| 15 April 2010
In our recurring theme of looking at the irrational side of human beings and ways to combat our poor decisions, we think some examples might be useful. Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management has a new book, Think Twice, which gives us some instructive examples.
Famously, developmental psychologist, Stephen Greenspan, published The Annals of Gullibility, the first comprehensive academic treatment of why people are gullible.
Almost immediately after its publishing in December of 2008, Bernie Madoff’s Ponzi scheme hit the news.
Ironically, Greenspan had a third of his retirement assets invested with Madoff.
Greenspan, who certainly should have known better, suffered from what is called superiority bias. He assumed he wasn’t as susceptible to the flaws he chronicled than the rest of us. We all suffer from this in one way or another. 80% of us believe we are better-than-average drivers.
Let us combine that with the anchoring and recency bias. Mauboussin relates the story of asking some students at Columbia University to write down the last four digits of their phone number. After doing so, he asked them to estimate how many doctors there were in Manhattan. Unsurprisingly he found that those with lower phone numbers estimated fewer doctors than those with higher phone numbers.
We tend to anchor to whatever information we have most recently been exposed to, regardless of its relevancy. We see this in investing when even experts decide the value of a stock or other asset is most appropriately based on what its recent price has been. Stocks are cheaper than they were, so they must be cheap. Never mind that they are basing their sense of value on the most expensive period for stocks in history. There are numerous examples of such biases and irrational beliefs.
How can we change? We actually cannot. What we can do is acknowledge our weakness and take steps to counteract them.
We stress a few ways to help us in our job. One is to read and listen to people who disagree with us. Frankly that doesn’t work that well, since (like most people) we find that everyone seems smarter when they agree with us, but it is a start.
We don’t invest in ways that require us to be right. It should help our portfolios if we are, but it shouldn’t be a necessity.
Once we develop a view, we decide all the ways it can be wrong. Then two things can happen. One, we may see things that we didn’t see before as we try and justify the view we didn’t hold. Second, we can at least make sure that our portfolio can account in some fashion for the risk we are wrong. The goal, build a portfolio that is robust to a number of scenarios, so that if we are over or underestimating the probability of something happening, you can still reach your goals.
Is there a bit more irony here?
There is. One of the things Mauboussin is urging us to avoid is what he calls "taking the inside view." Due to the biases that we humans bring to the table we tend to tell ourselves stories that interfere with objective analysis. We shut out things which disagree with our thesis as investors. Probably one of the most tragic examples of that tendency was the most famous and successful money managers of the last 20 years who worked at his firm, Bill Miller. Not blaming Michael, I doubt he had any influence over what Bill was doing, but the inability to objectively analyze why he had been successful in the past, and why the same tactics would be disastrous, led to three years of crippling underperformance.