“Stories are what stick with us. Statistics do not.” – Michael Mauboussin
Going into our EBI West Conference I wrote about how excited I was to hear Michael Mauboussin speak. He didn’t disappoint.
Mauboussin walked the crowd through a series of stories, examples and behavioral studies to understand how to make better decisions or avoid making poor ones. One of the most interesting concepts he covered is the idea of cause and effect.
Cause and effect can be easily misconstrued in the investment arena because there are very few formulas or if-then frameworks that work 100% of the time. Since there’s so much randomness and noise in the markets it’s easy to be fooled by outcomes. There are no counterfactuals so assuming that what really happened is the only thing that could have happened can get you into trouble.
Mauboussin referenced the work of Michael Gazzaniga, a psychology professor who wrote the book Tales From Both Sides of the Brain: A Life in Neuroscience. Gazzaniga’s research looked at patients who needed to have surgery that would effectively sever the communication between the right and left hemispheres of the brain.
Once these two sides of the brain were on their own the researchers gained some fascinating insights into the human mind. One side of the brain essentially would take any effect or outcome and immediately assign a cause to explain it. This side of the brain can’t really pick up on randomness, probability or luck. It simply comes up with a cause for every effect, even when it likely makes no sense.
The following from Mauboussin’s book, More Than You Know, sheds some light on this phenomenon:
To test the interaction between hemispheres, Gazzaniga and LeDoux crafted a clever experiment. First, through visual cues they secretly instructed the right hemisphere to perform an action. The left side could observe the action but had no idea why it was going on. Next, the scientists asked the split-brain patient to explain why he was acting. Remarkably, the left hemisphere made up explanations for the actions. For example, if the scientists instructed the right hemisphere to laugh, the patient’s left hemisphere would report that the scientists were funny guys. In LeDoux’s words, “the patient was attributing explanations to situations as if he had introspective insight into the cause of the behavior when in fact he did not.”
Even when the correct answer is, “I have no idea,” this “interpreter” side of the brain has no qualms about coming up with a story to give you a satisfactory answer. Most of the time it could be right but your brain has a hard time distinguishing between luck and skill in this endeavor.
Investing falls more on the luck side of the skill-luck continuum which makes it really difficult for people to separate good decisions from randomness. This makes it difficult to measure the effectiveness of our own decisions or judge the decision-making process of others.
Situational awareness is required to help better understand the difference between certain scenarios. Mauboussin gave the example of legendary sprint champion Usain Bolt. If any of us raced Bolt in the 100 or 200 meters we would expect him to destroy us every single time. Therefore there should be no reversion to the mean in this situation. You would expect skill to win out time after time.
Investing is mostly on the other end of the spectrum. You can’t expect performance to be persistent over time. No investment or strategy or portfolio manager can win always and forever. Eventually, you can expect above average performance to be followed by below average performance. Since there are so many skilled investors out there, you have to expect the role of luck to play a large role in investment outcomes.
When cause and effect have a clear relationship, you should have more confidence in your forecasting ability. When there is only a casual relationship between cause and effect, you should allow for more outlier events and luck to have a role in predicting outcomes.
When dealing with the complexities of the financial markets, you have to focus most of your time on the process being used to make decisions as opposed to the outcomes. Outcomes obviously matter but even the best decision-making framework will eventually lead to poor results on occasion. Intelligent investors understand that a good process has very little to do with short-run outcomes but quality decisions give you a high probability of success over the long-run.
How Market Crashes Happen
Now here’s what I’ve been reading lately:
- Dan Egan’s behavioral science reading list (Dan Egan)
- The practice of realistic optimism (Abnormal Returns)
- Investors are always compensated for their behavior (A Teachable Moment)
- How technology can improve organizational alpha (The Thought Factory)
- The reasonable formation of unreasonable things (Collaborative Fund)
- This is an investor’s nightmare scenario (Irrelevant Investor)
- Nir Kaissar and Barry Ritholtz debate stock market valuations (Bloomberg)
- A long chat with Peter Bernstein (Jason Zweig)