Why does systematic decision making through the use of even uncomplicated and limited variable quant models comes out ahead of expert opinions, which are nothing else but discretionary decisions made by experts?
The answer lies within us. Our emotional makeup or the behavioral tendencies, which are embedded in our thinking.
I would say that the human mind generally is very capable of consistently misjudging the world around us.
We are prone to over-or-under-estimating; being overconfident in our analysis while doubting data contrary to our opinions, using perceptions to create or fill-up what doesn't exist. Psychologically, our opinions are filtered through our biases.
It’s natural for humans to be illogical. It’s in our genes, and the problem is exacerbated when the decisions involve investing, money, emotion, and time constraints.
And we've witnessed these tendencies in our own investments.
How many times are we so sure about a stock, and continue to hold it even though there may be ample signs that the sentiment and story may have changed?
We convince ourselves to hold-on, even though an objective analysis would determine otherwise.
How many times you need to walk away, but you stay-on and make just one more trade because you feel very confident that this one will make up for all the rest that have been going wrong?
How many times you have a gut-feel that this is an absolute bottom in the stock and I can’t go wrong buying it here or averaging-down?
Most of the time, the “gut-feel” decision eventually leaves you poorer and feeling exhausted, disappointed, stressed, and frustrated.
I know these feelings, for I too have experienced them.
A legitimate question is why do experts perform poorly even when they’re given the model’s output before making their decisions?
Once again it’s our propensity to overestimate our abilities, and the feeling that we possess special insight that can allow us to enhance the model’s decision. Something as mundane as a rough commute or a missed train can affect the way you perceive things once you arrive at the trading desk. Furthermore, the decision-making can be inconsistent from person-to-person, even when they look at the same data. All these factors reduce our “enhanced” performance compared to diligently following a cold, emotionless, analytical, quantitative model.
Drawing on decades of research in psychology that resulted in a Nobel Prize in Economic Sciences, Daniel Kahneman, who was inspired by Meehl’s work, notes in his book, Thinking, Fast and Slow: