Value Investing

Michael J. Mauboussin: Q versus RQ – Differentiating Smarts from Decision-Making Skills

Differentiating Smarts from Decision-Making Skills By Michael J. Mauboussin & Dan Callahan, CFA via Credit Suisse 

Being rational is a moral imperative.”

Charlie Munger1

Intelligence quotient (IQ) and rationality quotient (RQ) are distinct. Think of IQ as the horsepower of an engine and RQ as the output.

We share the results of a classic test of calibration, which is an important facet of rationality. Well calibrated people know what they know and know what they don’t know.

Consistent with past research, we find that participants overestimate their accuracy as their subjective probability estimates tend to be higher than the actual percent correct.

Investors and executives can improve their rationality by keeping score, asking about others, using base rates, and updating probabilities.

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Introduction

Keith Stanovich, a professor of applied psychology at the University of Toronto, distinguishes between intelligence quotient (IQ) and rationality quotient (RQ).2 Psychologists measure IQ through specific tests, including the Wechsler Adult Intelligence Scale, and it correlates highly with standardized tests such as the SAT.3

IQ measures something real, and it is associated with certain outcomes. For example, thirteen-year-old children who scored in the top decile of the top percent (99.9th percentile) on the math section of the SAT were eighteen times more likely to earn a doctorate degree in math or science than children who scored in the bottom decile of the top percent (99.1st percentile).4

RQ is the ability to think rationally and, as a consequence, to make good decisions. Whereas we generally think of intelligence and rationality as going together, Stanovich’s work shows that the correlation coefficient between IQ and RQ is relatively low at .20 to .35.5 IQ tests are not designed to capture the thinking that leads to judicious decisions.

Stanovich laments that almost all societies are focused on intelligence when the costs of irrational behavior are so high. But you can pick out the signatures of rational thinking if you are alert to them. According to Stanovich, they include adaptive behavioral acts, efficient behavioral regulation, sensible goal prioritization, reflectivity, and the proper treatment of evidence.6

Your SAT scores shed little light on any of these qualities. So the first lesson in assessing your own decisions or those of others is to consider IQ and RQ separately. Warren Buffett, chairman and chief executive officer (CEO) of Berkshire Hathaway, equates IQ to the horsepower of an engine and RQ to the output. We all know people who are high on IQ but average or low on RQ. Their efficiency is poor. There are others without dazzling IQs but who consistently make sound decisions. They are highly efficient.

Warren Buffett has plenty of horsepower and output. But when asked about his success, Buffett emphasized that it was RQ that made the big difference, not IQ:7

How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a
200-horsepower motor and get it all into output.

Stanovich’s psychological research supports Buffett’s observation. While there is not yet a comprehensive test to measure RQ—Stanovich is working on it—we will look at calibration, one of the important facets of rationality.8 As part of this research, we measured the calibration of thousands of people. And part of the fun is that you, too, can participate in the exercise and see how you stack up versus others.

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Measuring Rationality

Cognitive scientists and philosophers talk about “instrumental” and “epistemic” rationality. Instrumental rationality is behaving in such a way that you get what you want the most, subject to constraints. Expected utility theory, which is based on a series of axioms, provides a normative framework for how to do this. You’ll be instrumentally rational if you follow the axioms.9

Epistemic rationality describes how well a person’s beliefs map onto the world. If you believe in the tooth fairy, for instance, you are showing a lack of epistemic rationality. Here’s a catchier way to remember the two terms: instrumental rationality is “what to do” and epistemic rationality is “what is true.”10

We will focus on observations about epistemic rationality. One way to assess this form of rationality is through a test of calibration. Think of a weather forecaster. If it actually rains 70 percent of the time on the days she predicts a 70 percent chance of rain, she is well calibrated. She is poorly calibrated, on the other hand, if it only rains on 30 percent of those days.

Exhibit 1 shows one approach to keeping score. The horizontal axis measures an individual’s subjective forecast (“there’s a 70 percent chance of rain tomorrow”) and the vertical axis captures the actual outcome (“it rained”). You know that someone is well calibrated if their results fall close to the line at a 45-degree angle.

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RQ
RQ

Full PDF below

H/T Derek

Differentiating Smarts from Decision Making Skills