Rat

When It Comes to Investing, Are You Smarter than a Lab Rat?

Rat

Please don’t be too quick to answer that question in the affirmative. Imagine that you are the subject of the following experiment. You are standing in a room with two doors—door #1 and door #2. In each trial, you choose a door, and either there will be a $20 bill waiting for you to collect, or there will simply be nothing. Today is your lucky day in that you get to play this game fifty times. However, you are told nothing about the decision-making process of the experimenter—all you know is that the $20 bill is waiting behind one of the two doors. Your first assumption might be that he is following a complex pattern to see if you have the intelligence to deduce it. However, just when you think you have discovered the pattern, your next guess is incorrect. Naturally, you assume that the experimenter is simply trying to outwit you by deceiving you into thinking you have found a pattern whereupon he places the money in the opposite door. Unfortunately, when you spot the “false pattern” and guess the opposite, you are wrong again! Boy is this ever frustrating! Finally, you just give up and pull a coin out of your pocket and start flipping it—heads for door #1 and tails for door #2. At the end of the day, you go home with $500. Although it’s not bad for a day’s work (if you want to call it that), somehow, you just don’t feel satisfied because if only you had simply figured out how the experimenter was deciding which door, you would have gone home with a lot more. Also, you are extremely tired from all the brainpower you expended in trying to deduce the methodology behind the experimenter’s door choice before you finally gave up.

Knowing your frustration, the experimenter invites you back the next day to watch the experiment from his vantage point so that you can see exactly how he is deciding which door gets the cash. Much to your surprise (and chagrin), he pulls out a coin and starts flipping it—heads for door #1 and tails for door #2. Naturally, you want to bash his head in, but before you can do that, he tells you that there is something special about this coin--it is a biased coin that comes up heads with a probability of 60%. I know—there is no such thing as a biased coin, but it just sounds so much better than saying that he was using a random number generator on his computer. As you watch the subject of today’s experiment go through the same mental gyrations that you did and get only about half of his guesses correct, you somehow manage to restrain yourself from telling him the secret while the experimenter is not looking.

Next, the experimenter asks you to take a walk down the hall with him where you find a parallel experiment taking place, but this time it is with a hungry rat in a T-maze who is rewarded with a morsel of rat kibble when he chooses the correct direction at the top of the T. The experimenter is flipping the same biased coin—heads for the right-hand side and tails for the left-hand side.  The experimenter asks you to observe the rat’s behavior, and here is where it gets interesting. You notice that the rat always chooses to go right, which is, of course, the optimal strategy. Naturally, it took a large number of trials for the rat to figure it out, but unlike you and all the other human subjects, the rat did figure it out. It dawns on you that the intellectual attributes that we most highly value in ourselves, the ability to reason and discern patterns, were actually detrimental in this situation. The natural tendency was to overthink the problem which obscured the true answer, and as Nassim Nicholas Taleb would say, the human subjects of this experiment were “Fooled by Randomness”.

The experiment described above was actually conducted by the late Professor Ward Edwards1 of USC over 50 years ago. The experiment is described by Philip Tetlock in his highly insightful book, Expert Political Judgment, which thoroughly explains why you should not rely on the predictions of experts as a basis for making investment decisions—in a nutshell, because they do no better than Burton Malkiel’s monkey throwing darts at the Wall Street Journal. Tetlock describes witnessing a reenactment of the experiment with a group of Yale students losing to a Norwegian rat, and he provides an academically-oriented explanation when he says, “Human performance suffers because we are, deep down, deterministic thinkers with an aversion to probabilistic strategies that accept the inevitability of error. We insist on looking for order in random sequences.” To put it succinctly, sometimes we are just too smart for our own good.

So how is this relevant to investing? Quite simply—if we know that in any year, about 60% of active funds will lose to their passive counterparts (see the “Annual League Tables” of the Standard and Poors Index Versus Active Scorecard) and we have no reliable way to identify the 40% that will win, then the optimal strategy is to stick with passive in all years going forward. Unfortunately, as human beings, we tend to overthink it and search for excuses to go active such as, “Perhaps this year will be a stock picker’s market”. In case you missed it, we completely debunked the myth of the stock picker’s market. To us, one of the great things about investing is that you don’t have to be a genius to do well at it—you just need to be as smart as a lab rat.

 

1Edwards, Ward, “Probability Learning in 1000 Trials,” Journal of Experimental Psychology, 62 (1961):385-94.