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When irrationality works

When irrationality works

Do you believe that economic success in life owes more to ability and hard work than to luck? If you do, it's more likely that you are heavily invested in equities.

I say this because of new research by the University of Melbourne's Nicolas Salamanca and colleagues. They show that people with a strong internal locus of control - those who believe they have control over the events in their life - are more likely to own shares than others and, among those that do own shares, have higher equity weightings than others. This is true even controlling for other determinants of equity weightings such as age, education and wealth.

Why is this? The authors rule out some possibilities. It's not because people with a strong internal locus of control are more optimistic than others, nor because they are more financially literate.

Instead, they say, it's because such folk believe that shares are less risky than people with an external locus of control believe them to be.

One piece of evidence for this is that people with an internal locus of control are more likely to sell options; if you think volatility will be low, you'll regard options as being overpriced and so will sell them.

This is consistent with evidence from outside economics. Dutch psychologists have shown that people with a strong internal locus of control also believe they are less prone to health risks than others; Noel Edmonds' belief that cancer is caused by negative thinking is an extreme example of what is in fact a common tendency.

There might be a simple psychological mechanism at work here. If you think risk is low in one domain - that luck plays little part in your personal life - you might well believe it is low in other domains.

In one sense, this is irrational. The stock market will fall or rise this year for all of us, so your psychological make-up shouldn't affect your judgment of the chance of it doing so.

However, this might be another example of an irrationality that can actually help us.

One reason for this is that people with a strong internal locus of control are more likely to succeed in life: they tend to earn more and to make better parents. As Friedrich Hayek wrote, the world is not a meritocracy but we often benefit by acting as if it were. Underestimating equity risk might be a small price to pay for the benefits of believing you are the master of your own fate.

What's more, this underestimation of risk might cancel out a bias in the opposite direction.

Christoph Merkle at the University of Mannheim has shown that people underinvest in equities because they overestimate how miserable they'll feel if they lose money, and underestimate their psychological resilience to losses. He calls this "loss aversion illusion".

Underestimating risk because of one's internal locus of control might cancel out this bias towards under-owning equities with the result that, on balance, you end up with a reasonable asset allocation.

Not all irrationalities are harmful. Given how ubiquitous they are, this is just as well.

MORE FROM CHRIS DILLOW...

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Chris blogs at http://stumblingandmumbling.typepad.com

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By Chris Dillow,
05 January 2017

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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