Behavioral Matters:
Insights from the application of Behavioral Finance
Issue 16 – November 18, 2009
Behavioral Matters is a series of essays on the application of Behavioral
Finance written specifically for professional investors and portfolio
managers.
Inside-Out Investing
It is the optimistic denial of uncontrollable uncertainty that accounts
for managers’ views of themselves as prudent risk takers, and for their
rejection of gambling as a model of what they do.
Daniel Kahneman and Dan Lovallo, “Timid Choices and Bold Forecasts:
A Cognitive Perspective on Risk Taking”
Analysis is fundamental to equity investing. Deep dives require that
you apply extensive energy and talent into understanding a company
and its ability to deliver excess returns. Yet this activity can awaken
behavioral tendencies that short-circuit your analytic processes.
Consequently, rigorous analysis can heighten the potential for over
optimism at exactly the moment when greater objectivity is needed.
This essay examines the importance of calibrating judgments as a
critical element of self-awareness and honing investment skill.
The Deep Dive
The greater the opportunity or risk associated with a decision, typically
the more analysis is performed. Investors commonly employ a process
or framework to guide them through the steps of detailed company
analyses. Such steps are analogous to what biologists, chemists,
physicists, and others refer to as the scientific method.
Presented with a challenging decision, we first reduce the problem to
its major components. These, in turn, are further deconstructed to
smaller and smaller components that facilitate our clear understanding
and confident resolution of these more manageable elements. After
gathering and analyzing appropriate data for all subcomponents, we
reverse the process, with the goal of understanding the initial or larger
question by assembling our understanding of the components and
their relationships to each other.
Done well, deep analysis can lead to rich proprietary insights about a
company’s likely performance or intrinsic value. This is the
“information advantage” that skilled professionals bring to portfolio
management. Intense rigor can also produce overly optimistic
conclusions—reflecting a runaway process that is being powered by
emotions rather than analytics.
Motivation, Please
Thinking is more emotional than commonly believed. The cognitive
process itself draws upon both the analytic and emotional parts of the
brain. Reasoning, therefore, is a blended outcome of the “best fit” for
the data being considered plus the automatic filtering and shaping of
that data to support beliefs, biases, or desires within the unconscious.
This model of thinking helps explain why even the most careful experts
sometimes engage in overly optimistic assessments when performing
rigorous analyses.
According to Shelley Taylor and Jonathon Brown, overly optimistic
assessments share certain qualities: “three main forms of a pervasive
optimistic bias: (i) unrealistically positive self-evaluations, (ii)
unrealistic optimism about future events and plans, and (iii) an illusion
of control.”1 Rigorous analysis often ignites these unconscious
motivations. The results can include both narrow framing of the
possible outcomes (resulting in extreme possibilities being heavily
discounted or ignored) and higher certainty or success rates being
assigned to each subcomponent evaluated (as if by merely analyzing
an uncertain event it has been rendered less risky).
Judgment is further affected when issues are viewed as unique.
Uniqueness is a favorite rationalization for why relative comparisons
are not applicable or for defending an idea in the face of strong
evidence that it is not a particularly good one. Kahneman and Lovallo
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offer this perspective: “The natural way to think about a problem is to
bring to bear all one knows about it, with special attention to its
unique features.”2 The tendency to focus on uniqueness is a risk worth
avoiding when developing a favorable thesis.
Inside-Out
The deep dive often reflects what Kahneman terms the “inside view.”
This is the view of a situation that is based on judgments applied to
specific facts about that situation, especially when they are not
benchmarked to similar experiences. Michael Mauboussin offers a less
flattering description: “An inside view considers a problem by focusing
on the specific task and by using information that is close at hand, and
makes predictions based on that narrow and unique set of inputs.
These inputs may include anecdotal evidence and fallacious
perceptions.”3 Yet inside views are the very cornerstone of the process
used by analysts and managers to shape investment decisions.
One technique recommended by both Kahneman and Mauboussin for
managing the perils of inside views is to balance them with “outside
views.” Outside views are based entirely on facts about comparable
alternatives. They ignore the specific attributes of the situation under
consideration and instead look at typical outcomes for similar
situations.
Consider a company analysis that requires forecasting the expected
revenue stream from a drug currently in Phase 3 trials. Formulating
such an outcome conventionally involves many steps, including
estimating the chances that the trial will be successful, anticipating a
likely efficacy for the new drug, and then translating this information
into estimates of market size, unit demand, cost, and price. Each of
these seemingly objective judgments will reflect selected experiences
in your memory and the belief you have in management’s ability to
think strategically and execute effectively—a classic inside view.
Approaching the same task using an outside view, one would begin by
identifying like companies that have attempted similar endeavors.
Once identified, the results from this group of comparable situations
would be analyzed to determine benchmarking information such as
percentage of success/fail, mean outcome when successful, and the
standard deviation across results.
Avoiding inside views is not realistic for most investors. Seeking assets
that can generate excess returns is, by definition, hunting for
uniqueness. Highly skilled investors, however, are experts at isolating
truly unique characteristics for any opportunity. Then they rigorously
analyze these characteristics as appropriate, drawing upon outside
views to sharpen judgments and spotlight key risks.
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Conclusion
Rigorous analysis is, in large part, what professional investors rely
upon to make buy and sell decisions. The risk inherent in such
analyses is that they can lead to overly optimistic assessments that
reflect the shortcomings of inside views. Outside views can be
incorporated into the evaluation process, helping you to calibrate
interim steps of your analysis. The takeaway for refining your investing
is this: Inside views may be essential for identifying opportunities that
are well reasoned, while outside views help keep your judgments
reasonable.
Notes
1. S. E. Taylor and J. D. Brown, “Illusion and Well-Being: A Social
Psychological Perspective on Mental Health,” Psychological Bulletin 103
(1988), 193–210.
2. Daniel Kahneman and Dan Lovallo, “Timid Choices and Bold
Forecasts: A Cognitive Perspective on Risk Taking,” Management
Science 39, no. 1 (January 1993), 26.
3. Michael J. Mauboussin, Think Twice: Harnessing the Power of
Counterintuition (Boston: Harvard Business School Press, 2009), 3.
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