How to make better investment decisions

When making investment decisions, our most damaging cognitive bias may be our tendency to ignore the past. Here’s how to avoid it.

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Daniel Kahneman: beware overoptimism

Daniel Kahneman, author of Thinking, Fast And Slow (2011), is one of the best-known names in behavioural finance. Starting in the 1970s, he and Amos Tversky examined decision-making, giving names to a range of cognitive biases that stop us from behaving in the narrowly "rational" way assumed by many economic theories. One such bias is singled out by Michael Mauboussin, director of research at BlueMountain Capital, as one of the most important for investors to overcome. In a recent interview with Real Vision, Mauboussin talks about the importance of avoiding overreliance on the "inside" view.

This is best illustrated with an anecdote from Kahneman. As part of a project to create a decision-making curriculum for secondary schools, Kahneman and some colleagues decided to write a textbook. Kahneman asked the team to estimate how long it would take. On average, the forecast was two years for a finished draft. He then asked a colleague who had worked on similar projects to give him an idea of how long those had taken. The man reflected, then, looking embarrassed, told Kahneman that about 40% of such teams never finished the book at all. Of those that did, the best result was seven years. So their forecast was hopelessly optimistic and in the end, it was eight years before the textbook was finished.

The key error, notes Kahneman, was to rely on the "inside view". In forecasting, the team had simply extrapolated from their own specific circumstances, rather than take the "outside view", which considered how things had panned out for other groups doing the same task. The outside view gives what Mauboussin describes as a "base rate" for a given forecast. You can then adjust this for the specifics of your situation. Your forecast may still be wrong but it shouldn't be as wildly inaccurate as one that starts with the inside view.

How can this help an investor? Take profit warnings (see MoneyWeek's financial glossary). When you see a share you own plunge in price, your instinct is often to sell in a panic. By knowing what has happened in the past, you can get a better idea of whether this makes sense or not. While at Credit Suisse (in a paper called The Base Rate Book), Mauboussin looked at events where a stock fell by 10% relative to the S&P 500 in a single day between 1990 and 2014. He examined many variations, but to take one example, if a company warned on profits but was already cheap and had done poorly in the run-up to the warning, that was typically a good time to buy. For any specific case, of course, "this time may be different" but if you can start from a relevant "base rate" you should at least thwart the human tendency to extrapolate, and thus improve your odds of making a good decision.

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