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ON DEC. 7, 2005, a curious thing happened in a Harvard classroom. Prof. Michael D. Smith stood in front of a group of computer science students to introduce a guest speaker: entrepreneur and former Harvard student Mark Zuckerberg. What was curious was that the room was nearly empty. The class met in a huge lecture hall, but there were barely a dozen people in the room.
How could that be? Why was there so little interest in Zuckerberg’s presentation? Some explanations come to mind. First of all, Facebook was still relatively young at the time—not even two years old—and Zuckerberg himself was just 21. Even the professor wasn’t sure how to describe Facebook, calling it a “social networking program, or whatever you want to call it.”
But I don’t think that fully explains the nearly empty room. Yes, Facebook was still relatively new, but even then its influence was growing quickly. It already had six million users across 2,000 college campuses, and it had more traffic than Google—60% more—so Facebook was hardly unknown.
The explanation, I believe, is a phenomenon known as “bounded rationality.” In short, what this means is that people don’t always make rational decisions—not because they don’t want to, but because they have a limited ability to do so. There is no shortage of information around us. What is in short supply, though, is the time required to process all the information that bombards us each day.
That’s why, I believe, so many presumably smart and motivated computer science students passed up an opportunity to attend an hour-long question-and-answer session with someone who was well on his way to becoming a leader in their field. It’s not that they didn’t know who Zuckerberg was. It’s that they didn’t realize who he was going to be, and why it might be worthwhile to attend.
Bounded rationality also impacts our ability to make good financial decisions. Research has shown that often we get interested in things just because they happen to cross our radar. At the same time, we tend to discount or ignore things that don’t grab our attention, whether they’re important or not.
How can you protect yourself from this phenomenon? Here are four ideas:
1. Each time you’re considering a big financial decision, ask why you want to make that particular decision. Was the idea the result of something you just happened to hear about—or was it the result of a methodical search?
2. Recognize the implications of bounded rationality for “hot” investments, be it Tesla stock, Fidelity Contrafund or cryptocurrencies. The stocks of fast-growing companies may get all the attention, but the data clearly show you’re better off with the stocks of more mature, slower-growing companies. So-called value stocks have outperformed growth stocks by a wide margin, on average, over time.
3. If you have an investment idea, and it’s not something anyone has ever heard of, don’t discount it. There’s an old joke about two economists walking down the street. Suddenly, one of them spots a $100 bill and begins to pick it up.
“Don’t bother,” his colleague says. “If there were really a $100 bill, someone would have already picked it up.”
The joke, of course, is that sometimes there really are opportunities that you spot before others do. It may be infrequent, but it does happen. I generally recommend against picking individual stocks, but that doesn’t mean it can never work. You shouldn’t be dissuaded just because it isn’t a company that everyone’s talking about. Just be sure to keep your bets to a reasonable size.
4. When considering financial risk, look beyond the recent past and the “consensus” view among Wall Street pundits. In November 2008, in the depths of the financial crisis, Queen Elizabeth II convened a group of economists and asked a simple question: Why didn’t anyone see this coming?
One brave soul answered, “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing.”
In other words, no one was worried about a recession, because no else was worried about a recession. If that sounds circular, it is. That’s why bounded rationality is so tricky. The lesson: As you structure your finances, try to go beyond the groupthink. Just because something has never happened before, or hasn’t happened recently, or no one’s talking about it, doesn’t mean it can’t happen.
Adam M. Grossman’s previous articles include Not So Easy, Many Happy Returns and Oracle of Boston. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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