The Myth Of The Rational Investor

There are many biases that affect investment both from a fund manager and investor perspective. So, what does that mean when it comes to formulating investment strategies?

- Hannes Viljoen

Economists, asset managers, investment managers, product developers and the likes all use the “rational investor” when making predictions and assumptions.

A rational investor, or rational behaviour, refers to the action or decision-making criteria of a person so that the optimum level of benefit is reached. But is the average person rational? We base so many model assumptions on this ideal, but does he or she actually exist? The existence of biases leads to an unclear answer.

Cognitive biases relate to information processing. It relates to the way we think and argue. Cognitive biases can lead to an illogical deviation from rationality and lead to poor decision-making.

A classic example of a cognitive bias is the gambler’s fallacy. If you flip a coin and the outcome is tails six times in a row, our inclination is to put a higher probability on the next coin toss being heads. But in reality the probability is 50/50, as each coin toss should be seen as an independent event that is not influenced by previous coin flips.

In a Monte Carlo casino in August 1913 the roulette ball landed on black 26 times in a row before a red number was thrown. People who fell prey to the gambler’s fallacy that night believed that the probability of a red number being thrown increases with each black number being thrown and consequently lost a lot of money. In reality the probability of a particular number being thrown on each turn of the wheel should be equal.