Let’s say you were offered a game where you picked one of two choices:
- A 95% chance to win ₹1,000,000 OR
- Certain offer of going home with ₹910,000
Classical economic theory suggests the value of #1 exceeds that of #2 by ₹40,000 (0.95 X 1,000,000 = 950,000) and therefore should be the choice of every “rational economic agent”. But it’s safe to say almost everyone offered this choice would pick the certain offer, #2. Could it be that we don’t like uncertainty and are willing to pay ₹90,000 to eliminate it?
Now consider a game with a different set of choices:
- Certain loss of ₹900,000 OR
- A 95% chance of losing ₹1,000,000
Here the individual faced with a certain loss versus the possibility (however low) of avoiding loss will take the gamble. #2 is the prevalent choice. What explains the “irrationality” in the choice of #2 in the 1st scenario and the inconsistency between the two scenarios?
Behavioral economics, an entire field of study, dedicated to identifying and studying these anomalies has collected a body of data that has time and again, showed that we have “systematic cognitive biases that greatly limit our intellectual capabilities”.
I recently came across an interesting paper titled “Humble Decision-Making Theory” – Amitai Etzioni, that outlines some of the most prevalent biases that plague our thinking. While the biases mentioned aren’t new, the overall prescription to adopt a more humble attitude while making key decisions resonates with the way of calm investing.
Since we are incapable of making truly “rational” decisions, we resort to using heuristics (simple procedures to help simplify difficult questions) – “I don’t know how well this auto company is doing financially, but the fact that I can recall so many of their cars on the road on the way here must mean they’re doing well”. “Humble Decision Making Theory” is therefore a method to counteract some of the likely biases that afflict us by adopting a more, you guessed it, humble approach to making key decisions, including those about investments. Here are some things humble decision makers do:
1. Treat all decisions as experiments
Assuming all our decisions are wrong and will have to be revised. This helps avoid what Daniel Kahneman calls “Theory induced blindness” where we feel so much of our pride and money invested in a decision, that we hold on to our rationale for having made a decision even when the original premise is falsified. Therefore, people avoid selling assets (stocks, real estate) that lose instead of rising, holding on to avoid having to realise a loss (loss aversion). This has been demonstrated time and again by the decline in volumes in bear markets compared to bull markets.
Treating the original decision as an experiment makes it easier to reverse it since it doesn’t reflect as poorly on the decision-maker. As new information comes available, one can revise and refine based on our experience. So your decision to buy a stock doesn’t have to anchor all your abilities and intelligence but can be treated as an experiment where you decided to invest into “a 2nd place consumer durables company when interest rates were expected to come down”
2. Keep substantial reserves in areas where you know the least
A review of 38 large government sponsored programs showed an average cost overrun of 186% indicating an inability to accurately estimate large programs. Less than 50% of small businesses are still operational after three years where owners underestimated not only the capital required but the timing of cash-flows as well. Decision-makers should therefore maintain a substantial reserve, especially in areas where they know the least. This lack of knowledge can also work the other way and leave us unprepared for opportunities that could come up.
So when markets are on a tear and you don’t know where they will be one week to the next, you’re better off parking your cash in a liquid fund and waiting for calmer times to deploy those funds.
3. Build in delays into your decision-making
This one seems counter-intuitive to the “he who hesitates is lost” believers. But our decision-making abilities are not static, but vary depending on time of day, when we had our last cup of sugary coffee, whether we just saw a picture on facebook a friend posted standing next to his spanking new Porsche Cayenne. As long as emotions play a role in distorting one’s judgment, decision-makers will benefit from setting up mechanisms and institutions that help them guard against being swayed unduly by emotions – at least by the wrong ones.
Sleeping over a decision to accept a job or buy that time-share is a good delay to normalize whatever emotions you’re feeling in the moment and to take a more balanced decision.
So, how does an investor adopt humble decision making?
Fortunately there exists a simple mechanism that encapsulates all the three points made by the paper; S.I.P, and that’s been covered here: ‘SIP, don’t guzzle investments‘
Reference: Humble Decision-Making Theory – Amitai Etzioni