Is the financial services industry entirely rational?

Such cognitive bias certainly constrains effective investment, leading to poor and even irrational decisions. 

Furthermore, such errors are made not only by private investors, but also by professionals and by the sellers in their various shapes and forms.

That this all poses serious threats to the industry as a whole is clear enough. But these psychological processes, which also extend to any business and so many other situations as well, tend to be underrated and insufficiently understood.

Further insights can thus be gained by considering the nature of and extent to which business people in the broadest sense can be expected to behave rationally. 

Even scientists, analysts and economists may get carried away with enthusiasm or other emotions and produce outlandish, misleading theories.

A new book on The Illusion of Rationality (Die Illusion der Vernunft) by German neuropsychologist Philipp Sterzer reveals some disturbing mental realities that are in fact essential to understanding the world of business and its various protagonists and players. 

The book is complex and so are the issues, such that this article can merely convey the essence of a range of related psychological problems that are fundamental to business and indeed any dealings with other people.    

Are we all crazy?

The book itself is quite general in nature, but the neuropsychological approach applies directly and powerfully to the financial and economic context, and has certainly enriched my own understanding of what I have studied, taught and experienced over the years. 

After all, if the question Sterzer raises is even partly correct, this affects financial matters radically: “Are we all crazy?”. 

While this generalisation is certainly and deliberately way too strong, it does seem the case that many people are totally convinced about things that have little to do with reality. 

The challenges of our times all require balanced and clinically rational decisions. Yet, all too often, the diametrical opposite prevails.

And this may have nothing to do with honesty and integrity either, but result from something dysfunctional in the brain and its thought processes. 

Sterzer points out that it is not only conspiracy theorists or religious fundamentalists who behave in this manner, but potentially anyone and everyone.

Even scientists and by implication analysts and economists, whose very job it is to portray as realistic a picture of the world as possible on the basis of data and facts, may get carried away with enthusiasm or other emotions and produce outlandish, misleading theories and prognoses. 

As for the military and political contexts, the less said the better. And closer to home, at the time of writing, I observed an irrational driver risk a head-on collision with another car, rather than slow down for a turning cyclist (me) who had the right of way.  

It seems, so continues the Berlin-based psychologist, that our brains build visions of the world based on our own perceptions and often immutable but false convictions. 

This is so even when the facts quite obviously reveal, or at least suggest, a different story. Everyone, even with the best of intentions, operates to some extent "divorced from reality".

Various shades of irrationality have a lot to do with the economic, financial and countless other problems of this world.

Perhaps we need this mechanism to survive in certain contexts and situations, but the results can still be disastrous.

Sterzer was motivated to write this book to investigate how exactly these convictions develop in our heads. 

What selective and aberrant processes lead us to deal so badly with climate change, pandemics, religiously motivated (and other) wars, or the economy?

It is not possible to explain the neurological processes in this article; suffice it to say they take many forms and exert a very substantial impact on human behaviour. 

Does rationality triumph? 

The global, local and personal challenges of our times all require balanced, objective and clinically rational decisions that are in the best interest of all involved. 

Yet, all too often, the diametrical opposite prevails. In the worst cases, major (and minor) decisions are made by people who are arguably acting neither rationally nor objectively.

From the investor in the street, to the bank manager and right up to government economic advisers and presidents, there are those who are just not psychologically able to perform effectively and optimally.

The book contains many compelling cases and examples. Let us look at just two, one of which is general and the other which relates to money. 

Some serious rethinking of the behaviour of others and indeed of oneself may be long overdue. 

At the Berlin Charité hospital where Sterzer is a professor, an old man was recently treated for being convinced he was under observation by the East German state police, the Stasi.

He was sure they had installed a device in his flat that could read his brain waves, and thus went around in an aluminium helmet intended to prevent electronic access to his head.  

When Sterzer pointed out that the Stasi had been out of existence for more than 30 years, the old man laughed and said “you just have no idea”.

While this is an extreme and hopefully rare case of clinging to a notion that has nothing whatsoever to do with reality, less extreme but more damaging cases are rampant out there. 

Where, when and how many is difficult to determine, but various shades of irrationality have a lot to do with the economic, financial and countless other problems of this world.  

And it can work the other way around as well. One must be careful accusing people of being mad, as such claims can themselves lead to appalling mistakes and injustices.

Sterzer cites a case relating to the Bavarian HypoVereinsbank, and one Gustl Mollath, whose wife worked for this bank. He was convinced that in the 1990s she was involved in a grand scale in tax evasion.

It is not uncommon the perpetrators will not even be aware of these failings.  

His allegations caused a rift in the marriage, finally leading to divorce. Mollath’s wife then laid charges against him for assault and deprivation of liberty.

Fundamental to the case was a psychiatric report that declared Mollath as suffering from paranoid personality disorder, and him then being forced to endure years of intensive treatment. 

To cut a long story short, it eventually turned out that he was not crazy at all and his suspicions and allegations were true. His wife was involved in financial crimes after all. 

Irrational theories

Getting back to the theory, I studied and taught economics for many years, and major theories were based on the notion of entirely rational firms, investors and buyers.

Subsequent theories then toned this down with the concept of 'bounded rationality', which may still give people too much credit for rationality. 

It is quite possible, in other words, that many decisions and behaviours in the market go beyond mere sub-optimality and are just downright irrational.

Unbounded irrationality? To the extent that this applies in practice, some serious rethinking of the behaviour of others and indeed of oneself may be long overdue. 

Indeed, the book then deals with a series of alarmingly common cognitive distortions and biases that can affect anyone.

Firstly, there is clustering illusion, which means over-interpreting groups of data that in fact either mean nothing at all or not what you think. 

Then there is the halo effect, which leads to trusting someone for the wrong reasons, such as him or her being associated with someone else who really is honest. 

These errors occur at all levels and all sides of the market. 

Utterly convincing friendliness and care may be no more than a façade and have no bearing on subsequent behaviour. Emotional reasoning is yet another danger, which can lead to arbitrary inferences. 

And if this were not enough, there are still confirmation bias, blind spot bias, choice bias and backfire effects. If you peruse the literature further, you may additionally recognise people who are prone to generalisation, minimisation or magnification, and last but not least, selective abstraction. 

Furthermore, it is not uncommon the perpetrators will not even be aware of these failings.  

What this means, especially in the context of money, is that a large proportion of people with whom one interacts are irrational to a greater or lesser degree, and as a result susceptible to all manner of behavioural errors. 

Furthermore, these errors occur at all levels and all sides of the market. 

Above and beyond dishonesty, greed and conflicts of interest, we have to do with counterproductive behaviour that can lead to bad advice, mismanagement, misrepresentation,  jumping to conclusions, twisting things around and much more.   

There is no easy way to deal with all this. However, being rational yourself is a great start and helps a lot.

So too does being extremely careful in any decisions and interactions, double or triple-checking, getting references and ensuring that only objective, factually correct and reliable information form the basis of decisions and actions. 

Good luck is also unfortunately also part of the equation.  

Brian Bloch is a freelance journalist based in Germany