Mauboussin on Investor Psychology – Part 1

by on August 2, 2017  •  In Michael Mauboussin

There seems to be a fair amount of behavioral investing tidbits originating from Columbia Business School affiliated sources these days. We previously posted excerpts from a Kingstown Capital interview (Columbia Business School alums) in which they discuss how they’ve woven behavioral psychology into their investment and team management process.

Below are excerpts (Part 1 of 3) from Thirty Years: Reflections on the Ten Attributes of Great Investors by Michael Mauboussin (who teaches Securities Analysis at Columbia Business School). It’s a goldmine of insightful commentary on how behavioral psychology can greatly impact one’s likelihood of investment success.


Psychology

“Investors face a slew of psychological challenges. Perhaps the most difficult is updating beliefs when new information arrives.”

“Most people prefer to maintain consistent beliefs over time, even when the facts reveal their beliefs to be wrong… We all walk around with views of the world that we believe are correct. You are compelled to change your mind only when you confront reality that disconfirms your beliefs. The easiest way to avoid the sensation of being wrong is to fall for the confirmation bias. With confirmation bias, you seek information that confirms your view and interpret ambiguous information in a way that is favorable to your belief. Consistency allows you to stop thinking about an issue and to avoid change as a consequence of reason.

But great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy. The trait of seeking alternative views is called being ‘actively open-minded,’ a term coined by a professor of psychology at the University of Pennsylvania named Jonathan Baron. Actively open-minded is defined as ‘the willingness to search actively for evidence against one’s favored beliefs, plans or goals and to weigh such evidence fairly when it is available.’”

“The practical challenges are to avoid overreacting to information that appears to explain causality on the surface but in fact does not, as well as to detect information that does matter but that does not appear to be causal. In addition, while it is often clear to shift your degree of belief up or down, the magnitude of the shift is also important. The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous. They actively seek varied points of view and update their beliefs as new information dictates. The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio. Others, including your clients, may view this mental flexibility as unsettling. But good thinking requires maintaining as accurate a view of the world as possible.”

Additional common psychological pitfalls include:

“Two areas of research, heuristics and biases and prospect theory, merged economics and psychology in the last half century. While many of the ideas had been around for a long time, Daniel Kahneman and Amos Tversky did a great deal to formalize the thinking.

The heuristics and biases literature notes that we tend to operate with rules of thumb (heuristics), which are generally correct and save us lots of time. But these heuristics have associated biases that can lead to departures from logic or probability. Examples of heuristics include availability (rely on information that is available rather than relevant), representativeness (placing people or objects in categories that are inaccurate), and anchoring (placing too much weight on an anchor figure). There is now a long list of heuristics and biases, and great investors are those who not only understand these concepts but take steps to manage or mitigate behavioral biases in their investment process.

Prospect theory shows how the decisions by individuals depart from normative economic approaches in risky situations. Loss aversion, which says that individuals tend to suffer more from losses than comparable gains, is a good example. While there may be a persuasive evolutionary explanation for loss aversion, it is not good for money management.”

“The ability to sidestep behavioral biases is likely part disposition, part training, and part environment. Great investors are those who are generally less affected by cognitive bias than the general population, learn about biases and how to cope with them, and put themselves in a work environment that allows them to think well.”

 

Psychology, Team Management, Process Over Outcome

“The challenge today is to implement methods to manage and mitigate behavioral biases. There are a few techniques that can be helpful. One example is the use of checklists, which come in two forms. A DO-CONFIRM checklist allows an investor to do his or her job as they see fit but prompts pauses to make sure the job has been done thoroughly. Our experience is that checklists can be effective for the routinized aspects of investing, for instance making sure that the analyst has done a competitive strategy or return on invested capital analysis properly. A READ-DO checklist is useful in periods of high stress. One case is when a stock you own drops sharply versus the market. A checklist can lay out the protocol to ensure the best possible decision.

Another technique is an explicit effort to improve choice architecture. Research in psychology demonstrates that how choices are presented influences behavior. Nudges are structures that encourage positive behaviors without limiting options.

Having an organization with a high level of cognitive diversity, people with different training experience, personalities, and skills, is perhaps the most powerful antidote to bias. But cultivating cognitive diversity is not enough. You must manage diversity. ‘Psychological safety’ is the single factor that best predicts good performance for a team. This means that people feel free to voice their views and are willing to take appropriate risks.”

“Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions. His claim is that the overlap between these abilities is much lower than most people think. Importantly, you can cultivate your RQ. Warren Buffett captures this idea when he distinguishes between an engine’s horsepower (IQ) and output (RQ): ‘I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.’”

“…there is a still a lot of upside in properly building an investment firm. In the past 30 years, we have learned a substantial amount about how our minds work, the value of diversity, and the role of training…the organization has to manage cognitive bias. Only then can an individual in a firm reach peak performance.”

“Qualities such as active-open mindedness, thinking probabilistically, an ability to update views frequently and accurately, and persistence are not well captured in tests. Even proxies for intelligence, such as graduating from an elite university, do not do the job.”

“Progressive investment organizations will extend their selection process to including screening for rationality, which will likely improve results.”

The same psychological pitfalls that apply to one individual can lead to either magnified or different implications when a team of individuals simultaneously suffer from various psychological pitfalls. Therefore, when structuring a team/firm, one should consider how these biases can creep into and corrupt the investment process across the organization, and structure teams and incentives to mitigate negative effects.

 

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