Michael Mauboussin, chief investment strategist, Legg Mason
Just after handing in the manuscript of his latest book, Think Twice: Harnessing the Power of Counterintuition, Michael Mauboussin and his family had a single bad experience with the service at an otherwise fine Manhattan restaurant. His wife, Michelle, vowed never to return. It was a reaction based on instinct and the typical belief that the future would unfold like the past. For her husband, one of the more cerebral of market strategists, it was a personal example of why smart people keep making bad decisions, the very subject of his book. In reality, that restaurant will probably do better next time, while the eatery that had a good day is more likely to have a bad one at some point.
That's the mistake you say investors keep making when they seek out hot fund managers and discard those that have hit a rough patch.
If you say a sporting match or a portfolio manager's returns combine skill and luck, I think everybody gets that. But we're not very good at weighing the relative contributions of each.
What we know is in any system that has skill and luck combined, there's going to be a very powerful tendency toward reversion to the mean, especially if luck is a big component.
Do you think investors underestimate just how much luck is involved?
If you look at investing, especially for short periods of time, luck is a very large component. People have a very difficult time understanding the role of luck and hence start to make decisions based on randomness rather than the skill component.
So the admonishment to investors when they're looking for an active manager is to spend as much time as possible paying attention to that manager's skill, which means how they actually approach their job.
But as you note, it's hard to separate luck from skill.
Easy to say, difficult to do in practice. But that's another important lesson. Don't get duped by the randomness. And in investing, it's very difficult to not get duped.
Apart from giving good restaurants and money managers second chances, what is the essential lesson people should draw from Think Twice?
When you face certain types of situations, your mind is going to naturally pull you in one direction, when a better way to think about it is something different. So the first overarching theme is to prepare yourselves. Learn about these kinds of situations, recognize them in the context and then take some steps to try to mitigate those mistakes.
An example?
When we look to solve problems, almost all of us take what's called the inside view. We gather the information that's available to us. We impose our own views of things and then we project them going into the future. That's the natural way. This is how your mind wants to do things. This is not just investing. It could be things like remodelling your kitchen.
Another way of doing this is treating your problem as if it's part of a larger reference class and asking what happened statistically to that larger class, the so-called outside view. Almost always the outside view gives you an answer that's more pessimistic than the inside view.
What's an example in the investing world?
For many companies, we have lots of data, in the aggregate, on, for example, operating profit growth rates. We know what percentage of companies can grow at what rates.
For example, Amazon.com is a stock that we own. There's an analyst who ... suggested they could grow 25 per cent [annually]top-line for 10 years. They're obviously a fairly large company already.
So the question is: How many companies in history have gone from that size and grown at that rate? The answer is one. And it was called Wal-Mart. Is there a chance Amazon could do it? Sure. But when you look at the large group of companies that were in a position to do that, only one ever did.
You write that experts aren't good at predicting outcomes. Why is that?
I should be careful, because I like to say if you have a leaky toilet, hire a plumber. You hire an expert for certain tasks. And experts are very good at ruling out bad alternatives.
So I don't want to be completely dismissive. But the broader point is that, increasingly, computers are encroaching on that expert territory.
Alternatively, when facing complex problems with lots of possible outcomes, we find that crowds do better than the experts.
Given your focus on how to make better decisions, how are you approaching investing these days?
As an organization, we [Legg Mason]have tried to think about things probabilistically. In every case, we try to think about possible outcomes and attach probabilities to those. Clearly, we had a difficult period.
I think, in part, the lesson we're trying to draw from that is: Were we dynamic enough in thinking about the possibilities of something very bad happening?
You also recommend people do pre-mortems to test their investment ideas before plunging ahead.
It's really helpful. The power of it [examining all possible outcomes in advance]is you're not yet invested, you're not emotionally attached.
The confirmation bias is very powerful. Once people make a decision, they tend to seek confirming information and push away disconfirming information. But if you've not yet made the decision, you don't get yourself into that bias.
If you can identify 30-per-cent more things that could possibly go wrong, that's very helpful.
***
Michael Mauboussin
Titles: Chief investment strategist at Legg Mason Capital Management and adjunct
professor of finance at Columbia Business School in New York.
Education: BA in government from Georgetown University.
Career start: Packaged foods analyst at Credit Suisse in 1992.
Latest book: Think Twice:
Harnessing the Power of Counterintuition, Harvard
Business Press, 2009
Previous books: More Than You Know: Finding Financial Wisdom in Unconventional Places - updated and expanded,
Columbia Business School
Publishing, 2008; Expectations Investing:Reading Stock Prices for Better Returns, co-author,
Harvard Business School Press, 2001.