In 1999, Richards J. Heuer, Jr – who worked for the CIA for almost 45 years – produced a volume of writing called: ‘Psychology of Intelligence Analysis‘. It collated internal articles written for the CIA Directorate of Intelligence. Its aim was to provide analysts with the tools to reach judgements in situations which “involve ambiguous information, multiple players and fluid circumstances”. The insights drawn together by Heuer, Jr are designed to assist in the profound challenge of using our limited human mind to tackle deeply complex problems. Investors face this exact test but spend far too much time focusing on getting more, better or new information, and far too little time on how we process it. Good analysts and investors need to think about thinking. This book is an excellent place to start.

The full text is available to download, but here are some of my own highlights:

“the mind cannot cope with the complexity of the world. Rather we construct a simplified mental model of reality and then work with this model.”

We use mental models (consciously and unconsciously) to help us interpret a fiendishly complex world. We cannot escape all the limitations of this necessarily parsimonious approach, but we can be more aware of the models we use, why we use them, and the implications they have for the choices we make.

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“perception is demonstrably an active rather than passive process; it constructs rather than records reality.”

As investors we do not impartially receive information, but instead interpret it based on our own experiences, identity, biases and incentives.

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“When faced with a paradigm shift, analysts who know the most about a subject have the most to unlearn.”

I am always become nervous when investors talk about ‘paradigm shifts’, as it is usually a prelude to losing money. The point Heuer, Jr raises is a good one, however, in that experienced analysts can often be vulnerable in situations where the environment changes dramatically. Moving from an environment of no inflation to high inflation might be a good example of this in recent times.

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“Events consistent with these expectations are perceived and processed easily, while events that contradict prevailing expectations tend to be ignored or distorted in perception.”

If feels great when things transpire as anticipated, but quite troubling when they don’t. It risks our thesis being wrong or our credibility being questioned. Therefore, when we receive information that seems contrary to our view we are prone to reinterpret it to fit our narrative, or downplay it.

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“despite ambiguous stimuli, people form some sort of tentative hypothesis about what they see. The longer they are exposed to this blurred image, the greater confidence they develop in this initial and perhaps erroneous impression.”

We tend to make initial, snap judgements based on sketchy information. Although this might be an effective adaption (is that a lion approaching?) it can also be a problem. We can easily become wedded to that first impression even if the evidence is weak.”

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“The amount of information necessary to invalidate a hypothesis is considerably greater than the amount of information required to make an initial impression.”

We live in an investment world where people not only want an opinion on everything, but they want it instantly. This is incredibly dangerous. Initial judgements are not throwaway, they can have a sustained impact on our future decisions, even if they are deeply flawed.

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“dealing with highly ambiguous situations on the basis that information that is processed incrementally under pressure for early judgement….is a recipe for inaccurate perception.”

Speed and pressure are a terrible combination for good investment decisions.

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“There is, however, a crucial difference between the chess master and the master intelligence analyst. Although the chess master faces a different opponent each match, the environment in which each contest takes place is stable and unchanging.”

Financial markets are a complex, adaptive system. This makes them both endlessly fascinating and incredibly difficult to predict. Investors need to understand the nature of the game they are playing.

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“A historical precedent may be so vivid and powerful that it imposes itself upon a person’s thinking from the outset”.

Salience of past events has a dramatic impact on how an investor thinks. Understanding the events that we have experienced is likely to provide a good read on how we might interpret a new situation.

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“inferences based on comparisons with a single analogous situation are probably more prone to error than most other forms of inference.”

The worst type of chart crime in investing – a current bear market overlaid with an historic bear market – is a vivid example of the dangers of using one striking historic precedent as a basis for judgement. That is not how complex adaptive systems work.

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“Analysts actually use much less of the available information than they think they do.”

More information often does not lead to better decisions, just greater confidence in those decisions. How much of the information in that 134-page research report really influenced our judgement?  

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“Information that is consistent with an existing mindset is perceived and processed easily and reinforces existing beliefs.”

Confirmation bias is one of the most powerful forces in investing. We see the information we want to see.

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“analysts typically form a picture first and then select the pieces to fit.”

Most investors start with a conclusion and then select the appropriate analysis to justify it.

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“Critical judgement should be suspended until after the idea generation stage of the analysis has been completed.”

Generating new ideas and hypotheses is very difficult. It is particularly challenging if they are immediately criticised and killed (it is easy to dismiss something new). The best way to avoid this friction is to separate the development of fresh thinking from its criticism. (Idea first, critique later).

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“Analysts start with the full range of alternative possibilities, rather than with a most likely alternative for which the analyst seeks confirmation.”

As much as we may dislike it, there is always a range of potential future paths ahead of us and we need to be clear about what they may be. Point forecasts or singular views are a recipe for poor judgements (although they will occasionally make us look very smart).

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“The most probable hypothesis is usually the one with the least evidence against it, not the one with the most evidence for it.”

Investors should spend as much time looking for ‘broken legs’ – reasons why their view is flawed – as they do seeking to prove they are right.

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“certain kinds of very valuable evidence will have little influence simply because they are abstract.”

Investors love the inside view – this fund manager has delivered stellar returns and has an incredible backstory – and ignore the outside view – only 5% of fund managers in this area deliver alpha.

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“Coherence implies order, so people naturally arrange observations into regular patterns and relationships.”

Financial markets are chaotic and full of randomness, which we abhor. Thus, we spend our time attempting to find spurious links and causality.

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“two cues that people use consciously in judging the probability of an event are the ease at which they can imagine relevant instances of the event and the number or frequency of such events’.

The availability heuristic can easily overwhelm our probability judgements. Recent and high-profile occurrences become high(er) probability.

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“an intelligence report may have no impact on the reader if it is couched in such ambiguous language that the reader can easily interpret it as consistent with his or her own preconceptions.”

It is okay to be specific about probabilities. Not only does it immediately acknowledge uncertainty it makes it far easier to change our mind than a single point forecast.

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Nothing is more important for investors than spending time considering our own behaviour and thought processes. What we believe to be cool headed, impartial judgements are no doubt choices shaped by a sea of incentives, biases and foibles many of which we will be oblivious to. It is hard to admit it, but we don’t’ really know why we make the choices we do. Heuer, Jr’s book can help.

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Heuer, R. J. (1999). Psychology of intelligence analysis. Center for the Study of Intelligence.

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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).