Most people would agree with the following statement by celebrated behavioural psychologist Daniel Kahneman – from his best selling book describing new insights into how good and bad decisions are made:
“Why do investors, both amateur and professional, stubbornly believe that they can do better than the market, contrary to an economic theory that most of them accept, and contrary to what they could learn from a dispassionate evaluation of their personal experience?”
The book is well worth a read, since the author convincingly explains why the human mind manages to be corrupted by emotions, outside influences and even experience resulting in very bad decisions. I have an example that happened to me on the weekend.
I was driving to a destination, and suddenly realized my pre-programmed (experience) nervous system was guiding the car to my office…..NOT to where I actually intended to go. My brain’s autopilot was making bad decisions for me. I’m sure it’s happened to you too quite often.
The brain’s powerful ability to process and store complex routines and have them upload and launch into action almost subconsciously when needed is both a gift and a curse. It is a curse when we allow junk we have stored in memory to influence decisions we make, and by golly we sure do it all the time.
Now read the quote again. You don’t need to be a scientist to detect an air of disdain for investment professionals. I love it when an opinion is offered without any empirical justification, even by someone who believes opinions should ONLY be presented after careful analysis and statistical testing.
In contrast to his bias concerning the financial industry, in the book he explains how remarkable it is that clinical professionals are able to absorb complex routines and then apply this experience in order to quickly assess a patient’s symptoms and almost without thinking begin a remedial process (like driving to my office without even thinking about it). Of course, there are no statistics confirming the number of good decisions versus bad ones made by clinical staff. Why bother researching it; they’re saving lives aren’t they?
The clinical professional is considered cool under pressure and wise; while the investment professional is a self-delusional dufus. Why would a student of psychological behaviour make this distinction? I have some ideas. For instance, it easier to ‘comprehend’ that the body has a finite limit of possible ailments and potential remedies, and who better than an experienced expert to react quickly and wisely based on experience rather than waste precious time on tests to conduct a careful diagnosis? Our minds have a pretty solid model of the body (everybody has one after all), but even so no psychologist or layman would presume to be as informed about how it works as a trained and experienced medical doctor right? This respect for the medical profession in general is conditioned – of necessity (for your own good, listen to the doctor) and by design. I know of doctors who readily admit that decision-making in life-threatening and stressful situations is far from scientific and have acknowledged in private conversation that BAD decisions are plentiful but swept under the rug ASAP to avoid scrutiny. Poor decisions are simply “not talked about.”
A good friend of mine was in great pain immediately following surgery that was necessary to lower the risk of a future heart attack….the hospital staff were befuddled because there should have been no post-operative pain at all with all the painkillers they’d administered. It didn’t even occur to them to test for a heart attack. Although trained to spot a heart attack victim, they assumed that the pain was either imaginary or caused by the operation somehow. It turned out when tests were finally conducted, that he did indeed suffer a massive coronary during the surgery. Bad judgement (laziness?) prevented them from immediately doing tests they would normally do routinely. Without supporting reliable data (with really big sampling) of course, it is foolhardy to purport that clinical decisions based on instinct or experience would be any more effective than a random walk right?
On the flip side, laymen are quite content to believe they fully understand financial markets. Despite the fact that the global system of finance must be infinitely more of a conundrum than the human body (try to get the “Market” into an examination room in order to observe and study it), the average guy (yes, even the behavioural psychologist) with an introductory course in finance and some statistical training under his belt considers himself an expert.
The ‘theory’ that the author quotes (the Capital Asset Pricing Model) has never been proven. Yes, it is convenient to have a big-picture theory based (loosely) on micro-economic theory – but no investment professional in his right mind would claim to believe in it as strongly as the author proposes. It’s like claiming you understand a forest from afar…..all you see are big trees and that’s the end of it. What about mice, deer, tree varieties, bush and plant species, bear, wolves, deer, elk, insects, water, climate and so on? It’s the multitude of little things combined that make a forest, and distinguish it from an African jungle, the Everglades or the Amazon.
Similarly, there really is no “Market” in the sense that a layman imagines it. It is the vast array of component parts that together dynamically (not statically) comprise this thing that we see from afar, and choose for ease of discussion to label the Market.
For the record, the notion that stock prices embody all known information is an assumption required to develop the CAPM model, and is NOT actually a theory at all. And the idea that stocks follow a ‘random walk’ has also been discredited by academics and practitioners so often it’s embarassing to bring it up in a conversation among true investment professionals.
Anyone who believes the mission of an investment professional is really to outperform the “MARKET” is just wrong. The botanist endeavors to understand plant life in bits and pieces, hoping to preserve and hopefully improve the prospects of healthy plant life in their community or in general. The investment practitioner hopes to accomplish no more than to apply a tiny bit of theory that is demonstrably effective based on observation and experience – in a hugely volatile and unpredictable global environment – to preserve and hopefully grow wealth for the benefit of clients who have substantially less training and experience.
Here is another quote from the book:
“Given the professional culture of the financial community, it is not surprising that large numbers of individuals in the world believe themselves to be among the chosen few who can do what they believe others cannot.”
What a load of BUNK! Unfortunately, there is a wealth of information (good and bad) published and distributed about the world of finance and investments out there, and one byproduct of this is indeed a propensity for average folk to falsely believe themselves educated about the subject (the author is himself a prime example). What does this have to do with the culture of the financial community? NOTHING.
There are nowadays millions of self-proclaimed health experts – far less qualified than an already long list of dubious holistic ‘doctors,’ chiropractors and nutritionists – because everyone who reads enough so-called literature on the topic of health (even if it’s all wrong, it’s in print and therefore must be true) comes to believe they are sufficiently knowledgeable to derive conclusions and even provide advice. Oops, have I allowed my own biases to creep into my judgement?
Social scientists, yes even those trained in economics like yours truly, often fall into a common trap. An introductory course in statistics doesn’t sufficiently distinguish the difference between theory and statistics. We test a theory using statistics, but the temptation to try and fabricate a theory in an effort to explain a statistical observation is often irresistable. Take the following quote from a recent research report as a ‘for instance.’
In a research bulletin from Barclays Capital entitled “Global Portfolio Manager’s Digest – Market Myths versus Facts” we were blessed with the following wisdom:
Value investing works. Our European equity strategy team found investing in inexpensive stocks that had high profitability and good momentum was historically a successful strategy. The Data Miner highlights names that currently fit their value-quality-momentum strategy.
A common mistake we make is deriving theories and inferences based on empirical (statistics) information. The study quoted makes just this mistake. It is highly likely that cheap stocks that subsequently exhibited rising profits and momentum did outperform. BUT this isn’t a theory….it’s a tautology. The expression: ‘Good performing stocks that had (past tense) momentum performed well,’ is equivalent to saying that ‘kids that grew faster tended to be taller than the others.’ Just nonsense. I don’t want to get too carried away nitpicking, but to a seasoned professional momentum is anathema to value investing. The researchers really confused things by improperly defining value investing as a methodology or style in the first place.
Now having a theory, approach or ability, however briefly it might actually work, that does helps predict the future momentum in the profits for a company or industry, or an acceleration in stock price momentum is worth a fortune. An investment professional can occasionally identify one or more of these rapidly based on a limited amount of information, just as an experienced doctor can quickly diagnose (better than you or I) that someone ‘likely’ just had a heart attack. Neither judgement would be foolproof, but a judgement could be made and often has to be made.
Don’t get me wrong. There is plenty of good stuff in this book, and much useful theory has been developed by behavioural psychologists in academia; theory that drastically improves our understanding of how people make decisions and judgements. The more we understand what contributes to bad decision-making, the easier it should be to prevent some bad decisions before they occur. But we must be practical – smoking will very probably cause cancer, yet people continue to smoke.
Modeling reality is no easy task, but the determination of humans to continue to try has led to quantum leaps forward in terms of intellectual, medical, technological and mechanical progress. That is, provided we believe that what we experience is even real. Maybe Einstein was right when he said “Reality is merely an illusion, albeit a very persistent one.”
It’s so hard to think without bias, that even brilliant behavioural psyhologists find it almost impossible to eliminate their own biases when studying or discussing the subject of….”thinking without biases.” I think this funny – whether there is a reality or not.
Do you believe you understand the investment industry? Watch this video and perhaps you might understand it a bit better.
Another great post Mal. I had to laugh when I read the “research” bulletin from Barclay’s; they should be embarrassed. We do the best we can given our limited capacity to understand the world and the complex global system. To quote Clint Eastwood “a man has got to know his limitations.” Once we understand this we can make better decisions.
I first read this article the day it was posted, and knew right away that I wanted to respond. Three weeks later I’m finally responding. I know my System 2 brain is slow but come on! How slow is too slow?!
It is interesting that the author uses the example of medical professionals to make the point of how unfair it is that investment professionals, who also make quick decisions, are seen by Kahneman (and others) as self-delusional dufuses; whereas doctors facing similar split second decisions are “cool under pressure and wise”. The sad reality is that medical professionals may too need to be reclassified as self-delusional dufuses! James Montier describes doctors as a “terrifying bunch of people” in that when they were 90% sure they were correct, they were actually correct less than 15% of the time. Doctors too (or perhaps especially) are prone to the same overconfidence bias that people in the investment industry are prone to. Efforts are under way to remedy this in the medical field, and the investment industry should (and is) doing the same. A recent trend is for doctors to incorporate procedures and checklists similar to what is used in the aviation industry. This is done in an effort to reduce overconfidence errors, and prevent System 1 from ruling the decision making process in areas that require and deserve more thought. The author’s good friend, whose diagnosis of a heart attack during surgery was missed, would have benefited from these types of processes; ones that challenge and correct our gut level thinking.
An additional challenge found in the investment industry, that is not a characteristic of the health care discipline, is the difference between relative and absolute knowledge. In the investment industry it is not simply a matter of what you know, and in fact more times than not, it is “what do you know that the guy on the other end of your transaction doesn’t know.” For doctors, the heart attack or illness isn’t competing against them. When it sees a really exceptional surgeon come into the room, the cancer cells don’t raise their game in an effort to ensure victory. If the medical team is smart enough to diagnose and treat, they win. This is not true in the investment industry because in most cases, a win for one person is a loss for another. We are not competing against idiots. The other side wants to win as badly as we do, and therein lays the problem.
Worse yet, we are not competing against one individual but rather the collective wisdom of the markets. Although prone to bubbles, the markets are smarter than we give them credit for and quite frankly, smarter than any one of us. In a famous experiment by Jack Treynor, students were asked to guess the number of jelly beans in a jar. Not surprisingly, the average guess was within 3% of the number of beans in the jar (there were 850 beans and the mean guess was 871). What is surprising, and incredibly meaningful to this discussion, is that only one person did better than average. In other words, the market of students was collectively so smart only one person did better. The investment markets, to say the least, are extremely difficult to beat. And even when we do beat them, as we should from time to time, it is hard to say whether it was skill or luck. Eugene Fama says that it takes 35 years of data to distinguish skill from luck. Anything less is noise.
Speaking of noise, another way to look at this is the idea of noise versus signal. As I use it, noise just refers to data that can trip you up in the decision making process and signal is what you really need to pay attention to. While the medical professional does indeed have to deal with a tremendous amount of noise (it is a soft science after all); in the markets, noise is at a whole new level . At best, our industry is 90% noise and 10% signal. Worse yet, the noise is purposely deceitful, often masking itself as signal. Active management industry is a zero sum game. For every manager that outperforms, there exists another manager (or perhaps several managers) that have underperformed. Someone somewhere is trying to take profits from you, and they have a vested interest to try and trip you up with noise masquerading in signal’s clothing. In a game of the greater fool (as active management is), don’t forget the reality that you may just be that fool!
So as I see it, both the medical industry and the investment industry have plenty of room for improvement. The title, “Behavioural psychologists DON’T understand the investment industry” begs the retort: do we even understand our own industry? And to this I would simply say no. This is clear when you consider that so much of our inflated industry now exists to create alpha or outperformance of some fashion or another. Further, it is entirely possible and in fact likely, that an outsider such as Nobel Laureate Daniel Kahneman would see things about us more clearly than we do ourselves. After all, he doesn’t have to defend the industry or worry about people seeing him as a “self-delusional dufus”. There is no greater benefit to our industry than to have Daniel Kahneman show us what we have failed to see for ourselves in well over 30 years of studying the markets.