There’s No Substitute for Good Judgment

Source: The Economist

“P.T. Barnum was right.”

So says Commander Lyle Tiberius Rourke in the Disney film Atlantis: The Lost Empire, referring to the famous expression attributed to the great American showman: “There’s a sucker born every minute.” Even though Barnum didn’t say it, we get it. In talking about the scientific method in his famous 1974 Cal Tech commencement address, Nobel laureate Richard Feynman emphasized the point: “The first principle is that you must not fool yourself – and you are the easiest person to fool.”

Accordingly, we’re right to be skeptical about our decision-making abilities in general because our beliefs, judgments and choices are so frequently wrong. That is to say that they are mathematically in error, logically flawed, inconsistent with objective reality, or some combination thereof, largely on account of our behavioral and cognitive biases. Our intuition is simply not to be trusted.

Part of the problem is (as it so often is) explained by Nobel laureate Daniel Kahneman: “A remarkable aspect of your mental life is that you are rarely stumped. … you often have [supposed] answers to questions that you do not completely understand, relying on evidence that you can neither explain nor defend.” We thus jump to conclusions quickly – far too quickly – and without a proper basis.

We aren’t stupid, of course (or at least entirely stupid). Yet even the smartest, most sophisticated and most perceptive among us make such mistakes and make them repeatedly and predictably. That predictability, together with our innate intelligence, offers at least some hope that we can do something meaningful to counteract the problems.

One appropriate response to our difficulties in this area is to create a carefully designed and data-driven investment process with fewer imbedded decisions. When decision-making is risky business, it makes sense to limit the number of decisions that need to be made. For example, it makes sense to use a variety of screens for sorting prospective investments and to make sure that such investments meet certain criteria before we put our money to work. An Investment Policy Statement outlining limits to investment and thereby limiting the number of decisions to be made and even further limiting the number of decisions to be made quickly is imperative.

It’s even tempting to try to create a fully “automated” system. However, the idea that we can (or should) weed-out human judgment entirely is silly. Choices about how to create one’s investment process must be made and somebody (or, better yet, a group of somebodies*) will have to make them. Moreover, a process built to be devoid of human judgment runs grave risks of its own.

Take the case of Adrionna Harris, a sixth grader in Virginia Beach, Virginia, for example.

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We Are Less Than Rational

Investment Belief #3: We aren’t nearly as rational as we assume

Traditional economic theory insists that we humans are rational actors making rational decisions amidst uncertainty in order to maximize our marginal utility. Sometimes we even try to believe it.  But we aren’t nearly as rational as we tend to assume. We frequently delude ourselves and are readily manipulated – a fact that the advertising industry is eager to exploit.¹

Watch Mad Men‘s Don Draper (Jon Hamm) use the emotional power of words to sell a couple of Kodak executives on himself and his firm while turning what they perceive to be a technological achievement (the “wheel”) into something much richer and more compelling – the “carousel.”

Those Kodak guys will hire Draper, of course, but their decision-making will hardly be rational. Homo economicus is thus a myth. But, of course, we already knew that. Even young and inexperienced investors can recognize that after just a brief exposure to the real world markets. The “rational man” is as non-existent as the Loch Ness Monster, Bigfoot and (perhaps) moderate Republicans.  Yet the idea that we’re essentially rational creatures is a very seductive myth, especially as and when we relate the concept to ourselves (few lose money preying on another’s ego). We love to think that we’re rational actors carefully examining and weighing the available evidence in order to reach the best possible conclusions.

Oh that it were so. If we aren’t really careful, we will remain deluded that we see things as they really are. The truth is that we see things the way we really are. I frequently note that investing successfully is very difficult. And so it is. But the reasons why that is so go well beyond the technical aspects of investing. Sometimes it is retaining honesty, lucidity and simplicity – seeing what is really there – that is what’s so hard.

Worth Reading

As regulars are well aware, I don’t provide linkfests, largely because others do it so well (such as Tadas Viskanta at Abnormal Returns, Joe Calhoun at Real Clear Markets, Barry Ritholtz at The Big Picture and Josh Brown at The Reformed Broker). But once in a while I highlight a piece that I haven’t seen elsewhere — though I could have missed it — that I think is particularly good. 

This interview from a week ago with the always terrific Michael Mauboussin at Compounding My Interests is outstanding. I encourage you to read it all, check out the links embedded therein, and then read it again. Here’s a snippet.

So as I think about the synergies between the worldviews, a few thoughts come to mind. First, it’s essential to provide your mind with good raw material. That means exposing yourself to a lot of disciplines and learning the key tenets. It also means spending time with people who think differently than you do. 

Second, you have to be willing and able to make connections. What are the similarities between disease and idea propagation? What can an ant colony teach me about innovation? What do physical phenomena, such as earthquakes, tell us about social phenomena, such as stock market crashes? You need good raw material to make connections, but you also have to be careful to avoid superficial links.

Finally is the idea of thinking backwards. Munger is a big advocate for this. You observe that something is where it is: How did it get there? Why did it get there? There are some fascinating challenges in this regard right now. We know, for example, that the sizes of cities and companies follow power laws. Why? By what mechanism does this happen? No one really knows, and the prospect of solving those kinds of challenges is exciting.

Mauboussin on the Santa Fe Institute and Complex Adaptive Systems

Betting on Investment Skill

In 2006, the TradingMarkets/Playboy 2006 Stock Picking Contest was won by Playboy’s Miss May of 1998, Deanna Brooks (shown right). Her portfolio, which bet heavily on oil and gold stocks, gained 46.43 percent on the year and every stock in it provided double-digit returns. She liked Yamana Gold because “What girl doesn’t like a little bling? I’m hot for gold this year.…” It wasn’t her only nugget of sterling analysis. She also liked Petrobras because “oil is making money” and IBM because computers “aren’t going away.” She wasn’t the only Playmate to find a rich vein of success. A higher percentage of participating Playmates bested the S&P 500’s 2006 returns than active money managers. Think about that for a moment. Over the course of a full year, a bunch of Playmates outperformed a whopping majority of highly trained and experienced professionals with vast resources who spend all day every day trying to beat the market.

It’s easy to say that the Playmates got lucky, and they did. But we’d never expect a guy swimming laps at the YMCA to beat Michael Phelps across the pool, a girl off the street to beat a Grandmaster in chess, or an unschooled janitor to solve an insanely complex math problem amidst a spot of cleaning in the afternoon that the best and the brightest need years to figure out. Not even once.

If something like that actually were to happen, we’d treat is as a marvel (as the movie, Good Will Hunting, excerpted above, does), not just as a whimsical curiosity to be used for the purposes of garnering a bit of publicity and ogling attractive women.

It’s tempting simply to say that the contest is too small a sample size to be meaningful and move on. Had she stuck with investing, Miss May’s performance would miss and miss by a lot, probably sooner rather than later, as all investment performance tends to be mean reverting. But we also know that sample size doesn’t mean much when little luck is involved. It doesn’t matter how many times I race Michael Phelps. The chances of my winning will always be vanishingly small — effectively zero.

It’s also important to emphasize (as Michael Mauboussin did in his excellent book, The Success Equation and at The Big Picture Conference recently) the paradox of skill when it comes to investing. As overall skill improves, aggregate performance improves and luck becomes more important to individual outcomes. On account of the growth and development of the investment industry, John Bogle could quite consistently write his senior thesis at Princeton on the successes of active fund management and then go on some years later to found Vanguard and become the primary developer and intellectual forefather of indexing. In other words, the ever-increasing aggregate skill (supplemented by massive computing power) of the investment world has come largely to cancel itself out.

These explanations are good as far as they go, but they hardly tell the entire story. Lady Luck is crucial to investment outcomes. There is no getting around it. Managing one’s portfolio so as to benefit the most from good luck and (even more importantly) to get hurt the least by bad luck are the keys to investment management. Doing so well is a remarkable skill, but not the sort of skill that’s commonly assumed, even (especially!) by professionals. 

More to the point, if investment returns depend that heavily on luck and real investment skill is that elusive and rare, what should we do with our (or our clients’) money? For some answers, we turn to the world of…poker? That’s right — poker. 

Worth Reading

As regular readers are well aware, I don’t frequently offer links to articles, largely because there are others who do it so well (such as Joe Calhoun for Real Clear Markets, Tadas Viskanta for Abnormal Returns, Barry Ritholtz and Josh Brown, among others). But there are four pieces that I want to highlight today, particularly in light of my recent work on the so-called “Yale Model” of investing (see here, here and here).

• Beating the Market Has Become Nearly Impossible
• You’ll never be a Yale superman
• Is Yale a Model?
• Time to Ditch the Yale Endowment Model

I also want to commend Michael Mauboussin’s fine offering on outcome bias which, coincidently, came out the same day I wrote about it (much less comprehensively). It should be read along with his excellent book, The Success Equation, which I also heartily recommend.

• Outcome Bias and the Interpreter

Happy reading.

The Tragedy of Errors

Larry Walters had always wanted to fly.  When he was old enough, he joined the Air Force, but his poor eyesight wouldn’t allow him to become a pilot. After he was discharged from the military, he would often sit in his backyard watching jets fly overhead, dreaming about flying and scheming about how to get into the sky. On July 2, 1982, the San Pedro, California trucker finally set out to accomplish his dream. But things didn’t turn out exactly as he planned.

Larry conceived his project while sitting outside in his “extremely comfortable” Sears lawn chair. He purchased weather balloons from an Army-Navy surplus store, tied them to his tethered Sears chair and filled the four-foot diameter balloons with helium. Then, after packing sandwiches, Miller Lite, a CB radio, a camera and a pellet gun, he strapped himself into his lawn chair (see above). His plan, such as it was, called for his floating lazily above the rooftops at about 30 feet for a while and then using the pellet gun to explode the balloons one-by-one so he could float to the ground.

But when his friends cut the cords that tethered the lawn chair to his Jeep, Walters and his lawn chair didn’t rise lazily. Larry shot up to a height of over 15,000 feet, yanked by the lift of 45 helium balloons holding 33 cubic feet of helium each.  He did not dare shoot any balloons, fearing that he might unbalance the load and cause a fall.  So he slowly drifted along, cold and frightened, with his beer and sandwiches, for more than 14 hours. He eventually crossed the primary approach corridor of LAX.  A flustered TWA pilot spotted Larry and radioed the tower that he was passing a guy in a lawn chair at 16,000 feet.

Eventually Larry conjured up the nerve to shoot several balloons before accidentally dropping his pellet gun overboard. The shooting did the trick and Larry descended toward Long Beach, until the dangling tethers got caught in a power line, causing an electrical blackout in the neighborhood below. Fortunately, Walters was able to climb to the ground safely from there.

The Long Beach Police Department and federal authorities were waiting. Regional safety inspector Neal Savoy said, “We know he broke some part of the Federal Aviation Act, and as soon as we decide which part it is, some type of charge will be filed. If he had a pilot’s license, we’d suspend that. But he doesn’t.” As he was led away in handcuffs, a reporter asked Larry why he had undertaken his mission. The answer was simple and poignant. “A man can’t just sit around.”

Luck Be a Lady Tonight

The self-serving bias is our tendency to see the good stuff that happens as our doing (“we had a great week of practice, worked really hard and executed on Sunday”) while the bad stuff is rarely our fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).  Thus desirable results are typically due to our skill and hard work — not luck — while lousy results are outside of our control and frequently the offspring of being unlucky.

Two fine recent books undermine this outlook by (rightly) attributing a surprising amount of what happens to us — both good and bad — to luck.

Consider All the Possibilities

I wrote earlier today about our general difficulty in dealing with probabilities in the context of Superstorm Sandy. Here is an interesting exercise broadly to test your abilities in this area and more particularly concerning information processing (from Michael Mauboussin‘s excellent new book, The Success Equation).  

Jack is looking at Anne but Anne is looking at George.  Jack is married but George is not.  Is a married person looking at an unmarried person?

• (a) Yes.
• (b) No.
• (c) Cannot be determined.

To see the answer and an explanation for it, right-click over the text between the asterisk marks below (I tried to match that text color with the background as closely as I could; the text will “show up” when you do that).

* The answer is (a) but more than 80 percent of people choose (c).  You can reach the correct answer only by considering all the possibilities. If Anne is unmarried, Jack is looking at her and if she is married, she is looking at George.   This is a very helpful exercise for investing and for life in general. Consider all the possibilities. *