Michael Mauboussin: When Smart People Investors Make Dumb Decisions
“Smart people make poor decisions because the mental software that we humans inherited from our ancestors isn’t designed to cope with the complexity of modern day problems and systems.”
Introduction (Via MichaelMauboussin)
If you ask people to offer adjectives that they associate with good decision makers, words like “intelligent”and “smart” are generally at the top of the list. Yet, history contains plenty of examples of smart people who made poor decisions as the result of cognitive mistakes. These mistakes can have horrific consequences, from the space shuttle Columbia disaster to the scores of bank failures across the United States since the start of the 2007 recession. But faulty decision making is also avoidable. Every day, research is offering new insights into the decision- making process. A science of choice is emerging, and the good news is that everyone, from students to stockbrokers, can learn how to make better decisions.
Smart people make poor decisions because the mental software that we humans inherited from our ancestors isn’t designed to cope with the complexity of modern day problems and systems. In short, smart people, like everyone else, face two major obstacles to making good decisions. The first obstacle is the brain, which evolved over millions of years to make decisions unlike what we face in modern life. The second obstacle is the growing complexity of the world in which we live.
How to Incorporate the Outside View into Your Decisions
1. Select a reference class- Find a group of situations, or a reference class, that is broad enough to be statistically significant but narrow enough to be useful in analyzing the decision that you face. The task is generally as much an art as it is a science, and it is certainly trickier for problems that few people have faced before. But for decisions that are common — even if they are not common for you — identifying a reference class is straightforward.
2. Assess the distribution of outcomes- Once you have a reference class, take a close look at the rate of success and failure. Study the distribution, including the average outcome, the most common outcome, and check for extreme successes or failures.
4. Assess the reliability of yourprediction and fine-tune it - How good we are at making decisions depends a great deal on what we are trying to predict. Weather forecasters, for instance, do a pretty good job of predicting what the temperature will be tomorrow. Book publishers, on the other hand, are poor at picking winners, with the exception of those books from a handful of bestselling authors. The worse the record of successful prediction is, the more you should adjust your prediction toward the mean (or other relevant statistical measure). When cause and effect is clear, you can have.
3. Make a prediction - With the data from your reference class in hand, including an awareness of the distribution of outcomes, you are in a position to make a forecast. The idea is to estimate your chances of success and failure. For all of the reasons that I’ve discussed, the chances are good that your prediction will be too optimistic.