How Not to be Your Own Worst Enemy
No matter how you spin it, economics and finance are inherently governed by human patterns of behavior. Finance, the markets and the economy are all made up of transactions between people, and almost every single piece of the whole is governed by emotions. If economics are not behavioral, I don’t know what the hell is. If you agree with biases being existent in your own decision-making, your natural reaction should be to find tools to protect yourself.
The really old school stream of efficient-market economists rejects the notion of exploitable psychological biases in markets, partly because irrational markets don’t lend themselves to the application of mathematical models. Modern behavioral finance, led by Kahneman, Tversky, and Thaler, has accepted and studied biases in economic decision-making more closely. There are many other useful sources, but the one speech that fills the most holes in my mental latticework is Charlie Munger’s famous speech “The Psychology of Human Misjudgement”,
The subject of this article is detailing tricks you can employ to protect yourself from mental biases. If you are yet unfamiliar with biases or are in need of a comprehensive overview of biases, I strongly recommend at least listening to Charlie’s speech and reading his commentary on the speech, available in “Poor Charlie’s Almanack”.
Biases Matter in Investing More Than Any Other Profession
There are several factors that contribute to investment professionals having a propensity to falling victim to mental shortcuts. For simplicity, we differentiate between the reptilian and the rational brain, a differentiation that can be backed up by research about the physical attributes of the brain.
Responses by our reptilian brain are instinct and reaction based, as opposed to rational, well-considered thought. The reptilian brain responses, mental shortcuts, biases, heuristics, or whatever you want to call them, developed as a natural part of evolution because they apparently had value to our ancestors. While it was useful for a caveman to stoop when everybody around was stooping (to avoid getting eaten by some flying monster), it is not necessarily useful for an investor to always simply “go with the herd”. Few jobs today require instinct based behavior, and while most jobs require rational thinking, investment professionals are especially prone to do exactly the opposite — resort to reptilian brain responses. Here are the main factors for why investment professionals are more prone to behavioral biases than other professions, and why the problem is getting worse as information flow progresses.
- The degree to which randomness dictates the outcome is great. While it would be fairly easy to evaluate how a dentist will perform in future operations based on past performance (or most professionals that work with their hands), it is hard to assess the true ability of an investor just from past performance, and hard to forecast performance. It could be the result of an inability/unwillingness to accept the degree of randomness involved in the outcomes that makes investors prone to mental shortcuts.
- The problem is ill structured, complex, information incomplete and ambiguous. This set up makes it likelier for people to use their reptilian brain, instead of rational thinking (see “The Little Book of Behavioral Investing” Preface).
- The feedback is not linear. As I said, there is a great deal of randomness when it comes to investment performance. While you will be likely to attribute good performance to skill, and bad performance to circumstances, the truth is that the risk and real probabilities are not apparent before nor after the fact. Suppose I bought puts because I believed there was a 90% of an upcoming earnings reports of company XYZ falling short of expectations. Even if the report is a positive surprise and I lose money, I can’t assess whether the bet was good or bad — I can’t see the odds of reality before or after the fact. Reality happens only once and you can’t rerun history. Also, investment situations always differ in circumstances, which makes analysis based on historic data somewhat more difficult.
- The drivers of outcomes are barely verifiable. Similar to the previous problem, you don’t know beforehand nor after the fact what factors are actually driving the situation. You might have figured that your investment thesis did not work out because the CEO failed to perform, while in reality other factors that you did not even consider wound up driving the value of your investment.
- Investment management is a pure thought job, but most of us work in environments where there is a pressure to perform a certain workload, with certain results, in a certain amount of time. Under growing time and performance pressure, it is easy to resort to mental shortcuts. This may even be a necessary reaction from the brain.
- Not only has the reaction window shrunk significantly over the last few years, information flow grew tremendously with the emergence of the internet at the same time. The challenge for an investor has shifted somewhat over the last 30 years from actually acquiring information to filtering the useful from the noise. The increased information flow makes for more noise (useless/meaningless information), sometimes overstraining the mental capacities of the individual and making it more compelling to resort to mental short cuts. At the same time, the greater available information makes it easier to fool yourself into believing that you have a greater degree of visibility than you actually have. Even though you have thousands of pieces of information at your fingertips, some of the most important ones may wind up not even being considered due to the sheer volume of information available.
- Maybe it is rational, or even necessary, to behave irrationally at times. Sometimes the environment pressures you to do something irrational. Could you argue that a portfolio manager should sell a position that he likes (assume for example a 5% gain foregone) because his biggest LP is terribly worried about the position and it is straining their relationship? In markets, you are dependent on the views of other market participants to realize the value of your investment. If you buy a stock that is worth $1.00 for $0.50, you have to find someone to give you $1.00 before you can realize a gain. If you accept that market participants are biased, you also have to accept that what they will pay you for your shares will be biased. Additionally, there is a feedback loop between objective reality and the way participants view reality (see George Soros Reflexivity). For example, market participants that bid up a stock price allow the company in question to realize real value from the rise in share price through acquisition of other companies by means of shares. Often times, it seems like market participants are confusing the price for a signal. These additions make the investment business inherently more complex, because the rational thing in the long run might be doing something that seems irrational in the short run (there are interesting links to evolution theory which I can’t comment on further at this point).
If you are an investor, you have to accept that your genetic makeup makes you unfit for your very profession, and you have to find ways to make yourself behave in rational ways. Just promising to be good is not good enough. The road to hell is paved with good intentions.
Here are some of my favorite tools that can help you guard against mental biases, shortcuts, and the like.
Checklists are an easy way to force yourself into structured thinking and you will find them throughout this list. You should treat every important checklist as an extension of your mind, and it should be continuously evolving. Checklists have to be simple enough to be useful, while capturing all important elements in an appropriate way. Adding to your list is not always the best way to improve. For example, resorting and shortening the list could make you more effective. You should have a checklist for all important activities that you perform on a consistent basis. Even the most experienced pilots and surgeons still go through their checklists every time they perform an important procedure. An investor would at least have a checklist for mental biases, an investment checklist, a list of mental models, a checklist for networking meetings, and checklists for various other business processes.
Checklists protect you from several mental biases, especially errors of omission, because they force you to go through items systematically without being allowed to skip one. Lists should help you to counter doubt-avoidance tendency, inconsistency avoidance tendency, but most notably availability-misweighing tendency among other biases. Even though it feels uncomfortable, after going through your checklist you will often find that important information pieces are simply not available to reach a truly informed decision and you will have to find a way to get comfortable with a greater degree of uncertainty than you originally hoped for when predicting outcomes.
The reptilian brain is often associated with thinking quickly, whereas the rational thought process is deliberately slow (see Kahneman Thinking Fast and Slow). Kahneman makes the interesting insight that humans use a combination of both systems to reach decisions, but are utterly ignorant about the great degree to which they actually use the reptilian brain, wrongly considering themselves more rational than they actually are.
The irrational brain is instinct driven, reactionary, and is resorted to when quick decision-making is required. Often times, a short-cut of some sorts is required, as perfectionists would never reach a decision because an optimal solution can often not be determined. We have to accept that we make imperfect decisions based on incomplete information (see Herbert Simon “Satisficing”), and accept the trade off between reaching a decision and making a decision on the ground of incomplete information.
So for once, accept that you are using your “irrational” decision making apparatus as a necessity. Be aware why and how you are applying mental short-cuts. Recognizing your own propensity to being biased is a recurring theme in this list. Second, slow down the thought process deliberately. Defer decisions, sleep over every big decision at least one night. Take your time to go through your mental routines, and don’t let yourself be easily pressured into early decisions.
An additional helpful tool can be that you schedule time to deliberately think slowly about a problem at a time. Scheduling time to focus on one particular problem, and knowing that the time is dedicated to this problem only, will help take stress of your brain and think more clearly. You don’t want to have something in the back of your mind that distracts you from focusing. “Getting Things Done” by David Allen is a wonderful book that can help you think more clearly by structuring your work and dedicating efforts to a problem at a time.
Use a Checklist of Biases
An absolutely essential tool for guarding against biases is reflection. You want to keep an evolving list of heuristics and go through the list item by item to try to understand how a particular bias influences your perspective and decision-making. Accept that you are almost always taking mental shortcuts. Try to answer: What mental shortcuts are you taking, why are you taking them, and what can be done about them? This checklist can be used in retrospect to evaluate on past decisions, but my favorite time to go through the list is just after the point where I think I have reached a decision. At this point, I will step back, go through my checklist, and reevaluate in lights of my biases.
If you are just starting to compile a list of biases, it is probably a good idea to initially adopt material that is already out there. Charlie Munger’s list of standard causes for human misjudgment is a great starting point. Several bloggers, like Shane Parrish, have also accumulated impressive lists of biases and mental models you can use.
Recognizing that you are biased is by no means the only step. You want to adjust your behavior according to your new insights. Often times, after recognizing that have fallen victim to a bias, you want to go back and collect additional information, adopt a new perspective, or maybe seek additional disconfirming evidence. Sometimes, you can identify the source of a bias and remove it. For example, you could cut yourself off financial media if the noise from experts is distracting you. The point is: let action (or inaction) flow from your newly gained understanding.
Keep a Diary
A decision diary (or for an investor, an investment diary) is another useful tool that makes reflection more objective, helps you guard against hindsight bias, and helps you improve by analyzing past thought processes.
Humans are bad at understanding and predicting their past and future points of view, and unless you are Mr. Spock, you are too. When evaluating past decisions, you want to evaluate them in light of the available information at the time. In your diary, write down as simply as you can why you reached a certain decision, what information you considered and how you weighed the information pieces.
Describe the thought process in your decision diary, and always make your diary entry as soon as possible. Don’t wait weeks after a decision to make your diary entry. It might be useful to not only write down the decision that you made and why you made them, but also the decisions you did not make and why you shied away or deferred. Another useful feature of your decision diary could be that you write down different scenarios that you could imagine developing from that point. Visualize them, and attach probabilities. Make a pre mortem before the decision; think of a range of good and bad states a couple of years down the road and write down what your explanation for the outcome would be. Through addition of these features, a periodic review of your decision diary will be more educational, but also more painful.
You will overcome the “I knew it” default reaction when you see a stock going up that you looked at before, and probably spend fewer sleepless hours over missed opportunities. Sometimes, you might fail to make sense of your own notes, and sometimes you will be embarrassed by the stupidity of the thought process laid out by your past self. These might be necessary concomitants of honest self-reflection (see George Soros’ investment diary in Alchemy of Finance).
“What could I have done differently?” is a question that always comes up when reviewing a bad investment. Seldom, people ask this question when an investment or decision worked out, and almost never do they ask how much of the positive outcome is actually attributable to luck.
Diaries are a good way to not only analyze where you have made mistakes in the past, and why other things worked out, but also to understand when a bad outcome was actually achieved with a sound process (bad luck), and when a good outcome was driven by factors you did not even consider (luck).
Use a Range of Mental Models
The key here is looking at the issue from many different perspectives. Don’t do this sporadically, but make a list of mental models. Apply this list to difficult problems and important decisions, treat it as an exercise and evolve it into a habit. It will require you to frame problems in different ways, reframe questions, and simplify.
Building and maintaining a list of mental models is a life-long exercise, and a whole topic in itself. Once again, I resort to other resources. First of all, Charlie Munger presents a comprehensive list of mental models. The list of mental models might be to some degree overlapping with perspectives of the bias checklist.
An investor’s mental model list should certainly include:
- Logic, number, and probability based thinking like that of a mathematician, physicist, engineer, accountant, Nassim Taleb (whatever he is)
- Social problem solving tools e.g. the perspective of a psychologist
- Natural sciences, particularly biology
- Business perspective
Subsets of these mental models are incredibly powerful problem solving tools. For example, inversion, or adopting the perspective of smart people holding the opposing view. This is sometimes called “playing devil’s advocate”. You really want to think about what you are missing, and seek to disconfirm yourself. You should welcome opposing arguments or views on an investment, specifically from those you know to be the most well informed or educated on an investment. You are certainly not as well trained as a professional psychologist, or mathematician, but you want to foster the little mathematician, physicist, or philosopher in you and soon you will find that the big ideas are mostly covered in rather elementary material. As an added bonus, you will simply learn more about more topics over time.
I like to imagine myself in different roles, similar to what an actor would do. I like to try to think like people from different professions and backgrounds. For example, I’ll imagine myself to be a psychologist, mostly ignorant of mathematical problem solving tools on one day. The next day, I pretend to be a mathematician and accountant working together to solve the problem. Another day, I may prepare a presentation to short the stock I want to buy. To make it more fun, I sometimes act as if I was, or could ask, a person of history or great fame.
Religious Christians might ask “What Would Jesus Do?” for moral guidance. Maybe, as an investor, you should ask yourself more often what Charlie Munger, Warren Buffett, or Benjamin Franklin would do, or how they would view a situation. The book “Think and Grow Rich” introduces the idea of an invisible council – a group of people you would love to consult on a problem. Visualize this group of people sitting in a circle with you and imagine them answering your questions. Of course, the characters you imagine will be as you make them up to be. You may find yourself truly shocked when a member of your invisible council gives an answer that seems to truly surprise you.
Benjamin Franklin is quoted saying “An ounce of prevention is worth a pound of cure.” Precommitment is related to this idea, despite the fact that the word precommitment makes no sense to me. Because you accepted that you cannot rely on your decision making apparatus in the heat of the moment, you make the decision at an earlier point when you can think more rationally. The great Sir John Templeton believed heavily in commitment, and kept a list of stocks with price thresholds under which he would buy the stock no matter what.
One of the first important commitments you want to make is a commitment to rational thinking, or at least, the aspiration of it. Commit to going through your checklists, and other tools and tricks that should help you think more rationally, instead of reaching the easily available conclusion. Maybe more importantly, commit to not doing other things, like trading on an idea the same week that you hear about it.
Your commitments should be written down, and items should be only adjusted if practically not achievable, or when the evidence has clearly changed. Overcome the impulse to start off with an extensive list of commitments, as every commitment limits your flexibility. Also, once you break the first commitment, it becomes easier for you to break subsequent ones, so use them sparsely.
Limit Options and Noise
Limiting options and noise is a tool that helps you not do some things, which is hugely important (see Franklin’s quote above). Studies have found that people that superficially exercise more discipline, partly seem to do so because they never consider some of the bad behaviors as available options, which puts less stress on their brain to force it to behave well. Limiting options works on psychological levels, as well as on physical levels. You could for example say that you will never renegotiate a price once you made a firm offer. This will not only make it easier for you, because you know you will never have to go through tough negotiations, it will also make it more likely for your counterparts to accept the offer, because they run the risk of breaking the deal if they try to lower the price. Limiting options can be in many regards a helpful tool as students of game theory will understand.
On a different level, you can simply seclude yourself from the noise of the financial media and the talking heads. You can, to a huge degree, influence your environment, where you live, what kind of people you interact with. I admire people like Guy Spier who show the integrity to move to a more secluded location to limit options and noise. You don’t have to go so far yet. Start by switching off the TV. Next, stop checking your stock prices on a daily basis (you can still follow the news).
This is not really a tool, but a mindset. However, I believe it is worthwhile briefly highlighting separately because it might be one of the most important pieces of the puzzle.
Be processed focused. You cannot control outcomes, and there are imponderables. What you can control is what you do. Wisely distinguish between what you can influence and what you cannot. Distinguish between something that you had missed, and something that was not realistically considerable at the point in time when you made the decision. The more randomness is involved in the outcome, the less linear the feedback will be, and consequentially the more you will have to focus on the process instead of taking short term results at face value. This presents a difficult problem, because optimization of the process requires some feedback, which in this case is not reliable. The optimization of processes with unreliable feedback is an extensive and different discussion.
In the end, confidence should not necessarily come from a belief in the certainty of outcomes, not even from previously good results. Real confidence should stem from a belief in the quality of the process, and a belief that the process will continue to improve. Don’t think of yourself as someone who is a “winner”, or is “right”. Rather make it part of your self-identification that you are a person who will do everything possible to achieve good outcomes, and who refuses to be fooled by randomness.
The road to hell is paved with good intentions. Accept that you are subject to biases like everybody else. Use tricks and tools to make yourself behave more rationally, instead of relying on your superior discipline.
Use the tools frequently, and train yourself to the point where resorting to them becomes the default reaction when facing difficult problems. Build your list of mental models and behavioral biases, and learn from your decision diary. As with everything, your tools will only be as good as you apply them. Accept the struggle with your own biases as a life-long battle.