Against the Gods: The Remarkable Story of Risk (52 page)

Despite the criticisms of Markowitz's theory of portfolio selection,
his contribution has been immense. It has provided the foundation for
the primary theoretical work accomplished since 1952 and has given
rise to practical applications that dominate the field of investing. Indeed, diversification has become a veritable religion among investors.
Even the attacks on Markowitz have triggered new concepts and new
applications that might never have come about without his innovative
contributions.

Yet much of what one makes of Markowitz's achievement, and the
structure whose foundations he laid, depends on how one feels about
the controversial issue of investor rationality. Just as Wall Street was
beginning to apply the new theories of investment, the sound of different drummers was heard. The critically important work on rational
behavior, most of which dates from the tumultuous early 1970s, provoked a dramatic break with the optimistic views of rationality that had
characterized the innovations of the 1950s and 1960s. The stage was set
to take up cudgels against the models of Daniel Bernoulli, Jevons, and
von Neumann, to say nothing of the central assumptions of traditional
economic theory.

The response to this rough assault on hallowed principles of behavior was tentative at first, in part because academics do not always express themselves with clarity, and in part because of the enormous vested interests that had accumulated around the established theories of decision-making and choice. But the gloomy environment of the 1970s provided the impulse that unleashed the power, ingenuity, and common sense that marked the new ideas and ultimately brought them into the forefront of academic research and to the attention of practitioners. Today the journals are full of attacks on concepts of rational behavior and risk aversion.

Daniel Bernoulli had admitted in his paper that there were "exceedingly rare exceptions" to his propositions. He underestimated how frequently human beings stray from the strait and narrow path he laid out for them. Recent research reveals that many of the deviations from established norms of rational behavior are systematic.

There is another possibility. Perhaps people are not nonrational, but the traditional model of rationality may specify a pattern of behavior that captures only in part the way that rational human beings make their decisions. If that is the case, the problem is with the model of rationality rather than with us human beings. If the choices people make are both logical and predictable, even with varying rather than constant preferences, or with preferences that do not suit the strict prescriptions of rationality, behavior can still be modeled by mathematical techniques. Logic can follow a variety of paths in addition to the paths specified in the traditional model.*

A growing volume of research reveals that people yield to inconsistencies, myopia, and other forms of distortion throughout the process of decision-making. That may not matter much when the issue is whether one hits the jackpot on the slot machine or picks a lottery number that makes dreams come true. But the evidence indicates that these flaws are even more apparent in areas where the consequences are more serious.

The word "irrational" may be too strong to apply to such behavior, because irrationality conveys craziness and most people are (perhaps by definition?) not crazy. Richard Thaler, a University of Chicago
economist, has observed that people are neither "blithering idiots" nor
"hyperrational automatons."14 Nevertheless, Thaler's pioneering studies of how people make choices in real life reveal significant deviations
from what Bernoulli or Markowitz believed.

This is a fascinating area, a course in self-discovery. The more we
learn about it, the more we realize that each of us fails the traditional
tests of rationality in ways that we may never have thought about. Von
Neumann, despite the brilliance of his insight, omitted important parts
of the story.

ll of us think of ourselves as rational beings even in times of crisis, applying the laws of probability in cool and calculated fashion
.to the choices that confront us. We like to believe we are aboveaverage in skills, intelligence, farsightedness, experience, refinement, and
leadership. Who admits to being an incompetent driver, a feckless debater, a stupid investor, or a person with an inferior taste in clothes?

Yet how realistic are such images? Not everyone can be above
average. Furthermore, the most important decisions we make usually
occur under complex, confusing, indistinct, or frightening conditions.
Not much time to consult the laws of probability. Life is not a game of
balla. It often comes trailing Kenneth Arrow's clouds of vagueness.

And yet most humans are not utterly irrational beings who take
risks without forethought or who hide in a closet when anxiety strikes.
As we shall see, the evidence suggests that we reach decisions in accord
with an underlying structure that enables us to function predictably
and, in most instances, systematically. The issue, rather, is the degree to
which the reality in which we make our decisions deviates from the
rational decision models of the Bernoullis, Jevons, and von Neumann.
Psychologists have spawned a cottage industry to explore the nature
and causes of these deviations.

The classical models of rationality-the model on which game theory and most of Markowitz's concepts are based-specifies how people
should make decisions in the face of risk and what the world would be
like if people did in fact behave as specified. Extensive research and
experimentation, however, reveal that departures from that model occur
more frequently than most of us admit. You will discover yourself in
many of the examples that follow.

The most influential research into how people manage risk and
uncertainty has been conducted by two Israeli psychologists, Daniel
Kahneman and Amos Tversky. Although they now live in the United
States-one at Princeton and the other at Stanford-both served in the
Israeli armed forces during the 1950s. Kahneman developed a psychological screening system for evaluating Israeli army recruits that is still in
use. Tversky served as a paratroop captain and earned a citation for bravery. The two have been collaborating for nearly thirty years and now
command an enthusiastic following among both scholars and practitioners in the field of finance and investing, where uncertainty influences
every decision.'

Kahneman and Tversky call their concept Prospect Theory. After
reading about Prospect Theory and discussing it in person with both
Kahneman and Tversky, I began to wonder why its name bore no
resemblance to its subject matter. I asked Kahneman where the name
had come from. "We just wanted a name that people would notice and
remember," he said.

Their association began in the mid-1960s when both were junior
professors at Hebrew University in Jerusalem. At one of their first meetings, Kahneman told Tversky about an experience he had had while
instructing flight instructors on the psychology of training. Referring to
studies of pigeon behavior, he was trying to make the point that reward
is a more effective teaching tool than punishment. Suddenly one of his
students shouted, "With respect, Sir, what you're saying is literally for the
birds.... My experience contradicts it."2 The student explained that the
trainees he praised for excellent performance almost always did worse on
their next flight, while the ones he criticized for poor performance almost
always improved.