A recent Harvard Business Review article co-authored by psychologist and Nobel laureate Daniel Kahneman gives a checklist approach to decision making at an institutional level to avoid biases. According to the article, the potential for distortions is so high that knowing biases were not enough to eliminate these. The authors illustrate the reflective and intuitive thinking process. In intuitive thinking, we don’t focus on doing things, we just do them. Intuitive is good at making contextual stories. This is when cognitive failures happen, as there is no way of knowing when they are happening. According to the authors, talking doesn’t eliminate biases. A more methodical approach is needed. A study observed that eliminating biases achieved 7 percentage points higher returns.
Kahneman and team suggest eliminating biases can improve decision making profitably. So, if the method works for businesses, the approach should also work for investors and markets, and could be an improvement on the three-year reversal cycles of behavioral finance where worst stocks outperform the best. We reviewed Kahneman’s checklist for decision-makers to see if the approach also assists an investor.
Is there any reason to suspect motivated errors (or errors driven by the self-interest of recommending team)? Now, this could be a good business checklist but the markets are known to have a manipulation element, the zero-sum game instruments, your loss is my gain. Above that, we are living at a time of educating society about ethics and conflict of interest. Markets are full of motivated errors.
Did the person who made the recommendation, fell in love with it? From a market perspective, advisory services are ranked based on their recommendations. And, few take a detour on a previous forecast. So, market analysts can be assumed to be mostly in love with their forecasts.
If there are dissenting opinions within the recommending team? Though there are always dissenting opinions among market advisories, there is always a clear skew either on the buy or on the sell side. More often on buy than on sell. Hence, dissenting views are not polarised enough in markets.
A question that decision makers should ask the team making recommendations — Could the diagnosis of the situation be overly influenced by salient analogies? Trading volume and new highs are known to have an undue influence on investors.
Other questions include: Can you see the halo effect? Do you know where the numbers came from? If you had to make the decision again in a year, what information would you want? Are people making the recommendation overly attached to past decisions? Investors generally buy companies with an aura. Investors don’t just buy numbers, as there are many variables in markets. Hence, stories are bought or sold, not numbers. Few investors learn from mistakes, as there is a limited annual review. If 80 percent of investing is momentum, the past trend exerts an excessive influence on investors.
Further, is the base case too optimistic? Is the recommending team overly cautious? Is the worst case bad enough? This depends on the investment style. A contrarian approach is counter-intuitive. A contrarian never works with an optimistic base case. When he invests or recommends, s/he suggests taking the risk, not be cautious. A contrarian looks at the worst case. The checklist again proves momentum investing is full of biases and hence poor decision making. And, the only way to control our own intuition could be to embrace the objective contrarian approach. Buy the worst and sell the best.