New Podcast Episode – Diversity and Decision Making

In the latest episode of the Decision Nerds podcast, Paul Richards and I explore one of the most important subjects in the asset management industry – diversity and inclusion – with Tom Gosling. Tom is a committed and thoughtful supporter of D&I. A practitioner turned academic who helps build bridges between researchers, policymakers and those at the coal face.

He has a thoughtful take on some important strategic and practical D&I issues. In the episode, we discuss:

– Why overstating the business case for diversity (improved profitability or alpha) may be more harmful than beneficial.

– Why the moral, social and economic arguments for diversity may be stronger but are not talked about enough.

– How to make genuine and substantive change around diversity and avoid a culture of box ticking.

– What more diverse teams mean for performance.

– How we can create decision making environments that make the most of the advantages of diverse teams.

This is a fascinating and important subject from both a macro (social justice / fairness) and micro (how do diverse groups function) perspective. The issue is far more complex than we could hope to do justice to in a single podcast episode, but we hope that it is a useful starting point for further debate and discussion.

You can listen here: Decision Nerds

Investment Junk Food

Easy and instant access to information is often framed as a major advantage to present day investors compared to their predecessors, but if anything we suffer from a profound information disadvantage. The benefit of improved knowledge is easily overwhelmed by the behavioural challenge of dealing with an incessant torrent of noise. Much of what investors consume is little more than investment junk food, tempting us into decisions that feel good in the moment but come with a material long-term cost.

Whether it be an update on why the stock market closed lower today, a vivid description of a new and profound economic theme, or a compelling account of why we are headed for a recession, such communication bears a striking resemblance to the attractions and dangers of junk food. It provides us with a quick fix, is more interesting than the stuff that does us good and can create long-term damage.

Not only is it appealing, it is everywhere. Investment junk food is prolific. It is like being in a supermarket with row upon row of cakes and ice cream, with the fruit and vegetables hidden on a shelf in the back corner. Making smart decisions in such an environment is incredibly difficult.

The driving force of this problem is incentives. Investment junk food is created for usually one of two reasons – raising assets or attracting eyeballs. The primary motivation is not typically to improve our long-term financial health, but to profit from us in some fashion.

While the occasional chocolate bar is unlikely to be of detriment to our long-term well-being; investment junk food can be more pernicious. Seemingly small, in the moment, mistakes can compound into dramatic long-run costs. This torrent of unhelpful communication matters and is far from benign.

Financial markets are a natural and compelling storybook. A constant stream of heroes, villains, opportunities, threats, failures and successes. This makes them captivating and intriguing – the perfect setting for creating investment junk food.  There is always a new story to tell and sell.

One of the major behavioural problems investors encounter is mistaking the ceaseless action in markets as a call to action in our portfolios. If something is happening in markets, then something should be happening in our portfolios. Investment junk food preys on this misconception. It tells us that things are changing and asks us why we are not doing anything about it.

For most investors financial markets should be chaotic and fascinating, but our portfolios should be stable and dull.

The most common defence of the industrial production of investment junk food is that clients demand it, so it must be produced. If we didn’t tell them how the stock market performed last month, they would demand to know why. There may be some truth to this, but it is also a vicious circle. Clients want it because they are continually fed it. Perhaps we could try reframing those expectations and talking more about good investment behaviour.

The problem with these fruits and vegetables of the investment communication world, is that they can seem repetitive and dull, much like good, long-term investing. There are two solutions to this – communicating the same messages in different ways (which certain people do exceptionally well). Or by telling people about all the enthralling and emotive things that are happening in financial markets, and then why they should not be doing anything about it.

We can look at the junk food, but just not eat it.

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Things Professional Investors Should Say but Can’t

One of the main challenges faced by professional investors is that good behaviours are often in direct conflict with our own interests. This is either because our incentives are misaligned – what’s beneficial for the business or my career is not necessarily good for my client – or we feel compelled to meet the erroneous expectations of what good investing behaviour is. This profound dissonance means that there are plenty of things that professional investors should be saying, but really can’t.

Such as:

“Sorry, I am not sure how the market did yesterday, I didn’t check.”

“Yes, this is the second quarter in a row where we haven’t made any changes to your portfolio. I hope we don’t make any all year.”

“You could listen to me talk about inflation, but I am just as bad at forecasting it as everyone else.”

“We are managing too much money, its probably not in your best interests to invest with us.”

“Our recent strong performance is totally unsustainable.”

“I have to admit, we have been incredibly lucky”.

“Our new CEO is really focused on improving short-term performance.”

“The performance fee structure means that I can become very rich, even if I underperform.”

“There really is little value in complexity, you are better off keeping it simple.”

“Yes, I have kept a record of my macro forecasts and trades, would you like to see it?”

“If you want to take a genuinely long-term, active approach, you will have to put up with years of underperformance. Even if we are good.”

“Although I say I have a long-term investing horizon, most of my decision are about keeping my job for another year.”

“To tell you the truth, this merger has been an absolute nightmare.”

“The recent team restructure has changed everything, we have lost some of our best people”

“I have no idea how markets will perform over the next year, and neither does anyone else.”

Although these issues can seem minor and akin to the classic sales activity of any industry – highlighting the perceived virtues of a product or service – there is something more damaging going on here. Incentives drive behaviour and too often the incentives of professional investors are pointed in the opposite direction of their clients.

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Should Investors Trust Their Gut?

Investors often talk about making a decision based on a feeling in their gut. Explaining how some form of unconscious intuition led them to the correct choice.  Although this is an appealing notion – particularly as people only seem to mention it following success – it can also be a dangerous one. Should investors really be trusting their gut and, if so, when?

In 2009, psychologists Gary Klein and Daniel Kahneman published a paper called: “Conditions for Intuitive Expertise: A Failure to Disagree”. This work was particularly notable as the two authors had seemingly ideologically opposed views on the subject of intuitive judgements. Klein had focused much of his career on how experts often make high quality, snap judgements; whereas Kahneman had famously highlighted the flaws and biases inherent in such short-term views (often referred to as system one thinking).

Despite these seemingly polar opposite opinions on intuition, Klein and Kahneman found that they concurred much more than they disagreed. Their common ground can tell us a lot about whether and when we should rely on our intuition.

Klein’s view on intuition is defined as the study of ‘naturalistic decision making’, the genesis of which came from the observation of chess grandmasters and their ability to make robust, instinctive decisions. This work expanded into other fields where similar expert intuition was found to be in evidence – such as a fire chief anticipating the collapse of a building, or a nurse rapidly identifying a child with a dangerous infection.

This type of expert intuition is a form of pattern recognition, where we draw on historic experience to the extent that it becomes an ingrained, unconscious feature of how we reach a judgement.

Contrastingly, Kahneman’s perspective was trained on heuristics and biases – how our instantaneous judgements are often partial, noisy and flawed. Such mistakes in thinking were made by esteemed and experienced experts such as clinicians, political forecasters and – unbelievably – investors.

In one instance we have individuals able to make strong intuitive judgements, even in stressful and uncertain environments; in another we have our intuitions leading us horribly astray. How can we align these seemingly diametrically opposed stances?

The answer is that whether or not we trust our gut is dependent on the context of the decision.

Klein and Kahneman agreed that there were two critical conditions, which needed to be in-place for expert intuition to be effective:

– It must be a ‘high validity’ environment: ‘High validity’ seems a somewhat impenetrable term but is relatively simple. To quote directly from the paper: “Skilled intuitions will only develop in an environment of sufficient regularity, which provides valid cues to the situation”. Good intuition relies on some form of stable relationship between cause and effect; these don’t have to be perfect but need to be reasonably predictable. Despite a chaotic environment, there are a set of signals that might indicate to a firefighter that a building is about to collapse.

– There must be an opportunity to learn: Intuition is about recognizing patterns, so we must have enough opportunities to learn those patterns and receive feedback. It is very dangerous to develop intuition based on small but highly salient examples.

It is easy to see how investors can fall foul of gut feel choices. We are constantly making decisions in low validity environments – where conditions are unstable, noisy and prone to change through time. The patterns we observe in one period may not repeat in another.

Does that mean that investors should never be led by their gut? Not quite. It depends on what the intuition relates to. If we have a feeling that we are about to enter another bear market for stocks, this is likely to be entirely erroneous – such views meet both criteria of where intuition fails us.

If, however, we have a gut feel that investing in an asset class that has risen stratospherically over the past year is likely to be a bad idea, this is more likely to be a smart intuitive judgment. Why? Because there is far more validity in this situation – regular historic patterns of assets with spectacular performance subsequently disappointing.

As Klein and Kahneman point out, high validity does not mean that every intuitive decision will be right, but they will put the odds on our side over time.

The challenge for investors is to know when to trust our gut and when to ignore it. We almost inevitably make more intuitive judgements than we care to admit. Often making up our mind immediately, before carrying out some more detailed (after the fact) work to disguise the real driver of our choice.

The other major issue faced by investors is the conflation of intuition and emotion. They are both decision-making factors that can lead us to act quickly, but they are very different. Making a choice based on fear, greed, anxiety or excitement can feel something like intuition but has little to do with pattern recognition and all to do with biology. We should always avoid emotion-laden investment decisions.

The relief for investors is that – unlike the firefighter or the nurse – most of us don’t have to make snap judgements, we have time on our side even if we often don’t act like it. This doesn’t mean we should entirely ignore our gut but use the time we have to think about what it is telling us and whether it is the right type of situation to trust it.

Kahneman, D., & Klein, G. (2009). Conditions for Intuitive Expertise: A Failure to Disagree. American Psychologist, 64(6), 515.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

New Decision Nerds Episode – F&^% Ups

We all make mistakes, some big and some small.

Understanding how errors happen and how they can be managed is a critical element of good decision making. Whether in investing or everyday life.

In this bite-size episode of Decision Nerds, Paul Richards and I tackle this by examining the curious case of the ultra-marathon runner who got in a car. Getting in a car wasn’t the problem – the fact that it was in a race and that she took a podium position was. Several days later, she had to apologise and explain what had happened with all the grief, Twitter pile-ons and general angst that you might expect.

Was this a case of a cynical cheat getting caught, or an example of when environmental factors can lead to a poor decision that spirals out of control? Our take is that it’s probably the latter and we’d all do well to learn what we can from this unfortunate situation so that we can manage our own errors more effectively.
We discuss:

The crucial role of the decision environment – the impact of factors such as tiredness, anxiety, emotions etc.

Short-term, ‘in the moment’, thinking – how we often act to satisfy short-term needs and neglect the long-term costs of our choices.

The compounding effect – how small errors can become big problems.

Sharing the burden – how getting others involved quickly can make things easier, but why we might need strong incentives to do this.

Available through all your favourite pod places, or stream it here