Why does systematic decision making, using even uncomplicated 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 behavioral tendencies, which are embedded in our thinking.
Research reveals the human mind is very capable of consistently misjudging the world.
We are prone to over-or-under-estimating, being overconfident in our analysis while doubting data contrary to our opinions, and using perceptions to create or fill-up what doesn't exist. Psychologically, our opinions are filtered through our natural biases.
This is not always a bad thing, e.g., in everyday mundane decision-making or when it's a question of survival. But the biases may create a tougher situation for sound decision making when such decisions involve investing, money, time constraints, and emotion.
Charlie Munger, Vice Chairman of Berkshire Hathway and long-term investment partner of Warren Buffett, refers to these emotions, multiple biases and tendencies acting at the same time in the same direction guiding us towards an irrational action as the "Lollapalooza effect." In his book, Poor Charlie's Almanack, Munger talks about a number of cognitive biases that we should be aware of in order to make better investment and business decisions.
Many of us may have already witnessed these irrational tendencies in our own investments.
How many times are we so sure about a stock that we 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 we need to walk away, but stay-on and make just one more trade because we feel very confident that this one will make up for all the rest that have been going wrong?
How many times we have a gut-feel that this is an absolute bottom in the stock and we can’t go wrong buying it here or averaging-down?
Most of the time, the “gut-feel” investing decision eventually leaves one poorer and feeling exhausted, disappointed, stressed, and frustrated.
I know these feelings, for I too have experienced them.
Computer algorithms simply don't feel that way.
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. So the experts when given the same model's output end up modifying it, and making the results poorer. Something as mundane as a rough commute or a missed train can affect the way we perceive things. 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.
In October 2017, Richard Thaler, a behavioral economist from the University of Chicago, won the Nobel Prize for his work on exploring the biases that affect how people absorb information and arrive at decisions. In other words, how people are not rational as is often assumed in econometric models, but instead have mental quirks or biases, limited self-control and rationality, and social preferences that lead them towards irrational behavior, and shape market outcomes. He was not the first behavioral economist to receive the coveted Nobel Prize for work in the field of behavioral impact on decision-making. Other Nobel Prize winners were Daniel Kahneman and Vernon Smith in 2002, and Robert Shiller in 2013.
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: