We know that tests of conventional intelligence that measure Intelligence Quotient (IQ), are only a part of a measure of how well someone thinks. Yet, most societies focus on intelligence as predictors of successful decision-making. IQ, on it’s own, has been found wanting in explaining success or failure in environments that call for complex decision-making.
A paper by Michael Mauboussin and Dave Callahan of Credit Suisse “IQ versus RQ” (link to paper provided at end of post) explores the role of rationality in investment decision-making and it’s impact on success or failure. Prof. Keith Stanovich, a professor of applied psychology at the University of Toronto, believes that ability to think rationally is an equally if not more important aspect of successful decision-making in fields like investing, hence introduced the Rationality Quotient (RQ).
Warren Buffett equates IQ and talent to horsepower of an engine and RQ as the output of that motor. Therefore, a person with high IQ and low RQ can be considered an engine with low efficiency.
“How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.
Simply put, Rationality Quotient (RQ), is the ability to think rationally and, as a consequence, to make good decisions.
Measuring rationality: Calibration and Conviction
Cognitive scientists refer to something called “epistemic rationality” – how well a person’s beliefs map onto the world. For example, believing that a black cat crossing your path will cause a series of bad things to happen indicates low epistemic rationality.
Prof. Stanovich is currently developing a test of calibration to assess this form of rationality. Think of a stock market expert. If the market corrects sharply 70% of the time on the days when he predicts “70% chance of a sharp correction”, he is well calibrated. If the market only corrects 30% of those days when he makes that same prediction, then the “expert” is poorly calibrated and suffers from overconfidence.
In investing and capital markets, we’re more likely to come across “experts” who make statements about what is happening and what will happen in markets while sounding completely assured (subjective probability of close to 1). Funnily, this confidence doesn’t waver based on how many times they get things completely wrong (low objective probability), the red decisions in the chart above. However, this calibration is a vital tool to determine the quality of the advice being doled out.
Conviction is the other aspect of rationality, that is, how well a person does when she assigns extreme probabilities. Assigning 50% probability that markets will go up on any given day is essentially same as a coin toss, thus, not high on conviction. Thus, if you get those predictions right where you assign extreme probabilities, that indicates high calibration and conviction.
Assessing how rationally you think therefore depends on how close to the perfect calibration line your estimates and decisions are, and also how many high conviction calls you get right.
Note how the concept of rationality doesn’t require you to be right all the time, but being close to the 45 degree line. This means, based on current NIFTY levels if you feel 1 year returns are 60% likely to be flat, you factor that into your investment decision making not by selling all holdings (that would mean 100% certainty), but by directing additional investments into debt instruments. If the markets do remain flat close to 60% of the time in similar conditions, that’s a well-calibrated decision.
Rational people know what they know, and more importantly, also what they don’t know, when taking decisions
Prof. Stanovich and team devised a quiz to help determine your calibration and conviction through a freely available fun and simple quiz.
Try it out here: https://confidence.success-equation.com
Four lessons for investors
Investors can train themselves to be more rational with specific steps in the investment decision-making process:
1. Keep Score
When making investment decisions, track what your expectation was, why and compare it to what actually happened. Over a period of time analyze which decisions did well and which didn’t to see if any patterns emerge.
For example, tracking your decisions over a couple of years, you realize maybe stock purchases made on impulse after hearing a glowing recommendation did worse than those you spent some time researching.
2. Ask about others
Studies at Princeton University have shown that we’re good at spotting biases in others’ thinking but not as good with our own. So, when talking to an investor about their approach and results, ask what they think of someone else’s approach and you’re more likely to get a better unbiased view
3. Use base rates
If 95% of all penny stocks end up losing most of their value, then however “unique” or “special case” the company you’re looking at might seen, the 95% chance of loss is the base rate and your decision should factor that in. This is one of the most effective de-biasing tools to avoid getting carried away by irrational exuberance.
4. Update probabilities
We tend to estimate probabilities and seek our information that confirms our assumptions, called confirmation bias. The best decision-makers instead update their estimates in small increments based on additional information.
What do people with high RQ look like
Based on extensive research, Stanovich and team identified eight characteristics that set those with high RQ apart:
- Engage in inductive reasoning
- Exhibit cognitive control
- Comfortable with numerical reasoning
- Actively open-minded
- Have a limited need for closure
- Trained in probabilistic reasoning (understand base rates)
- Effective working as part of a team
- Growth (versus fixed) mindset
Read the report here
Deductive reasoning vs Inductive reasoning – livescience
Fixed vs Growth – the two mindsets that shape our lives – brainpickings