Cognitively Yours 1.14

 

Raja R, Author

"A tendency to judge things by their believability rather than their validity is a clear evidence that logic goes out of the window when beliefs are strong"

In the previous posts, we have used stories and analogies to make the understanding of complex financial problems in an easy way. In this blog, let’s start with a popular story:

"The Verger" short story by Somerset Maugham

Maugham's "The Verger" is a simple tale about a simple man who does his duties with great joy and dedication. Albert Edward Foreman has been the verger of his church for sixteen years, doing all the menial and manual duties of the vicarage. He loved his job and there were no complaints about him until a new pastor arrived and made a startling discovery; Foreman cannot read. While that fact has never interfered with his duties, the new preacher is appalled and immediately fires the verger. And so, he loses his low-paying job as a verger because it is discovered that he is illiterate, but he adapts to his problem by becoming a successful shopkeeper. He finds he is better off being illiterate. Albert Foreman was happy because he did not aspire to social success even after he made a lot of money. He and his wife were both content to lead simple lives. Foreman goes on to start a very practical business, opening a tobacco store where he sees a need, and is amazingly successful. Years later, when Foreman was asked to sign some papers at the bank but could not read them, the banker was astonished at what this man had accomplished without the ability to read. When he asked Foreman, what he would have done if he could read, Foreman gave a quick and simple answer: he would have been a verger.

We tell stories to make sense of an over-complicated world, with too much information to process. The stories we tell aim to help us make sense of the sequence of events that we experience — to determine causality — in a world filled with randomness. Our inclination to create narratives to explain events, however, increases the likelihood that we use stories inaccurately, to provide a nice, comforting explanation for something that cannot or should not be explained nicely and comfortably. These stories address our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations and narrative bind facts together. As Daniel Kahneman says “Subjects’ unwillingness to deduce the particular from the general was matched only by their willingness to infer the general from the particular” makes it easy for us to infer based on these stories. “The verger” story does provide us a comfort that a missed opportunity may be a blessing in disguise, which may not be true always. The final statement in the story 'I can tell you that, sir,' said Albert Foreman, a little smile on his still aristocratic features. 'I'd be verger of St Peter's, Neville Square' is so effective that it makes us to generalise a random event.

They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding. “Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, but declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.”- Daniel Kahneman. The careful use of words in these narratives create an aura of authenticity.

In the previous blog post ‘Cognitively Yours 1.8’, we discussed the story of honeymoon couple titled “The man in the Green Bathrobe”. Why is the bathrobe green? Stories with more salient detail tend to be more memorable. Thus, we give the groom a bathrobe of the same colour that we associate with money “greenbacks”.

“The backward-looking mental tripwire that causes us to attribute a linear and discerned  cause-and-effect chain to our knowledge of the past. There is a deep biological basis to the problem: we are inundated with so much sensory information that our brains have no other choice; we must put things in order so we can process the world around us. It’s implicit in how we understand the world. When the coffee cup falls, we need to know why it fell? (we knocked it over). If someone gets the job instead of us, we need to know why they were deemed better? (They had more experience, they were more likeable). “Without a deep search for reasons, we would go around with blinders on, one thing simply happening after another. The world does not make sense without cause-and-effect” says Nassim Nicholas Taleb.

Daniel Kahneman in his book "Thinking Fast and Slow" created a fictitious character Linda and created a survey. On similar lines, if we create a survey around our great cricketer Rahul Dravid

Which alternative is more probable?
Rahul Dravid is an accomplished cricketer who builds his innings with immaculate defence in batting and tonnes of  patience or he is a level-headed gentleman.

Going by the reactions to the recent ad of Rahul Dravid, many would have chosen the second choice, if a poll had been held, similar to that of Linda, a bank teller, which Daniel Kahneman, describes vividly in his book.

This again demonstrates the power of narrative. We are so willing to take a description and mentally categorise the person it describes — in this case, level headed gentleman is much more salient than an established cricketer — that we will violate probabilities and logic in order to uphold our first conclusion. The extra description makes our mental picture much more vivid, and we conclude that the vivid picture must be the correct one. This error very likely contributes to our tendency to stereotype based on limited sample sizes; a remnant of our primate days which probably served us well in a very different environment. 

These four syllogisms provide us with a mixture of validity and believability. The table below separates out the problems along these two dimensions. This enables us to assess which criteria people use in reaching their decisions. These syllogisms are constructed similar to what James Montier constructed in his paper and book. 

Sl. No.	Type	Description
1	Active Investment (MFs)	No Investments are risk free. Some mutual fund schemes are also highly risky. Therefore, there are riskier investments other than mutual funds.
2	Passive Investment (MFs)	Over the long term, active and passive returns are found to be near indistinguishable. The Total Expense Ratio of actively managed funds is much more than the passive funds. Therefore, active and passive investors earn almost the same gross returns in long-term, while passive investors possibly earn higher net return.
3	Tax	There is always tax incentive for all for holding investments for long-term. Long-term capital gains are always taxed lower than short-term capital gains. Therefore, all investors should hold long term to get tax efficiency.
4	Banks	No bank deposit is risky. Some private small finance banks are risky. Therefore, small finance banks cannot be considered as banks.

Validity and Belief

		Belief
		Believable	Unbelievable
Logic	Valid	Active Investment (MFs)	Passive Investment (MFs)
	Invalid	Tax	Banks

The study by James Montier revealed that it is the believability not the validity of the concept that seems to drive behaviour. When validity and believability coincide, then 90% of subjects reach the correct conclusion. However, when the puzzle is invalid but believable, some 66% still accepted the conclusion as true. When the puzzle is valid but unbelievable only around 60% of subjects accepted the conclusion as true. Thus we have a tendency to judge things by their believability rather than their validity - clear evidence that logic goes out of the window when beliefs are strong. Of course, the syllogisms which I created are relevant to finance, unlike that of James Montier. If a similar poll is conducted, I am sure that identical results will emerge. I leave it to readers to come to their own conclusion.

Photo credits: www.freepik.com

Reference: Thinking Fast and Slow by Daniel Kahneman, Fooled by Randomness and The Black Swan by Nassim Nicholas Taleb, Value Investing and related articles by James Montier,