“The behavioral issue of overconfidence comes into play here. Research suggests that people are too confident in their own abilities and predictions. As a result, they tend to project outcome ranges that are too narrow. Numerous crash-and-burn hedge fund stories boil down to committing too much capital to an investment that the manager overconfidently assessed. When allocating capital, portfolio managers need to consider that unexpected events do occur.”
“…we often believe more information provides a clearer picture of the future and improves our decision making. But in reality, additional information often only confuses the decision-making process. Researchers illustrated this point with a study of horse-race handicappers. They first asked the handicappers to make race predictions with five pieces of information. The researchers then asked the handicappers to make the same predictions with ten, twenty, and forty pieces of information for each horse in the race…even though the handicappers gained little accuracy by using the additional information, their confidence in their predictive ability rose with the supplementary data.”
Too much incremental information can lead to a false sense of comfort, overconfidence bias, and too narrow outcome ranges.
Given our psychological propensity for overconfidence and too narrow outcome predictions, does this mean portfolio sizing decisions should be based not only on what we know, but also on what we don’t know? As if investing wasn’t hard enough already…
Psychology, Expected Return
“Probabilities alone are insufficient when payoffs are skewed…another concept from behavioral finance: loss aversion. For good evolutionary reasons, humans are averse to loss when they make choices between risky outcomes. More specifically, a loss has about two and a half times the impact of a gain of the same size. So we like to be right and hence often seek high-probability events. A focus on probability is sound when outcomes are symmetrical, but completely inappropriate when payoffs are skewed…So some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.”
Certainty and being “right,” does not always equate to profits. Paraphrasing the great Stan Druckenmiller, being right or wrong doesn’t matter, it’s how much you make when you’re right and how much you lose when you’re wrong that ultimately matters in investing.
Team Management, Psychology
“…the way decisions are evaluated affects the way decisions are made.”
“One of my former students, a very successful hedge fund manager, called to tell me that he is abolishing the use of target prices in his firm for two reasons. First, he wants all of the analysts to express their opinions in expected value terms, an exercise that compels discussion about payoffs and probabilities. Entertaining various outcomes also mitigates the risk of excessive focus on a particular scenario -- a behavioral pitfall called “anchoring.”
Second, expected-value thinking provides the analysts with psychological cover when they are wrong. Say you’re an analyst who recommends purchase of a stock with a target price above today’s price. You’re likely to succumb to the confirmation trap, where you will seek confirming evidence and dismiss or discount disconfirming evidence.
If, in contrast, your recommendation is based on an expected-value analysis, it will include a downside scenario with an associated probability. You will go into the investment knowing that the outcome will be unfavorable some percentage of the time. This prior acknowledgement, if shared by the organization, allows analysts to be wrong periodically without the stigma of failure.”
“The only certainty is that there is no certainty. This principle is especially true for the investment industry, which deals largely with uncertainty…With both uncertainty and risk, outcomes are unknown. But with uncertainty, the underlying distribution of outcomes is undefined, while with risk we know what that distribution looks like. Corporate undulation is uncertain; roulette is risky…"
How interesting, some people associated risk with uncertainty, but Mauboussin highlights an interesting nuance between the two.