Meet Grunt, a Stone Age economist. Grunt spends his time assessing risks. Usually these involve delicate decisions that may end up having quite important consequences – like whether he's alive at the end of the day or not. Whether it's attempting to impress a potential mate or ingratiating himself with the alpha males or simply choosing not to eat that odd smelling fruit he's constantly having to weight risks and probabilities. Grunt, however, isn't blessed with modern economic theory and probability analysis is unknown to him. Although his grasp of number theory that doesn't run much beyond one, two, err … a whole load he has a mechanism that's been honed over hundreds of generations. Rather than rationality Grunt relies on the Affect Heuristic.

Risk Is Not Equal to Reward

It's perfectly obvious to the average strategically shaved simian that humans manage individual risk pretty well on the whole. Despite the aberrations in the gene pool that regularly show up in the Darwin Awards we mostly avoid killing ourselves in pointless ways and are remarkably adept at navigating our way through the incredible complexity of modern life without getting run over along the way. No one, outside the confines of academic fantasyland, really believes we do this though rational analysis of risks.

This idea of "risk" is the bugbear at the root of most modern confusion in economics and investing. Risk to the majority of us is something of which we have an instinctive sense, an idea which is infused with an emotional charge that guides us through our lives, mostly with reasonable success. When market commentators gaily refer to "risk and reward" and tell us that we can only achieve abnormal returns by taking on excess risk we don't think of rational calculations, but of danger of some kind. Usually we're not quite certain about what sort of danger this is. Economists are certain, but are wrong.

Rationalism – the idea that people are effectively emotionless calculators of risk – has a very long history, back at least to Plato and the ancient Greek stoics and can be traced forward through the likes of Descartes and Kant right into twentieth century psychology and economics. Oddly, it seems that the proponents of the rationalist viewpoint were themselves driven by emotion – distaste at the idea that emotions could rule human behaviour. The whole rationalist agenda can…

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