Why should an investor investigate human studies fields like moral psychology, philosophy, and behavioral economics? Because people make investing decisions, people make consumption decisions, and the marketplace is not just influenced by but composed of decisions that people make. The nature of people is what drives the course of the market, profits, and long term prosperity. Then to be a good investor means being a good student of human nature and everything about human nature.
Of course, this absolves no one of the need to understand double entry accounting, charts of accounts, balance sheets, income statements, and the mathematics of compounding interest and finite series. You still make major mistakes if you get the human part right but fumble the numbers. The human mind is not very good at maintaining objective tallies over long periods of time or memorization of precise facts. Accounting math is still critical for obtaining and maintaining objective measurements of businesses and their results.
One meta-problem before us is how to weight our efforts in numeric evaluation against gains of human-centered knowledge. An implied assumption behind the number valuations of companies I've published since February is that the factual (objective, predicted long-term) value of a company may be different than how the market values it. We got the objective measurements from estimates of future earnings and the stability of the company's future revenues and growth. This is very numeric, but the basis for the numbers is often quite soft. To obtain such numbers, in 2021 we have to estimate how many widgets will be sold in 2031, and even in 2041. The accuracy of those numbers is highly questionable. The correct way to proceed is to refine your estimates of those numbers, and my proposal is that the best way to do that is to understand people. That leaves us with a potential division of labor something like 10% math, 90% psychology for our investment analysis efforts.
Prospect Theory: Interactions Between Loss Aversion and Clan Values
One way to check one the value of an investment theory approach that is heavily based in psychology is to look at the field of behavioral economics. In chapter 4 of Richard Thaler's book Misbehaving, on page 31 of the paperback version of the book, is a graph (figure 3) showing the utility of different amounts of gains and losses. It looks like this:
The curve is nonlinear for positive gains, with additional gains returning less amounts of utility. One hamburger right now is good and two is better, but at a certain point you are full and you don't want any more.
Likewise, the curve shows diminishing negative utility for increasing losses. If I lose $1 at a poker game, I'm slightly poorer and my ego is bruised. If I lose $2 at poker, I'm even poorer, but my ego hasn't been bruised much more than it was before.
The part that bothered Thaler and other behavioral economists is that this utility curve is not symmetrical. There is a kink in the curve at zero, with steeper losses of utility for small losses than there are for small gains. A loss of $1 hurts worse than a gain of $1 benefits. (Notice that the asymmetry of utility gains and losses is reflected in the availability of words in English. We have a word for small losses ("hurt") but there is no corresponding word for a small gain.) This phenomenon has been well-established through repeated experiments and reported in the economics literature. You can find many examples demonstrating it Thaler's book. It's not intuitive: Thaler himself says in Misbehaving:
Examine the value function in this figure at the origin, where both curves begin. Notice that the loss function is steeper than the gain function.: it decreases more quickly than the gain function goes up. Roughly speaking, losses hurt about twice as much as gains make you feel good. This feature of the value function left me flabbergasted.
What does this mean, and why does it exist? It's probably worth several articles or papers in themselves, but for now, I will say that it means that the human mind is trying to "ratchet up" its state in the world. Tentative gains are okay, but do not lose what you have. Perhaps this reflects a policy that is optimal for survival in a physical body. Loss of a limb or bodily functions that are permanent are very severe handicaps. It's not worth gaining a bunch of hamburgers if you suffer a deep wound.
There is a possible social explanation as well. In clan-based cultures, those in which scarce goods are often held in common by the community, gains are shared, but personal losses (cuts, bruises, exhaustion) cannot be. Hence, any losses are not shared, but gains are, and this internalization of the asymmetry of economic results experienced when living in a community are built into human psychology. When a hunter returns to the village, he alone bears all of the scars and injuries, but the meat is shared evenly with all. Some of us may no longer live in clan-based cultures, but most of the world still does, and nearly all humans did for at least the last 70,000 to 100,000 years, so those lessons are built into our genes.
Anti-Normative Ramifications
That graph is important, and I suspect that it derivable from first principles for humans and most or all animals, and has ramifications for political economy, macroeconomics, and philosophy. Thaler says
That is a lot of wisdom in one image. Little did I know that I would be playing around with that graph for the rest of my career.
The graph may be even more important than that. Earlier in chapter 4 of Misbehaving Thaler says
Prospect theory sought to break from the traditional idea that a single theory of human behavior can be both normative and descriptive.
This little sentence is tucked away in a lengthier passage, but it shouts loudly, if you are looking for the message. Let's unpack it.
The phrase "traditional idea" indicates a common assumed idea, among academics. He is saying that it is a postulate of the business of studying human behavior; that few would question it. Hence, the sentence says that most academics are seeking theories that impose standards of human behavior based on scientific results.
I'm not surprised, though such propositions are rarely stated explicitly. It could be that a lot of the motivation academics in human studies have is the desire to impose normative standards on others. People want to not only be correct for themselves in their own lives, they seek either to validate those ideas by affecting others, to gain by controlling others, or simply to control others for the pleasure of it. Academics have these same impulses, except that they seek moral superiority through knowledge and specialized analysis.
But wait, does Thaler really mean to use the word normative in that sense? Earlier, he says
By "right" I do not mean right in some moral sense; instead I mean logically consistent, as prescribed by the optimizing model at the heart of economic reasoning, sometimes called rational choice theory.
In case I was confused about the possible uses of the word normative, I looked it up. From a DuckDuckGo search I got
normative
adj. Of, relating to, or prescribing a norm or standard.
Establishing or setting up a norm, or standard which ought to be conformed to.
That seems pretty clear: it is the traditional use of the word, it is the way it is used in philosophy, and there are no additional nuanced meanings. The Merriam-Webster definition also does not admit for a meaning of "normative" as being "logically consistent." So, although Thaler is trying to use the word in one particular sense, I am suspicious that the proffered definition is a covering of tracks. After all, why re-define a word on the first page of a chapter to make it mean something else? Perhaps an editor flagged it, and Thaler expanded on his first draft, and in so doing attempted to sweep a distraction aside.
Perhaps more likely is the idea that certain economists, such as behavioral economists, collectively misuse the word "normative" in a way that has come to mean something slightly different than the way the rest of us use it, but which still retains some of its original meaning, even if the community itself is unconscious of this retained meaning.
It seems likely that a community of behavioral economists would encounter this problem. Consider their task: They are seeking to understand how people make decisions in reality, which may not match what rational thinking says that they should do. Right away, we have a baseline problem: Is the rational thought process the baseline, or human behavior itself? What word do we apply? The word "normative" means "ought" normally, and so if people "ought" to be rational, then can we use the more academic word "normative" in its place?
The Verdict on Normative Human Studies
To return to the idea that inspired the previous section, it seems likely that most human studies academics are indeed seeking to construct a single theory of human behavior that is both normative and descriptive. Thaler calls this a "traditional idea", because academics assume that they have a license to pursue such a thing. Evidence: Several existing Nobel prize winning economists use their fame to push normative judgments through the mass media, judging and proclaiming standards for society. They are often even objectively wrong, but since newspaper articles are not peer-reviewed before publication, and opinion pieces are not intended to be fact-checked extensively, they continue.
Thaler's point was that behavioral economics succeeded in part because it breaks with this tradition, by seeking results that showed that humans behave in ways that are non-normative, in all senses of the word! Whether we use the normative definition of "normative", or Thaler's, we get to the result that people do not behave according to the rules of rationality.
Which is something that any 14 year old teenager could have told you.
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