Sunday, December 11, 2005

Limits of Rationality: Beware the Paralimbic Cortex

My prior post featured a game theory question from my undergraduate Economics mid-term that illustrated, if nothing else, the practical dangers of applying rational logic to real world economics. While it's fun to ponder the fate of the sheep, who among us would actually take the little lamb's place, shielded only by the recursive logic that promises safety in large even numbers of rational yet ravenous predators? Even setting aside the cerebral limits of feline cognition, we naturally discount the purely logical solution because we intuitively understand the scientific findings that my college roommate has published on the limits of human rationality...

David Laibson is a pioneer and rising star of Behavioral Economics, a new branch of economics that models the reality of non-rational decision-making (I'm guessing he's the only Harvard economics professor to achieve tenure before puberty). Economists initially pooh-poohed Laibson's field (Myron Scholes once told me over a round of golf that behavioral economics is nonsense), but pioneers like Laibson proceeded to produce models that exceeded classical models in their prescriptive power. Laibson now teaches a slew of popular courses on campus including Ec 1030: Psychology and Economics in which, I imagine, he considers in gory detail what really happens to the sheep.

(Our other roommate for all 4 years of college and the first avowed atheist I ever met, Aaron DiAntonio, is also on the Nobel path for his work at Washington University on the biochemistry of fly brains. I was clearly the dunce of the dorm room, tolerated only for my pizza money and general tidiness.)

Laibson's research has focused on inter-temporal choices--that is, decisions we make that affect us later (such as how much to save for retirement). Specifically, studies confirm that many people make short term decisions when offered immediate gratification, and long term decisions when asked to make the same choice well in advance. Consider the following two examples:

1. You are in a shopping mall next to your home and you win a drawing, which pays out either $10o today or $105 tomorrow. Which do you think you would select? Not surprisingly, many people would choose the $100 today (probably because there is something they immediately want to buy). But what if the choice of prizes is $100 credited to your account in 90 days, or $105 credited 91 days from now? Almost everyone (even the people who selected the immediate $100 payoff in the previous situation) figure that they might as well wait the extra day for $5 more. (Of course many will evidently change their minds if given the chance on day 90!)

2. It's time for dessert, and you have just enough room left for the slice of pie presented before you. Of course, sometimes you eat it and sometimes you don't. But if you make the choice well in advance of the meal, you are much more likely to make the longer term choice of declining dessert. We all intuit that it's easier to avoid putting the treat in your shopping cart than it is to avoid the treat at mealtime.

These examples expose the illogic of human decision making. If $100 today is better than $105 tomorrow, than discounting back 90 days ought to yield the same calculus--$100 in 90 days must be better than $105 in 91. And yet it's not. The same goes for eating dessert.

The immediate gratification of food, sex, sleep, entertainment, shopping, comfort and other personal leisures factor stronger in real time decisions than they do in long term planning. That's why we often choose to restrict our own options (buy illiquid investments, buy only healthy food, ask the hotel clerk for two wake-up calls, and avoid old girlfriends)--we don't trust ourselves to make the right decisions. And often when we do trust ourselves, we fail to recognize that we will change our minds when making the same decision in real time. This psychological fact defies the rational assumption in economics that options can only help the optionholder, not hurt. Sometimes, in fact, we act in ways that imply a negative value to our options!

Collaborating with neuroscientists from Princeton, Laibson published fascinating findings last year in Science Magazine. Using functional MRI, they showed that short vs. long term decisions are made using different parts of the brain depending upon the immediacy of the short term benefits (paralimbic cortex for immediate gratification, lateral prefrontal cortex and posterior parietal cortex for delayed gratification). No wonder we can make drastically different decisions around the same set of tradeoffs!

Human intellectual frailty impairs not only classical macroeconomic models, but also our lives. The good news is that, in the absence of immediate gratification, our posterior parietal cortices compel us to overcome irrational impulses. We shop smartly to help our diets; some attend church sermons to curb "sinful" tendencies; as of last week, non-smokers can even take a vaccine to prevent unwanted addictions; and sheep avoid fields populated by large, even numbers of smart but hungry lions.

Finally, this phenomenon explains in part why thoughtful entrepreneurs raise venture capital (Hah! I told you I'd bring this baby home)...

Many entrepreneurs try to control the composition of their boards of directors, but more experienced entrepreneurs tend to share control, inviting the participation of their venture investors and outside directors. Surely, the entrepreneurs reduce their own options in the process, but those options have negative value! They expect good, experienced directors to compel them, once every quarter or so, to stop fighting fires and consider the long term direction of the company. Are we on plan? Why are there variances and what should we do about them? Do external factors (such as competition) warrant a revisit of our plan? Without the deadline of a board meeting, it's easy and natural to let these critical questions slide for too long. Raising venture capital from an investor with a track record of bringing this discipline is tantamount to making the right long term decision before the paralimbic cortex takes over!


  1. Chris Walsh8:43 AM


    Last week, over at Bruce Schneier's blog, a reference was made to the tendency among some phycisists to think that physics can explain everything. Quickly, someone threw in "economists think the same thing". Bruce remarked that increasingly he was thinking the economists might be right. As a sociologist, I'm not allowed to express such views, but I am extremely excited about the work that is being done to understand at a neurological level where preferences originate, and what evolutionary purpose they may serve. This may ultimately allow us to understand (rather than merely describe) the bounds of rationality.

  2. David, an interesting post as promised. As you might surmise from my vehement opposition to the Lion puzzle, I'm very much a fan of behavioral economics and finance. It's in understanding the irrationality of the real world that I believe we can maximize financial returns...that's one of the reasons I probably never loved my economics classes at Wharton; too traditional.

    Where do you stand on the work of Daniel Kahneman? I've found his approaches quite illuminating and fairly coincident on the surface to what Laibson postulates.

  3. Anonymous12:14 PM

    You stole my friends name, I'll eat you... SCUM, give it back to him!! Loser!

  4. Anonymous12:16 PM




  5. Anonymous4:14 PM

    David, this was an interesting post but I completely disagree with your last paragraph. Unless of course you meant it in jest.

    The VC today provides money that's all. It is Shylock's profession reinvented for the modern age. We entrepreneurs take money usually out of a position of weakeness and you make us pay dearly for that. Not to mention anything of the tax you place on us.

    I don't believe we are seen as anything but a risk to be managed - a variable in a spreadsheet if you will.

    I speak from experience, I was very closely associated with one of the companies you funded.

  6. Peter Harrington10:40 AM

    Anonymous said:

    --- We entrepreneurs take money usually out of a position of weakeness and you make us pay dearly for that.

    What drivel! I am always amazed when i hear people sprout this crap. Look, ANONYMOUS, if you don't want to take the VCs money -- DON'T. Nobody is forcing you.

    If you are lucky enough to live in a country with a system-wide infrastructure that allows that to happen (and potentially provide *you* with much better returns) and you and Co. decide to use it, then please don't whine!

    "Ohh, I took his money, and that's all I got -- woe is me! And now I have to give him a cut -- how unfair!".

    BTW, Shylock is not the precursor of VCs, he is the precursor of modern banking (lend money, get interest). And by bringing Shylock into the equation, you put yourself in a corner -- you must own up to being either historically ignorant (in both senses) and social-tone-deaf, or just plain racist.

    You probably will need that last statement explained to you. Go get a clue, will you!

  7. Robert Kwan7:11 PM

    Ah yes! The vigorous defense from the brown noser.

    Why make a personal attack? Why not let the man have his say and move on? Perhaps he has good reasons.

    I disagree with some of the comments in that paragraph as well. For example, the success of a company is the idea and the execution. A VC with a track record or without a track record is simply money at the end of the day. There is a cost to that money. If you have a track record yourself, that cost is lower than if you don't.


  8. Anonymous9:48 PM

    Peter Harrington:

    And by bringing Shylock into the equation, you put yourself in a corner -- you must own up to being either historically ignorant (in both senses) and social-tone-deaf, or just plain racist.

    You probably will need that last statement explained to you. Go get a clue, will you!>

    Excuse me - Did someone cancel the first amendment in the last 24 hours? I make an observation based on my considerable personal experiences and you see fit to attack it on a base level? Very classy. I think you demonstrate your own arrogance by your words.

    For what its worth, you are incorrect too. Modern Banking came from the Templars.

  9. Anonymous (4:14, 9:48)

    Please stop--you embarrass yourself and it is too painful to read. (i) No need to invoke the first amendment--Peter didn't curb your constitutional rights by noting your racism. (ii) Peter did not claim that banking came from Shylock (a fictional character)--he was merely correcting your implication that Shylock was a VC. (iii) You are the one who attacked at a base level, anonymously hurling "Shylock," at a Jewish blogger no less.

    Such a shame--Chris and Jason launched an interesting thread of comments about the real point of the blog post, and instead a bitter loser hijacks the conversation. Tempts to me to exercise editorial privilege! (No, Anonymous, that's NOT a constitutional violation either.)

  10. Anonymous7:00 AM

    Different anonymous but I thought you were an atheist?

  11. Anonymous8:36 AM

    Oh please David! If you care to debate this on actual merits versus clouding it with the always handy racism card, lets go ...

    I disagreed with your last paragraph. I wasn't making a personal attack but a general observation on the venture capital business.

    Track record or no track record, VCs are in the business of lending money at usurious rates. There is definitely a market for it because there are people Honestly tell me how many times have you let your entrepreneurs materially renegotiate the termsheet to even slightly tilt in their favor?

    I concede you are taking the risk and you should be compensated for it but in guaranteeing a disportionate compensation for yourself ("yourself" in the general sense) you are practising the textbook definition of usury. The entrepreneur and the employees also takes a lot of personal and professional risks, family instablity, and poor salaries to make this work realizing fully well that their eventual compensation is disproptionately lower. You look at that and says "great, that's how it should be because that shows you are committed and passionate". If I had a penny for everytime I heard that either explicitly said or implied, I would be a rich man.

    Now let's look at the value-add + oversight aspect. Unlike some old school VCs, most VCs enter the business right after school or 1-2 years after schoool. What operational experience or value add do you (again "you" in a general sense) really bring? Not a lot. A few contacts here and there - that's about all.

    One area of "value add" is in the inevitable management change - but I think is in most part motivated by your need to get close to the company. You sense something make not be working but you are too busy to really understand the dynamics because you sit on at least 5-6 boards among other things. You may disagree - but let me challenge you with one basic question - off the top of your head, can you name the top non-exec employees in every startup you are associated with and why they are the top employees?

    So you bring in your CEO (who then brings in his crew) who you think you can trust. These guys are basically professional CEOs who realize that whether this specific company flies or dies, their success is in staying close to the VC. Which they do with great aplomb, often to the detriment of the company.

    Still trying to ascertain the value add BTW ...

    Let's look at the track record aspect - What's track record in the VC context? Successful exits. Honestly, from an entrepreneur's perspective, all this translates to is a few more contacts, and a couple of meetings but not much else. In the end, whether a company is successful or not depends on the company, the market dynamics and the underlying execution. No company was a hit just because it had a VC with a track record. It is the company all the way. However, after a few successful exits, you develop a reputation for being 'good'. Good to whom and for whom?

    In short, there is really no difference b/w a VC with a track record or a Vc without a track record. In the end it is just the money albeit at usurious rates.

    Finally, let's put the racism thing to rest. I am not a racist and I didnt event notice you were Jewish (I didnt get the Jewish & Atheist BTW) until you pointed it out. I compared your profession to usurious money lending and naturally picked the most visible example of that. That's it.

    Finally the fact that I have to do this anonymously simply speaks to the fact that I can be more free with my thoughts without worry of professional persecution (let me head that off at the pass - that's not meant to be racist either - its simply how I feel). At the end of the day, I still need folks like you.

    Anyway, this is my last cpmment on this matter. I am sorry if you felt personally attacked in any way. I think you are probably a smart/nice person guy but you work in a crappy industry with no heart and a lot of double talk.

  12. Robert Kwan12:41 PM

    Had to comment again as I found this whole exchange amusing. I think the Mr. Anonymous makes several interesting points about the venture business.

    In case I didn't make this point strongly enough before: though his post was sharp edged, I don't think there was any reason to resort to unnecessary name calling & personal attacks. Words like "racist", "bitter loser", etc don't belong in the vocabulary of a VC at the helm of a storied firm like BVP.

    Just telling it like it is.


  13. Robert,

    Fair point. Well said. Mea culpa. I will temper my reactions.

    Anonymous, the value of VC is obviously a judgment call, and differs from startup to startup. However, you mis-read my post. I did not advise anyone to select a VC based simply on a track record of success (whatever that means, as you pointed out). I specifically endorsed any "investor with a track record of bringing this discipline"--that is a pattern of dutifully and diligently supporting the company by engaging the management team in long term planning and review (and this applies to any investor, not just VCs). Whether or not an investor has a track record of gains, I don't think that too many CEO's would refute the value of this specific contribution. Indeed, it is one that I try to make to companies I fund.

  14. Mr. Anonymous5:43 PM

    "Mr. Anonymous". Robert, you have christened me Robert and I will adopt it as my nom de plume. Thank you for your support.

    David, I did not mis-read your blog. I read it and understood it well. I merely disagree with you and I have laid out in detail why. I gave you a prevalent viewpoint from the other side of the table. You dont like it but that does not change the truth.

    The bottomline is that the value VCs bring is not even remotely close to the value VCs take out. We beat that one to death and I think my points prevail.

    VCs have too many things going on to provide your focus and discipline to your investments. Your words are good but the action is lacking. I had a hearty chuckle at your choice of words ... "pattern of dutifully and diligently supporting the company" ... there is no such consistent pattern with any VC including yourself.

    However as long as people like me create a demand, there will be people like you to fill it. There will be a shakeout here at some point but I am not holding my breath.

    I will continue to read your blogs as they reveal a human side of you that I am pleasantly surprised by. Occassionaly I will choose to comment but I hope you will give me the courtesy of responding with grace versus the needless negativity and insults.

  15. Chris Walsh7:07 PM

    Well, that was an interesting side trip :^)

    I was surprised that the Laibson slides, and even the intertemporal choice paper didn't make much mention of Kahneman and Tversky, or Richard Thaler. As I mentioned in my previous comment, I am an interloper in this field, so perhaps some of the ignorance I may be betraying is excusable, but isn't their work rather significant, or is this behavioral economics a whole other animal? It doesn't seem that way to me, but I haven't read much of it.

  16. Chris,

    I am fairly certain that Laibson has a good relationship with Thaler. I seem to recall several times reading about Thaler providing Laibson and the other "young minds" advice...but I could also be completely misrepresenting that, too.

    But like you I would love to know where David and Laibson [if David is privy to that information] stand in terms of Kahneman.

  17. Peter Harrington7:00 PM

    “Mr. Anonymous” said –

    --- "Finally, let's put the racism thing to rest. I am not a racist and I didnt event notice you were Jewish (I didnt get the Jewish & Atheist BTW) until you pointed it out. I compared your profession to usurious money lending and naturally picked the most visible example of that. That's it."

    That makes sense, anon. As I said in my previous post you were either racist or ignorant. I think it’s clear that you are not racist.

    And BTW, in the general effort for all of us to tone down the rhetoric, I don’t mean that as a personal insult – simply as a statement of fact: you just “didn’t notice”/know that David was Jewish. And, I would wager, you don’t know either of the implications and abuses of Jews throughout history based on “Shylock” in particular and other such “characters” in general. That’s all I meant – one or the other… and I was right.

    Another aside – it is not at all oxymoronic to be Jewish and an atheist. In fact, I am surprised that more than one person commented on that. Unfortunately for Jews, the label is, as we say in computer science, overloaded. It means both an ethnic group *and* a religion, and thus obviously you can be one without being the other. Mary Doria Russell, one of my favorite writers and author of that fantastic book The Sparrow, is a religious Jew, although she is (I think) of Italian descent. David (I gather) is of Jewish ethnicity, but doesn’t subscribe to Jewish religious beliefs.

    ”Mr. Anonymous” also said
    -- "Finally the fact that I have to do this anonymously simply speaks to the fact that I can be more free with my thoughts without worry of professional persecution … At the end of the day, I still need folks like you."

    And now, back to the argument about the original point. In your sentence lies the heart of my disagreement with you, anon. I believe in the free market. In supply and demand. And I would bet, as an entrepreneur, so do you.

    So why then would you “still need folks like [David/VCs]” if they don’t give you any value? Why don’t you go to the bank and get them to loan you the money for your next startup, at a (non-usurious) lower rate? We both know the answer: as entrepreneurs, we don’t fit their risk/reward profile. Thus, even if giving you the money (for a highly risky venture) is ALL that a VC does, THAT value justifies the returns. If it didn’t, VCs would not exist in a free market. We would go elsewhere to (more cheaply) get the same service.

    The fact that they do exist means they provide a service to the infrastructure. If you find it distasteful, do not avail yourselves of their services. I don’t like, nor am particularly impressed by the intellect of many of them (and believe me, I know a lot) but I have nothing against the profession per se, and recognize their value to the system. The money is enough -- and if they help your company out in other ways, that's a bonus.

  18. Mr. Anonymous9:02 AM


    Nice to see you trying your best in productive discourse versus name-calling and poor assessments of who I am as a person and my values. Though the result leave something to be desired, I give you an A for effort.

    Clearly, you are not seeing my comments in its entirety. I make a couple of basic points

    1. You believe in a free market and so do I. Free market does not always mean a fair market. Thus, it is entirely possible that we need the VC and HAVE to accept the usurious rates they demand because we have no other good alternative (or have exhausted others like personal finances, mortgages, perhaps a bank loan, etc). The point is we take risks (financial, personal, & professional) and the VC takes risks (financial only) - However, despite the higher risk, we (the entreprenuers) are rewarded at a different and a much lower rate. Why? It comes down to avarice IMO. Hence the point about usury at its worst being at play in this industry.

    2. I dont think I made an assessment point whether or not whether VCs are useful - I think you made the point that most of them have poor intellect. Be that as it may, my main point is that they don’t add much value beyond money (I provided my assessment of this matter) and that the rates they charge for that are excessive.

    3. David Cowan made the point that 'good' VCs dutifully and digillently support the company that is good value. Yes I agree if they do it. My counter is they don't have the experience for it (Peter, you might add intellect here as well) and second, when they are not goofing around with their blackberry (or other flavor-of-the-day gadget), they have so many things going on that they don't have time or the focus. In short, they have the attention span of a fruit fly. And my basic point remains, even if they provide this service, the value they take out of the company is far too much.

    The bottomline is the VC market as it stands today is a study in utter contradictions.

    Finally re: the racist stuff, let it go will you? I am very well aware of your implication re: ignorance. I have to say, I am astounded by your arrogance.

    How do you know I am not Jewish? Why do you think I don't know about the persecution of Jews? Whilst on this topic how do you know I am not a minority?

    Shylock was a fictional character and stupid people did stupid things in his name. That's a fact but that doesn't mean you can't ever use that name or example - I used his profession as an example not his ethnicity. It is you who linked the two together - why? Why are they not separate as they should be? There is a lot I can read into that but I will not.

    The other easy thing to do is to strike the Merchant of Venice from literature.

    So, don't leap to asinine conclusions about people when you don't know them.

    To the others reading these comments, this tangent has gone on long enough and I hope we can close this trail with this note.

    BTW, I finally got around to reading Laibson's paper and I really enjoyed it. My exposure to Behavioral Economics has come from Thaler and I think Laibson takes it to another level

  19. Peter Harrington1:27 PM

    Mr. Anon,

    You are soo wrong, in soo many ways, but I am soo bored, you win. TKO: you have exhausted your opponent, even when you had said like twenty posts back that it was your latest on the topic ;) You certainly have the stamina to be successful entrepreneur!

    There is one thing, however, about which you were right: I do tend to be arrogant. I abjectly apologize. Still, I earn solace from the fact that being arrogant is not the worst thing in the world. In fact, as everyone knows, the worst thing in the world is someone who is arrogant AND ignorant.

    Now, since you are ignorant, and I am arrogant, let’s just make sure we never have any children, ok? :)

  20. Uh...

    I don't know what I have to say about all that inbreeding that will never go on between ignorant agrrogant people, but...

    I like the actual post alot. Very interesting and well written. Consider yourself subscribed.

  21. Say, check out Wells Fargo Bank for non-rational economics -- the Geary Street branch office is near the 33MUNI transit bus service in San Francisco, California.

  22. Nice article. I believe that our present vs. future decision making capabilities are skewed because philosophically, the future does not really exist. There is only the present - where we are now. The past is limited to our memories in the present and the future is limited to our dreams in the present. The only TIME that really exists is the present.

  23. I think the $100 v. $105 decision is a matter of trust. If someone offered me $100 now I would take it now since I wouldn't trust some fool who would give me money to be as foolish tomorrow for $105. But if this same generous fool were to offer me money in the future, I wouldn't trust him to be a fool in the future therefore what would it matter if I took the money in 90 days or 91 days? I don't trust him to give me any money at all so I don’t expect a payoff either way. Might as well take the 91-day payoff it’s a joke either way since the money isn’t in my hand here and now. It's a matter of trust or lack of and taking the money and running with it while you can in the now. This also reminds me of the AIDS epidemic in Africa. When I was a Peace Corps volunteer in Namibia in '99 all the volunteers were teachers: math, science, English, etc and at these teaching posts, we were to include AIDS education and the promotion of condom use. It seems such an easy idea: wear a condom and don't die. But condom use was explained to me in this simple metaphor: it's like dropping a post card in the mail and expecting a free refrigerator 6 months later. Don't wear a condom and die in the future. Believing these ideas depends on your level of trust. Do you believe you’ll get a refrigerator for nothing? Do you believe in the idea of a refrigerator in the future or an actual refrigerator in front of you in the now? Maybe I should read your fact filled blog and do some real learning instead of writing on and on so late at night.

  24. Very interesting and explained some of the problems I face.

    Eleven years ago, I went through 22 hours of brain surgery to remove a non-cancerous tumor. I was 17 years old when this was done.

    I've made a full recovery, but there were fundimental changes in how I behaved.

    In the years before my surgery, my mental abilities were on a downward slope. I complained to doctors, but they asserted that it was my imagination and I was merely seeking attention. Before my condition started to effect me physically, I was an advert long-term planner. However, now I have trouble planning even a week in advance for anything.

    Understanding that decision making is directed by two seperate areas of the brain has opened my eyes to the cause of this. I feel like I have been awakened by this knowledge.

    Thank you for sharing this, perhaps I will be enabled to make some changes in my life based on the knowledge that my shortcomings might be based on a medical condition.

  25. I'm late for this post, but am interested to know whether you deal with how the equilibrium of a lamb in the middle with the surrounding lions occurred. It's a convenient device, but it seems to me that most things that are actually interesting - and potentially value creating, occur in the process of moving, rather than in stasis. It is difficult to imagine the plausible scenario which prevented the lamb from being vulnerable before the impasse crystallised (not that economics has ever been primarily concerned with plausibility).

    I can't help but wonder if you really are an individual enrolled in an undergraduate economics course - you have a didactic style that seems very confident and mature and a grasp of literature that is strong across an unusually broad area for someone outside the academic world... (don't expect you to let this comment through)

  26. Okay, you guys are insanely clever. I did manage to understand most of it though. The 'Mr Anonymous' saga was rather amusing to me as I have pretty much the exact same thing occur frequently, but someone's defending a videogame or gadget to the death instead of economic principles!!

  27. I have been reading the posts and I must say that I smell a general disdain toward entrepreneurs. Can we be a bit more civil toward each other: David's point is well taken - We need money and you have it, great. But can it be said in a more polite way? Maybe I didn't read all of these posts (who has the time for that?) - but reading through the 'opening lines' gave me the impression that: most of these blogs portray entrepreneurs are starry eyed kids - whose infatuation needs to be moderated by a fatherly figure - ahem - the VC. and the rationale, is that: VCs have MBAs (read wisdom) while the entrepreneurs merely have an idea - to touch the moon - which can only be turned into an opportunity : by VCs value add! Lets dig Shumpeter from his grave!

    I think stereotyping one kind wont help resolve the problems the VC industry is facing at large - look at the SHE index data : to get the facts on alpha and betas of the VC club.. Yeah, I read, 1 out of 16 entrepreneurial ideas make it..etc etc.. etc



    UG: IIT
    3 patents ( now temper your emotions before you flame)


  28. perhaps because there is this linear superimposition - one more element to add in the Beta - ie. the probability (that the future wont happen)