In November I had the great fortune to participate in the Investment Decisions and Behavioural Finance course at the Harvard Kennedy School in Cambridge. It was an intense and exhilarating experience – an opportunity to have intimate discussions with esteemed members of what I call my “Behavioural Finance Dream Team.”
The criteria for membership on my Dream Team are stringent. One must be a leading thinker in the field with demonstrated contributions to both the professional and academic investment community. My bias is for those members with a practical bent – those who not only exchange ideas within the ivory tower of academia but also have a vested interest in translating those ideas into a professional practice.
In this latter category, the stand-out stars in attendance were Michael Mauboussin (Chief Investment Strategist, Legg Mason Capital Management), Andrew Lo (MIT Sloan School of Management), Max Bazerman (Harvard Business School) and Richard Zeckhauser (Harvard Kennedy School). I was also surprised and delighted to hear three renowned investment professionals offer their insights on behavioural finance, and thus have included them as new members to my Dream Team list: Jim Grant (Grant’s Interest Rate Observer), David Salem (Managing Partner and Chief Investment Officer for Windhorse Capital Management), and Larry Summers (President Emeritus, Harvard University).
If I had to distill the learning from the experience into one broad brushstroke, it would be the idea that it isn’t so much our ability that defines an outcome, rather it’s our choices. We all want to make better choices of course, especially as it relates to our investments. But the first step in that direction is to understand that the choices we make are very much a reflection of our beliefs and values, our cognitive biases, our peer groups, our past experiences and future expectations. Taken to the extreme, our unexamined choices are often distorted.
Thankfully we don’t need to worry about this too much because the stakes/consequences of many of the decisions we make on a daily basis (e.g., what to eat for lunch?) are so low. But when the stakes are high – and I would argue that the stakes are very high when making investment decisions – how can we undistort our decisions? What’s the Dream Team’s prescription for translating distorted decision-making into opportunities to make better decisions?
One solution is to train oneself to think about a range of outcomes and become better at estimating probabilities for each outcome. Let’s examine how this thinking would play out for an investor who plans to invest $1 million in the equity markets for 10 years. What’s the range of potential outcomes for this investor? Using history as a guide, the 10-year annualized returns for investors in the S&P 500 Index ranged from a high of 19.4% (1950s) to a low of -0.9% (2000s). The decades of the 80s and 90s provided double-digit returns, while the decades of the 40s, 60s and 70s provided mid-to-high-single-digit returns.
Given the range of possible outcomes, what’s the probable outcome for the equity investor over the next 10 years? Distorted decision-making would assign a high weighting or probability to either extreme – that is, to high double-digit returns or to negative returns. Undistorted decision-making would assign a higher probability to the long-term historical annualized average of 9.8%, which is based on returns earned by an investor in the S&P 500 Index over the 86-year period that data has been available, from 1926 to 2011.
When we train ourselves to consider two or three options – a best case scenario, a worst case scenario and a middle case scenario – we train ourselves to think about what’s possible, but also to focus on the probable. We make the choice to mitigate the effect that our beliefs, values, cognitive biases, peer groups and past experiences have on our decisions. This is Dream Team thinking in practice.