Last week we embarked on a discussion about how behavioral economist and 2002 Nobel laureate, Daniel Kahneman transformed the fields of economics and investing. I promised we would finish off the discussion with a look at noise, biases, and hindsight. Then Kahneman’s four simple strategies for better decision making that can be applied to both finance and life.
Even in testable domains where relationships are readily discernible and can be measured, noise can distort the results.
Kahneman described a study of insurance underwriters at a prominent insurance company. We all know, underwriting is far from an exact science but it is a domain with decipherable rules, where we can achieve expertise. When setting premiums, all underwriters have access to the same data. Yet premiums differ from one insurance company to the next, which I guess is expected. But the question asked is how large a divergence was there from one to another?
What percentage would you expect?” Kahneman asked. “The number that comes to mind most often is 10%. It’s fairly high and a conservative judgment.”
Ya, the divergence was 56%.
He stated, “Which really means that those underwriters are wasting their time,” [or ripping you off]. “How can people have that amount of noise in judgment and not be aware of it?”
Problems with the Noise
Unfortunately, the noise problem isn’t limited to just underwriting. And it doesn’t require multiple people to introduce the noise. One person is all you need to screw things up.
Indeed, even in more binary disciplines, using the same data and the same analyst, results can differ. “Whenever there is judgment there is noise and probably a lot more than you think,” Kahneman further explained.
An example, radiologists were given a series of X-rays and asked to diagnose each of them one at a time. Now, this is where it gets good! Even when the same technician was shown the same x-ray, “In a shockingly high number of cases, the diagnosis is different,” he said.
You never know if the technician could be having a bad day or thinking about a hot date that night and not concentrating on her job.
The same held true for DNA and fingerprint analysts. So even in cases where there should be one foolproof answer, noise can render certainty impossible.
We Use the Word “Bias” too Often
While Kahneman spent much of his career studying bias, he is now focused on noise. Bias, he believes, may be overdiagnosed and we can pretend to compensate for it. Whereas noise, the culprit in most decision-making errors, is much more difficult to remove.
“We should think about noise as a possible explanation because noise and bias lead you to different remedies,” he said.
“People are very loss averse and very optimistic. These two work against each other,” he said. “People, because they are optimistic, they don’t realize how bad the odds are.”
As Kahneman’s research on loss aversion shows, we feel losses more acutely than gains. The mindset of a winning trade isn’t anywhere near comparable to the kick in the gut pain when a position goes against us.
We tend to overestimate our chances of success, especially during the planning phase. And then whatever the outcome, hindsight is 20/20: Why things did or didn’t work out is always obvious after the fact.
“When something happens, you immediately understand how it happens. You immediately have a story and an explanation,” he said. “You have the sense that you learned something and that you won’t make that mistake again.”
These conclusions are usually wrong. Sort of like after a totally disastrous date, you swear to all that is holy you’ll never do online dating ever again.
“What you should learn is that you were surprised again,” Kahneman said. “You should learn that the world is more uncertain than you think.” What you should have learned is online dating is probably the best way to find dates but maybe dating itself is overrated.
So in the world of finance and investing, where there is so much noise and bias and so little trustworthy intuition and expertise, what can we do to improve our decision making?
Kahneman proposed four simple strategies for better decision making that can be applied to both finance and life
1. Don’t Trust People, Trust Algorithms
Whether it’s predicting parole violators and bail jumpers or what trade to enter tomorrow, algorithms are preferable to independent human judgment.
Kahneman said. “There are very few examples of people outperforming algorithms in making predictive judgments. So when there’s the possibility of using an algorithm, use it.”
Don’t trust your instinct when trading, it will probably be wrong.
2. Take the Broad View
“The single best advice we have in framing is broad framing,” he said. “See the decision as a member of a class of decisions that you’ll probably have to take.”
Don’t look at your last trade and project the future.
3. Test for Regret
“Regret is probably the greatest enemy of good decision making in personal finance,” Kahneman said.
If you deviate from the plan, don’t beat yourself up. Just get back on the wagon and enjoy the ride.
4. Seek Out Good Advice
Part of getting a wide-ranging perspective is to cultivate curiosity and to seek out guidance.
So who is the ideal adviser? “A person who likes you and doesn’t care about your feelings,” Kahneman said.
For him, that person is fellow Nobel laureate Richard H. Thaler.
“He likes me,” Kahneman said. “And couldn’t care less about my feelings.”
We’re the Plan in “Plan your Trade and Trade your Plan” TraderJanie