In a previous article we discussed about the various biases that affect us – Me, Myself and Mind. This time we will isolate the channels through which biases can affect us. The most simplistic would be external and internal. Let’s keep it simple…
External – Echo Chamber
We are constantly assimilating information from around us. TV, newspapers, books, blogs, social media etc… All of this gets mashed in our processing machinery. However we like things that echo our views.
If you think Trump is not a great leader, you will be attracted to negative headlines about him and vice versa. Reading an opposing viewpoint is like wading through thick muck. It gets very difficult to plod through the article. Almost every sentence is excruciating!!!
We like being in an echo chamber where our beliefs are echoed back. The problem with this is that there is no way to self-correct.
You might buy a stock with incredible growth numbers. The company is the darling of analysts. A lesser known report points out a few anomalies in the annual report – What next?
Reading that report takes effort. System 2 is engaged, it is hard work. You also have to fight that gut wrenching feeling as you poke your own beliefs.
The only cure for this is to actively search for competing points of view even dissent. Disconfirming evidence is more sacred than all those self-congratulatory evidence that you find.
Peter Lynch advises us to always find a bear case for every stock you want to invest in. This forces us to look for disconfirming evidence.
Beware of boards that create a comfortable echo chamber for the management.
“When the facts change, I change my mind. What do you do, sir?” – Keynes
External – Feedback
Aha! That has to be the cure for echo chambers. When the feedback is negative we should understand that our beliefs are wrong – Is that really true?
It is not that simple. Every outcome has a combination of luck and skill. We are notoriously poor at separating luck and skill. The stellar results of the company belong to the CEO (skill), while a prolonged period of losses are attributed to an industry downturn (luck) – Sound familiar?
Even with a robust feedback mechanism we are unable to pick up the right signal. The signal is colored by our need to feel good about ourselves.
“Man is not a rational animal; he is a rationalizing animal.” ― Robert A. Heinlein
Post-mortem analysis of decisions are very important to separate skill and luck. Only then can you understand if you are actually making progress. It is very difficult to do this – We love our Bubbles….
Competition is a basic human tendency. Using this drive can help you. Compete with yourself to become a better decision maker. Somebody who can analyze all investment decisions and take a clear-eyed view on what was a lucky stroke (general rising index) and what was driven by true skill of the master.
As if that was not enough, we also cannot think in probabilities. But the world around us is probabilistic
‘Thinking in Bets’ written by Annie Duke is an interesting book that uses Poker as an analogy to help improve decisions. The book highlights ‘Resulting’ – a common phenomenon where the result is used to decide the quality of the decision.
For example if you decide to take an alternate route to a restaurant on Friday evening. The route is usually a good way to avoid traffic. But – today the road is dug up, you have to turn back!
Was that a bad decision? Not necessarily. The probability that the road is undergoing repair is small – say 20%. So 8 times out of 10 you would have reached the restaurant in record time on a crowded Friday evening.
There are many alternate futures at any given point. Doing a pre-mortem and running through these scenarios is a great way to understand the impact of probability in decision making. If an outcome has a large positive outcome ($100,000) with a high probability (70%) and capped loss (-$10,000) with a low probability (30%) – You should pounce on the opportunity. This is what we call an asymmetric payoff
Another great way to improve decisions is to add – skin in the game. Nassim Nicholas Taleb in his book ‘Skin in the Game’ speaks about the ‘Bob Roubin trade’ named after Robert Rubin an investment banker and ex-US treasury secretary. Taleb says that with no skin in the game, ‘Bob’ has made $120 Million from Citigroup which later went insolvent and now the tax-payer pays for all those bad decisions.
It’s like playing Russian roulette with your neighbor’s dog. You make $1000 for every miss. You will keep pulling the trigger and collecting $1000 until the dog dies – no skin in the game! When bankers have no skin in the game it does not matter what the probabilities for a loss or blow-up are.
Adding skin in the game ensures that you engage system 2, think about the probabilities of a losing your shirt. A more careful consideration…!
Internal – Limbic system
Now for the ghost in the machine.
So you did all the right things – Looked for opposing views on the stock, thought of all the probable futures and have significant skin/money on the stock. But – your relative makes fun of your stock choice. In a heated discussion you try to convince him about the ‘second-level’ thinking you have employed.
You go to bed seething in anger. Your limbic brain has released adrenaline (Fight or flight response). You are determined to show him how great you are!
The next day – The unthinkable happens. This was a low probability scenario, the government announces a new regulation that affects your stock. The future possibilities and probabilities on your stock have dramatically changed – What now? Do you sell?
The limbic system is the emotional center of our brain. It governs the release of adrenaline to fight/flee, oxytocin for social acceptance and testosterone for drive. It is the animal portion of our brain it caters to the most basic instincts – Fight, Flee, Social togetherness and Drive.
This hormone release is like a dark ink released in clear waters. They make it murky and difficult to make an unbiased decision. This has to be the biggest obstacle to rational decision making.
Techniques like Mindfulness and meditation try to disconnect the emotion and view it as a passing feeling. But all this is very difficult. More on this later….