’ve lived in small groups where transactions were conducted repeatedly. The age of anonymous dining, and of the seemingly irrational far-from-home payment of gratuity, is rather a recent addition to our environment.

Alas, the article draws a few conclusions too many:

Neuroeconomics potentially challenges both parts of this argument. If emotional responses often trump reason, there can be no presumption that people act in their own best interest. And if markets reflect the decisions that people make when their limbic structures are particularly active, there is little reason to suppose that market outcomes can’t be improved upon.”

Whoa, there. A little friend of mine called natural selection disagrees with you. I’m somewhat perplexed by this conclusion making; because the logic center of the brain is not solely responsible for decision making, we assume that people don’t necessarily act in their own best interest?

The more sensible conclusion, it seems to me, is that emotional information is vital in determining what, exactly is in one’s best interest. And while this might not not necessarily mean that we’re perfect investors or gamblers, I think that those departures from rationality have much more to do with the availability of information and the costs associated with finding information and processing it. The more people understand about economics and investing, the better they do as investors, I imagine, and if they choose not to educate themselves completely on those topics, that’s because it’s costly to do so. In other words, this study tells me that when information is unavailable or too expensive, we rely more heavily on the emotional side of our brain. And I’d be willing to bet that doing so makes us optimal decision makers, or close to it.

Put it another way. Say science created an android that only made decisions using cost-benefit analysis and perfect rationality, and which could walk around the world living as we do. It seems very likely that that machine would be a far superior investor, shopper, and gambler than the average joe, but I also think it’s likely the machine would underestimate the risks involved with lots of dangerous activities, like walking around cities late at night or talking to telephone solicitors. Life is incredibly complex, and to doubt our decision making capabilities based on our performance in financial markets seems a little…unimaginative.

The second part of that quote above, about improving markets, also seems to be a little glib. We evolved as a species of individuals, which means that people were evolving in a more or less uniform way, but were doing so without communication between the living genes of one person and the living genes of another. In other words, our economy is the product of millions of years of evolutionary game theory. Our genes had to optimize our actions given the actions of others, which, although we’re all of the same species, can’t be genetically coordinated at a top-down level. The question is, therefore, what if there were a central planner who could set our economic thinking to optimize a society’s economy? Would it be possible to make us all better off?

And the answer is, I think, probably not, although the question is pretty complicated, as you might imagine. The economic thinking we evolved, which makes us generally want to maximize the good stuff while minimizing the costs, or bad stuff, isn’t just vital for the survival of the individual, it’s also vital for the survival of the species. As wasteful as we often seem to be, people are built to conserve things which are scarce and use things which are plentiful, and it’s difficult to imagine another way of thinking that would improve the overall production possibilities of the society, and not just shift costs and benefits around between people. If we didn’t care about personal conservation, then it’s likely that societal conservation would be in trouble, and we’d all die.

There are other things to consider, but all in all, the beauty part of economic behavior is that, in general, we all know what we each want and how bad we want it, we all try to get those things at a minimum cost, and the end result is a society that does close to the best it can at a minimum cost. Astounding, considering this came about from millions of years of evolution and natural selection. We evolved our economy just like we evolved our opposable thumbs and our (pretty much) hairless bodies. Tamper with that at your peril, I say.


* This appears to be an actual possibility, BTW. Read the article to see how, and then get started on what’s sure to be the biggest best-selling self-help book ever.