Guest Post: Rational Decisions In Closed Systems

Tyler Durden's picture

Submitted by Alexander Gloy of Lighthouse Investment Management

Rational Decisions In Closed Systems

In closed systems, rational decisions lead to irrational outcomes. Take a crowded stadium. A fight or fire breaks out. Panic ensues, and everybody scrambles to get out as fast as possible (rational). In the process, people are hurt or trampled to death (irrational).

The same applies to the stock market. Rational behavior demands you buy stocks when they are presumably cheap (April 2012), and sell when they are apparently expensive (March 2009).

Rational decisions will likely lead to mediocre investment results. Does this imply you have to become irrational?

Yes and no. It is very difficult for the human brain to constantly make irrational decisions. Apart from this, it would also be a hard-to-swallow pill for clients if you told them your investment philosophy was “I am trying to make you money by trying to lose money”. I have never come across a portfolio manager or fund with the stated loss of doing so (apart from some leveraged or commodity ETF’s where it is pretty clear from the beginning they will lose money over time).

You have to train yourself to constantly challenge prevailing opinions (the “consensus”). You can be as far away from consensus as you want, but you eventually have to be right.

I consider my investment views as pretty far away from consensus.  In my view, there are no positive outcomes or solutions to the Euro-zone crisis or over-indebted governments. At times, financial markets tend to ignore those issues (Q2 2011, Q1 2012). At other times, they matter (Q3 2011, now).

Trying to be “outside” of consensus is difficult, as it requires “mental capital”. You have to be able to withstand the daily barrage of tainted news, opinions and stock price movements. Going against the stream does not “feel” good and consumes more energy than simply floating with the tides. No pain, no gain.

It is not easy to maintain your views given the unhelpful mainstream media (concerned about advertising dollars from financial services firms). Politicians and central bankers are nothing but bubbling fountains of propaganda (they somehow make it easier to read the truth between the lines, since they always seem to lie; for example, if the Spanish Prime Minister says “Spain has not asked the IMF for a bailout” you can safely assume that he if just off the phone with Christine Lagarde, begging the IMF for help).

Unfortunately, some bloggers seem to be paid stooges, trying to make the public believe they shouldn’t sell their stocks, shouldn’t buy gold and, sacrilege, should not take their money out of their bank. I have seen instances where a blogger marvels at the “great snow”, pretending to ski on the slopes in Utah, while at the same time managing to post favorable comments on various macro-economic indicators coming out over the course of the day, complete with perfectly formatted and updated charts.

Back to the stock market: even IF everyone was smart enough to buy stocks in the darkest days of a recession it wouldn’t work – every buyer needs a seller. The structure of the market – relatively constant supply of shares and relatively constant amount of money available for stock market investments (= demand) require any changes in investor preferences (cash or shares) to be resolved via the price.

Humans are hard-wired to behave rationally. This makes it so hard for us to escape the “rationality-trap” of the stock market.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
idea_hamster's picture

  Humans are hard-wired to behave rationally

Human are hard-wired to conform to the group (line dance), do what they're told ("take off your shoes and walk throught the scanner"), and mimic others' behavior (buy index funds).

For the first million years, that was, in fact, rational.  Today, not so much, me thinks.  (But it sure is comfortable and easy!)

NidStyles's picture

Self-interest is rational. If it's in your best interest to go along with the mob so you have access to food and shelter, you are likely going to do so.

idea_hamster's picture

Yes, but if you continue to "go along with the mob" today for cable tv and a leased car, I suspect you won't have food or shelter in rather short order.

Our hard-wiring comes from a time far removed from modern society.

NidStyles's picture

Well a lot of that has to do with this illusion of society that has been propped up and created by essentially every institution that serves the state. Essentially if the state has anything to do with it, it's likely not real. TV brocasting has been under the control of the state since the FCC was created. it was further corrupted with the Nielson system, and the Corporatization of the whole affair. There are many examples of this documented over the past 100 years since the Fed was established. Before the Fiat currency this level of integration and control by those in power would never have been possible. 


A real society is really created by voluntary association between individuals. The society is the actual network that develops around these associations. 

What is in existence today is not a society, it's collectivization at the benefit of the state. It's not like I want to be friends with the police officer that lives down the street from me, but it's in my best interest to do so in order to avoid the power created by the stolen right's and coercion from invading what remains of my ability to have voluntary interactions. 

This is how this mess was created. As a third party observer of the situation I can only think that most of it was manufacturer with intent. 

Law97's picture

This is just basic herd behavior, which is actually quite rational.  If you stray from the herd, you are more likely to get picked off by predators.  Plus, as social animals who derive many benefits from communal association, humans are indeed hard wired to mimic the group so as to be accepted and trusted by the group. 


However, in its extreme, herd behavior can be destructive to the individual.  Witness lemmings. ....or perfect formations of men in military columns marching off to face the machine guns (WW1). 


This instinctive herd behavior is very hard to overcome.  Further, the more fear or insecurity an individual feels regarding his place within the group, the more likely he is to engage in ever stronger herd behavior.  A very interesting recent study found that the most fervent nationalists within countries tend to be foreign-born immigrants, children of immigrants, or member of some other semi-fringe group looking to gain acceptance.  Instict tells them, consciously or subconsciously, that they had better show their utmost loyalty to the group since they are already on shakey ground.   It is similar with investors.  The more nervous they are about making the correct investment decisions (and who isn't nervous these days!) the more likely they are to go with the crowd.  Fear tends tp tighten the herd.  Watching the markets these days remionds me of a large school of fish, thousands of them darting this way and that in perfect unison in response somewhere to some perceived threat or reward apparently, but to the individual, is is paramount just to stay aligned with your fellows. 

Since the irrational herd sets market prices, it is all too easy for a rational investor, to get trampled when the herd moves against him.  This was one of the hardest realizations to make as in investor personally.  I bowed out of in 1997, and actually began shorting it in 1998.  I lost a bundle and most of my portfolio by the time the market finally did collapse.  I was correct, and rational, but that doesn't matter.  You shouldn't be making investment (trading?) decisions based on fundamentals, but rather on the herd's *perception* of the fundamentals. 

idea_hamster's picture

You do know the lemming thing is apocryphal, right? 

Omen IV's picture

"I bowed out of in 1997, and actually began shorting it in 1998. I lost a bundle and most of my portfolio by the time the market finally did collapse. I was correct, and rational,"

Larry Tisch of Loews ran the portfolio for the company and lost the same way at the same time and he was very well regarded - the hard part in being a decision maker and making bets is the timing and depth of the conviction of the herd - it always takes longer than you can possibly believe

NidStyles's picture

If herd bahavior was rational, then why are the actions of the Herd so irrational? That entire rational is utter bullshit, it's an excuse for the intellectually lazy. Being part of the herd is not rational. Humans are raised to be irrational by the State, and you excusing it doesn't change that. 

Cognitive Dissonance's picture

This train of thought gets interesting if you follow it far enough. Are we hard-wired to conform, to be part of a herd? Or is that just social conditioning?

What shocked us 10 years ago (for example, US torturing "enemy combatants") was quickly rationalized and justified through government fear mongering and social conditioning. Now it barely rates a mention when new examples are exposed. 

Can we ever really recognize our own conditioned responses after we accept them as "ours"?

SAT 800's picture

The answer is known; it is that we are programmed, (hard wired), to conform. It is not social conditioning.

mick_richfield's picture

Well, OK.  If you say so.

Citxmech's picture


I see what you did there.

I think Marshall McLuhan said that advertising doesn't tell you what to think, it tells you what to think about.  A subtlety, but an important one (Coke v. Pepsi, what new car should I buy, what do I need to fit in, etc. etc.) the real questions have been intentionally marginalized and hidden.

Law97's picture

SAT is right.  We are hard-wired. 


By the way, is that 800 on the math or verbal ...or combined?

ZerOhead's picture

Absolutely and definitively hard wired in our genes. At one time there were evolutionary advantages to us behaving like sheep. Today unfortunately not so much.

All one has to do is look at dogs and the Russian fox-farm domestication experiments.

Cognitive Dissonance's picture

I follow you completely ZerOhead and you make good points.

But thousands of years of conditioning would also express genetically as those who did not conform to the conditioning were eliminated either forcefully or by "natural" causes. As I asked above......can we even recognize a conditioned response once we have accepted it as ours?

Remember that our initial conditioning begins with our parents, who were conditioned by theirs and so on. Much of what we think of as our own ideas and thoughts do not originate within, but were planted there by others. This is why the only way out is to look deeply within for the answers, to rediscover and embrace our own personal sovereignty.

SAT 800's picture

Conditioning does not express genetically. Too bad you skipped high school biology. Like all "philosophers" you are never wrong and always in love with the sound of your own voice. So boring and so useless.

ZerOhead's picture

Those who did not conform to the conditioning could indeed be eliminated from contributing to the future gene pool through social exclusion. In such a case where the social conditioning was not adopted the individual may have had genetic predisposition to not accepting the conditioning. A higher than average level of testosterone is one of the markers for both aggression and other antisocial (selfish) behaviour. Good in tribal 'leaders' in violent societies or where resource scarcity demands territorial defence or aggression to survive perhaps, but not so much appreciated by the group in general as too many of these individuals would at some time pose a threat to the existing power structure and the health of the group in general. We can't all be alpha male bankers and warriors you know!

Check out primate social behaviour, chimpanzee and bonobo specifically.

We. homo sapiens, behave no differently. Social condition is very important and can be used to make people believe anything (belief in God's, angels, fairies, Santa,or the goodness of the Fed) and do just about any injustice to another human including killing them and even feel good about it in the process.

But you need to have a fully PROGRAMABLE computer before you can install that new software.

Humans are fully programable. That quality is primarily genetic, not learned. Try it with a cat!

And yes we have all great deal of difficulty recognizing our own conditioning. Especially when it is in our own benefit not to. :)

And I am in big agreement to looking inward to finding the answers!

iamme's picture

"This is why the only way out is to look deeply within for the answers, to rediscover and embrace our own personal sovereignty."


It's impossible. Looking inside, can't break the loop.


Element's picture



to rediscover and embrace our own personal sovereignty.

 Terrerist !!!!

Citxmech's picture

Not so fast.  Dog and Wolf packs have leaders (Alphas) and followers (Betas and Omegas).  Some followers are upwardly mobility seeking (Betas), some aren't (Omegas).  There are mechanisms for dealing with leadership vacuums, etc.  There is a lot of behavioral variability found within every litter of pups.  Also, environment influences physical brain development.  It's not a black or white issue, but one of reinforcing interrelations.

ZerOhead's picture

You didn't read the study.

There is a genetic component to social behaviour in the foxes. The 'tame' foxes had a gene that was represented not only by non-aggressive tendancies but also was reflected in floppy ears and spotted colored coats just like normal domesticated dogs.



All in just several generations of selective breeding for the 'social' gene.

Citxmech's picture

Yes, I'm very familier with the Silver Fox study.  The collection of behaviors that we relate to as "tame" v. "wild" in animals clearly have a genetic component - one that is strikingly tied to certain physical characteristics (floppy ears, curly tails, certain markings, etc.).  That is a completely different from tame v. wild pack structure.  For example, wolves and domesticated dogs both have in-tact pack structures that recognize Alphas, Betas, and Omegas.  And dogs have been domesticated for at least 10k years.  As far as people go, I'm sure there is a also a genetic componant tending to result to any given populaiton having a percentage of leaders, aspiring leaders, and pure followers.  However, in environmental situations where a population has had its normal structure shaken-up, individuals can move from Omega to Beta/Alpha.  Additionally, upbrigning/nurture can stifle or reinforce leader/follower behaviors (eg overbearing parents, isolation, abuse, etc.).  My point is that leader/follower dynamics is a lot more complicated than selectively breeding the "independance" gene.

ZerOhead's picture

 That is a completely different from tame v. wild pack structure.  For example, wolves and domesticated dogs both have in-tact pack structures that recognize Alphas, Betas, and Omegas.  And dogs have been domesticated for at least 10k years.

This is suggestive of an underlying genetic as opposed to a social conditioning determinant. Especially obvious in pack behavior in dogs that have been raised with little contact from other dogs.. ie pets!

Once again... not to understate the importance of social conditioning... but it's first in the genes.

Citxmech's picture

For an example of the influence of nurture, see:

A study outlining the phenomena of "social feedback" in the development of leader/follower relationships.

Citxmech's picture

For an example a study indicating one mechanism whereby environmental factors affect physical brain development on a cellular level, see:

"During the first 2 years of life, there is sequential growth, prodigious proliferation, and overproduction of axons, dendrites, and synapses in different regions of the brain [*1].

[*1] Neurons are nerve cells, which communicate with each other by sending out "messages" from extensions of the cell body called axons and receiving "messages" into extensions called dendrites. The axon-dendrite point of communication is termed a synapse. Synaptogenesis is the creation of synapses.

This process is genetically determined. However, not all the synaptic connections survive, many being subsequently "pruned" due to lack of use (Singer, 1995). During this period of plasticity, or potential for change, the determination of which synaptic connections will

[Page 100]

persist is environmentally regulated, being dependent on information received by the brain. A competitive process operates, determining which neurons and neural connections will survive. The competition is, for instance, for potential binding sites on the receiving neuron. To quote Courchesne, Chisum, and Townsend (1994) "neurons that fire together, wire together". Synaptic connections that are not utilised gradually disappear. The progressive neuronal maturation and the establishment of synaptic connections are reflected in changes in the infant's increasing functional maturity."


"The complex interconnections between different areas of the brain, each with their own timetable for critical periods of maturation, contribute to the varied outcomes and developmental complications of early detrimental experiences (Kandel & Jessel, 1991).

Greenough and Black (1992) distinguish between two aspects of this environmentally dependent maturational process of the brain. They describe one aspect as experience-expectant, that is, development that will not happen unless a particular experience occurs during its critical period.

In this early phase, development is actually reliant on environmental influences. The predetermined sequences of expected experiences allow for an orderly process of synaptic connections, each stage building and depending on the establishment of the previous one. Greenough and Black further suggest that these early experiences have been selected through the process of evolution and are expected to occur reliably in the particular species and at a particular time in development.

This species-typical development is genetically determined and its organisation is designed to buffer the developing brain in a regulatory and orderly development in the face of a variety of environmental influences (Bjorklund, 1997). In turn, typical and expectable environmental factors and circumstances are themselves species-specific, presumably evolved to ensure the stability of development. As far as the human infant is concerned, new stimuli are expected to be presented in a way which is "safe, nurturing, predictable, repetitive, gradual and attuned to the infant's or child's developmental stage" (Perry & Pollard, 1998).

The overproduction of synapses tends to be found in situations in which a source of information can be relied upon to guide the elimination of unused synapses. They include the handling of young infants, responsive gaze, and talking to the infant. The absence of these interactions with the infant would be unusual and contributes to the elimination of synaptic connections.

Neglect and failure of environmental stimulation during critical periods of brain development may lead to permanent deficits in cognitive abilities. Experience-expectant development has been especially well studied in animals' visual cortex (e.g. Wiesel, 1982). In experiments now regarded as classical, Hubel and Wiesel (1979) showed that by temporarily blocking the visual input to one eye of a cat during a critical period of development, irreversible structural and functional changes are produced in the brain's visual cortex, leading to permanent impairment of vision in that eye."

NidStyles's picture

It's social conditioning. Why do you think public schooling is enforceable by law now? Why do you think there's a central authority for what the regents are able to allow in the school's curriculum?


Heck look at the origins of these words themselves. School comes from Schule, which originated from Schola. Schola means to Hold Back in Latin. Curriculum comes from the Latin Currie-cule, which means to actively pursue or to run. Actively holding back eh? It's miserable that people do not understand the nature of what they are speaking on, as they can not say what the words themselves actually mean. That means that the School's Curriculum is working I'd say.  

Element's picture



"US torturing "enemy combatants"


"We've always tortured enemy combatants!" - george orwell

govttrader's picture

Here's an idea

Of the last 13 new 30yr bond auctions (not re-openings, but new issues...going back to May 2009), buying 30yr bonds in the auction and holding the paper for 24 hours has been profitable 13 out of 13 times.   This stat is making its way around the street, so expect an additional amount of players in tomorrows auction. Should be bullish for the auction.  Also, shorts in S&P futures have been building as many Elliot Wave technicians have been talking about an  upcoming cliff in the S&P, as they look for a 100-300 point drop in the S&P 500.  This should be bullish for 30yr treasuries as stocks seem to be full of Central Bank hopium lately.

LawsofPhysics's picture

New to ZH I see.  We have been frontrunning around here for a while now.

Abraxas's picture

So, what's the right thing to do? If I am wired to be rational, but rational is bad for me and some, but not all, irrational decisions can be good, how do I make the rational irrational decisions? Sorry, this article doesn't help me.

Azannoth's picture

It might be doable though a Proxy, find the most rational person you know, like idk your mother, and ask her what she would do, than do the opposite :)

Abraxas's picture

OK I'll ask my mother-in-law


edit: wait, that won't work, she is the most irrational one. Maybe I should listen to what she says then.

sunaJ's picture

Nassim Taleb, when confronted with this problem, says that it is more about asking what you should NOT do: the Via Negativa.

(several great podcasts with Taleb here)

In essence, go about your life trying to build robustness (anti-fragility), but more importantly, avoid the things that will bring negative black swans - they can be mitigated in our personal lives quite easily without introducing negative or unintended side-effects (eg. don't smoke, don't hang around with gangsters, don't give your money to others to invest).  It leaves us wanting; however, because we tend to seek someone to tell us what we should be doing, not what we should not be doing.


Abraxas's picture

What you said sound very rational to me. Does that make it bad then? This is why I didn't like the article, it gave me nothing to chew on.

sunaJ's picture

Yeah, I thought the article would go on for several more paragraphs.  It seemed to be truncated just as it was introducing a topic.  I learned more about what this article is talking about from reading Taleb than from anything else.  The podcasts are a good intro.  Throw 'em on your iPod if you get a chance.

Azannoth's picture

Your theory sounds just about right, might also explain why I lost so much money in stocks. By thinking rationally you inadvertently loose any edge over the main stream thus are damned to sub-par results.

Than again today no strategy will really work, it's all about inside information and nanosecond execution times. No way you can win

Imminent Crucible's picture

"In my view, there are no positive outcomes or solutions to the Euro-zone crisis"

Hey, I know what you mean. But I can see some very positive outcomes. If the EuroZone crisis goes like any rational being would expect it to go, it means that trailer trash like Christine Madeleine Odette Lagarde and Mario Goldman Monti and a few hundred other Eurocrat scum lose their cushy sinecure jobs and maybe a few even get their arms and legs pulled off by furious Germans and Greeks pulling from opposite directions.

'Tis a consummation devoutly to be wished.

Waterfallsparkles's picture

Thew Market works in reverse of rationality.  That is why the People on the Street make so much Money.  You cannot be rational to trade stocks.

The Street uses that to their advantage.  A Company makes a profit over last quater but the miss estimates and the stock tanks.  Not rational.  A company posts lower profits but they beat the Market estimates the Stock runs up huge.

Bad jobs numer the Market rallys because Bernanke is going to print.

You have to be irrational to win in the Stock Market.

Neethgie's picture

tbf i always find in stocks the keynes's beauty contest idea seems to ring true. (one of his only idea's)

basically it says, dont pick the best one, pick the one most people will go for, which in stock terms makes sense.

q99x2's picture

Since I stopped supporting the tax man, stopped building the pyramids so to speak, I've had lots of time to study what they've been up to. It ain't pretty. They take their commands from a big headed bug like creature with a tail that travels in the tunnels between the Wells Fargo, the NY FED and the Brown Brothers Harriman. From there they run the human slaves tax money through Brown Brothers into Military funding and private biotech research centers and then out through the stock market and Wells and finally over to the Squid to bribe the worlds politicians so they can indebt future generations for centuries to come. I don't think I'm too rational but the more people come around to my way of thinking the more I'm in doubt.

CIABS's picture

It's something like that.  Obviously the internet is allowing the awareness to spread, which for me is not a reason to start doubting.  But of course a lot of the awareness is spreading through Alex Jones, whose followers often don't go beyond reciting a certain litany, much of which is either not known or untrue.

extendedorder's picture

The majority of people are not rational at all. they base their decisions on emotions and gut feelings not on facts and reasoning.

Abraxas's picture

This is why the stock market is just a big casino. No matter what, the house always wins.

Comicus's picture

People are too driven by emotions.  Even those who attempt to base their decisions on facts are often confounded by misinformation and DISINFORMATION.

i8emallup's picture

Panicked scrambling is rational?

NuYawkFrankie's picture

Re. Humans are hard-wired to behave rationally


Oh yeah?

I guess that must be  why - for instance - over 30,000 were mowed-down in ONE DAY at the Battle OF The Somme (WW1). It musta been in their self-interest to merrily march across no-mans-land into German machine-gun fire while playing "Bonnie Scotland" on the bagpipes.

 No - humans are hard-wired to behave like craven, slack-jawed freekin morons... the author of this article included, for making such a preposterous statement

mick_richfield's picture

If I had to listen to "Bonnie Scotland" played on massed bagpipes, I would probably make a dash for No Man's Land also.

Ungaro's picture

Yes, we are hard-wired to act rationally. The problem is that we can rationalize any irrational act, e.g.: genocide, murder, wars on the other side of the planet for the sake of our "national security", abdicating personal responsibility and surrendering personal freedoms for the sake of the illusion of security, ad nauseum.

Dr. Engali's picture

Rationally speaking I believe there can be a positive outcome in the Euro crisis. It calls for the politicians to do something irrational to their nature...which is tell the bankers to fuck themselves and do the right thing by their citizens instead of groveling at the alter of Goldman slacks.

Remington IV's picture

Panicked panicking