Jeff Foxworthy, that loveable avatar of all things backwoods, used to host a TV show called, “Are You Smarter Than a Fifth Grader?” that asked grade school questions of adults who had long since forgotten their lessons. Today, I will be your host on a game show that I call, “Are You Smarter Than a Rat?” Rather than quizzing you on the War of 1812 or long division, you’ll be presented with two lights – green and red – that will flash randomly. Your task will be to determine whether the next flash will be green or red. To make your job that much simpler, I’ll even tell you the odds! The green light will flash 80% of the time and the red light will flash 20% of the time. The rat you are competing against can’t speak of course, so the green light will provide food while the red light will provide a small electric shock.
Consider your strategy for a moment: How would you best determine the color of the next flash with a known 80/20 distribution pattern? Most humans begin the task and immediately begin to look for noise in the chaos: they try to discern a pattern. Which makes sense if you consider Harari's idea that organizing functional fictions into powerful social structures is what separates us from animals. By seeking to create signal in what is truly noise, the human subjects are able to identify the red or green signal 68% of the time. The rats, on the other hand, have no need (or ability) for higher order thinking and quickly learn to just play the odds. Quickly ascertaining that food comes about four times more often than shocks, they learn to guess green every time and end up with an 80% hit rate. The rats have no need to beat the system or craft an elegant story and the simplicity of their “dumb” approach allows them to outwit an ostensibly smarter opponent.
The market analogue of this is evident every time you turn on a financial news channel. Some Ivy League educated market wizard in a $3,000 suit is expounding a complicated macro thesis that interweaves everything from geopolitical threats to potential Fed moves to soybean production. Listening to such a story is hypnotic and rightly impressive; the human ability for higher order thinking and pattern recognition is on full display. But all too often our market wizard is like the human subject in our game show who has over complicated the task by half. The elegance of the story has overtaken the likelihood of its occurrence. The behavioral investor thinks like a rat, caring only for probability in a world that craves sophisticated nonsense. When asked to weave a story on a prominent financial news network, a behavioral investor will have no grand thesis, no series of dominoes waiting to fall. Accordingly, she will never be invited back. Instead, she will pursue a process-driven path of tilting probability in her favor at every turn, secure in the knowledge that “probably” is the most powerful word in investing.
If you enjoyed this article, please check out my award-winning book, The Laws of Wealth: Psychology and the Secret to Investing Success - available here.