Rational Ignorance

...excerpt from Mo Lidsky's latest book, Partners in Preservation

Economists have attributed a great deal of poor decision-making to rational ignorance. Rational ignorance refers to our conscious and deliberate choice to be ignorant about certain matters because the effort to educate ourselves about those matters appears too difficult or deemed not worth it. In other words, the opportunity cost appears to be too high. And investors may say to themselves, “Why should we understand all the specifics when our investment advisor or broker knows what he is talking about?” or "Why should I bother with these other asset classes when I can just stick to the stocks and bonds I'm familiar with?" We will soon see why this is a dangerous attitude.

Rational ignorance is a term usually used in a political context, referring to voters being ignorant about the people they elect. Voters tend to focus on one or two major issues and ignore the rest. The explanation for this phenomenon is because one person’s vote is not enough to sway any election, spending a considerable amount of time to get oneself educated on all the issues makes no economic sense. Any one person’s sophistication is not enough to make any material difference to election results. American economist and Nobel Prize winner James M. Buchanan said it best:

This greater complexity of political choice is compounded by an inability to gain from any investment in knowledge. In a market setting, a person can gain by storing food during the boom periods; it is a simple task to profit directly from knowledge. In a political setting, however, even if a person has acquired knowledge about the more complex question of “why,” there is no way that he can profit from his knowledge because a change in policy will take place only after a majority of people have come to the same conclusion. Consequently, it is rational to be considerably more ignorant about general policy matters than about matters of market choice.

While Buchanan is right about politics, he is overly generous in his estimation of those who can profit from being less ignorant. Regrettably, in financial services, most people are quite ignorant about the market or have adopted rational ignorance. They may know some things about stock selection, options, some elements of economics, or perhaps even something about real estate. But it’s certainly difficult to have both a broad and deep understanding of the investment universe. Therefore, most investors are still clueless about the ways that investment managers and advisors operate, how they get incentivized, and all the ways that investors can find themselves on the short end of the stick.

The bottom line here is to get to know what you don’t know. Avoiding rational ignorance and baseless discrimination against various asset classes or strategies - with which you may not have familiarity or experience - is imperative for a properly diversified investor.