A few years ago, I read Michael Mauboussin’s “The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.” It remains one of my dozen favorite investment-related books. I finally got around to reading his “Think Twice: Harnessing the Power of Counterintuition” on how we make—and all too often mismanage—decisions (including, but not limited to, investment decisions). He explains that mistakes are made because we fall victim to simplified mental routines that prevent us from coping with the complex realities. He also shows us how to recognize and avoid common mental errors.
In the introduction, Mauboussin highlights the importance of understanding that we often have to make decisions in the face of uncertainty, where, at best, we can only estimate the odds of potential outcomes. He writes that, sadly, especially when it comes to investments, too many judge the quality of a strategy based solely on the outcome—the strategy was good if the outcome was favorable. Instead, he says, we should judge the quality of the strategy by the quality of the decision-making process; and we must understand that quality decisions can lead to poor outcomes, and poor decisions can lead to good (but lucky) outcomes. The bottom line, he explains, is that “in a probabilistic environment, you are better served by focusing on the process by which you make a decision than on the outcome. Developing this habit, he continues, “opens a world of insight into decision making.”
Each of the eight chapters focuses on common, identifiable issues and the mistakes associated with them, and also shows that the mistakes are preventable.
Chapter 1: While we often view our problem as unique, others have usually faced the same problem. We can learn from the results of their decisions. If you want to know how something is going to turn out for you, look at how it turned out for others. For example, in corporate mergers and acquisitions, you can examine how similar deals have performed. Mistakes are often made because we are overconfident in our abilities, believing we are above average—the illusion of superiority. A related problem is that we tend to be too optimistic—we see our future as brighter than that of others. Another problem is that we believe chance events are subject to our control. It’s important to assess the potential dispersion of outcomes, not just the outcome you forecast.
Chapter 2: We fail to consider enough alternative options because we have models in our head that oversimplify the world. We are subject to “representativeness bias,” giving too much weight to the probability of something if we have seen it recently or if it is vivid in our mind. Availability encourages us to ignore alternatives, which, while allowing us to make quick decisions, often causes us to leave out alternative choices that could be better. Incentives and unconscious anchoring on irrelevant information contribute to this tunnel vision. To avoid the mistakes, explicitly consider alternatives, seek dissent, keep track of previous decisions, avoid making decisions when under emotional distress and understand incentives.
Chapter 3: While the research on prediction skills shows that experts in every field are not very expert at predicting the future when uncertainty is involved—the “wisdom of crowds” is more reliable—we often have an uncritical reliance on experts. “Experts” are people like us and are subject to all the same biases and mistakes. The evidence shows conclusively that the collective is most often better than even the best individual—as long as the collective isn’t acting as a crowd (in other words, there is diversity of opinion). Suggested solutions include seeking diversity of opinion and using technology—computers and collectives remain underutilized guides for decision making.
Chapter 4: “Situation influences our decisions enormously," Mauboussin writes. We underestimate how much we are influenced not only by others but by our own feelings. One of the many interesting stories in the book is of an experiment selling French and German wines. When French music was played, 77 percent of the sales were French wines, but when German music was played, 73 percent of the sales were German wines. Yet, 86 percent denied being influenced by the music.
Chapter 5: Cause and effect reasoning can fail when systems are complex because the whole is greater than the sum of the parts. Focusing on why individuals in a system do something—an investor in the market, an ant in a colony or birds in a flock—does not help explain how the entire system performs. Understand the rules that govern the entire system rather than the rules that drive the individual participants.
Chapter 6: We try to apply general rules in contexts that are not appropriate. As Mauboussin says, “it depends.” Importantly, correlation doesn’t imply causation. We must ask: Does the theory behind your decision account for circumstances?
Chapter 7: Small changes in a system can lead to a large change in output. We mess things up by assuming the same input will always have the same output. When making decisions, it’s critical to understand that the consequences of our actions are far more important than what we think are the estimated probabilities of outcomes. Thus, we should consider the potential dispersion of outcomes and be prepared to deal with any outcome, developing strategies to minimize the risks of the downside. We also need to beware of forecasters who tend to be highly confident of their predictions.
Chapter 8: Any system that combines skill and luck will revert to the mean over time. Ignoring this “law” makes people think they are special and that the rules of probability don't apply to them. This is reinforced by the “halo effect”—when someone is doing well, the media tends to lionize every trait of that individual. Of course, when they revert to the mean, the media tends to ignore the poor performance and forget all the praise they had heaped on the person.
Mauboussin concludes the book with some recommendations, including to remember to think twice before we make a serious decision. Other recommendations include:
- Seek diversity of opinion from diverse sources of information and dissenting views.
- Learn from the experiences of others in similar situations (making use of statistics when possible) rather than relying only on your own perspective.
- Don't be excessively optimistic about expecting to beat the odds.
- Beware of anecdotal information, and don’t infer patterns where they don’t exist. Make appropriate use of the power of information technology.
- Don’t assume correlation indicates causation. Have an intuitive theory to support the evidence.
- Avoid bias of favoring evidence that supports your beliefs, while ignoring contradictory evidence.
- Avoid making decisions when in emotional distress (stress, anger, fear, anxiety, greed, euphoria, grief, and so on).
- Beware of how incentives, situational pressures and the way choices are presented may consciously or subconsciously impact behavior and shape decisions.
- Consider the full range of possible outcomes and employ strategies that mitigate downside risks while capturing upside potential.
- Understand that luck often plays a role in success or failure. It’s important to consider the quality of the decision-making process and to not overestimate the role of skill (or lack thereof). A useful test of how much difference skill makes in a particular situation is to ask how easy it is to lose on purpose.
- Make use of checklists to help ensure that important things aren’t forgotten.
- Know what it is you cannot know, understanding that most surprises are unpleasant.
- Perform a “premortem” examination, assuming that your decision hasn't worked out. Come up with plausible explanations for the failure and revise the decision to improve the likelihood of a better outcome.
As Maboussin notes: "No one wakes up thinking, ‘I am going to make bad decisions today.’ Yet we all make them.” In a clear style, Mauboussin informs us about our mistakes and how to avoid them. He engages the reader with interesting stories and experiments that bring the message to life. The book makes a valuable contribution to the literature on decision making when both luck and skill are involved. It is thoroughly researched and well written. I highly recommend the book to anyone interested in making better decisions (including better investment choices).
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.