HOW WE MAKE DECISIONS

"Everyone is entitled to his own opinion, but not to his own facts." - Senator Daniel Moynihan

Intuition is extremely important for survival. It gets us through the day. It allows us to make hundreds of routine decisions quickly and efficiently. Without intuition, we would not get very much accomplished. But for some decisions, and especially investment decisions, relying too much on intuition is dangerous.

For example, when Facebook did their IPO last year, it was intuitively obvious to millions of investors that it was an opportunity to buy shares of a fast-growing company that was the dominant force in social media, and therefore had a great future. But we now know that anyone who purchased Facebook shares that first day got hammered. What happened?

The Facebook deal was a classic case of mass over-reliance on intuition. Investors understandably assumed that a company as famous and dominant as Facebook would be a great investment. That assumption was intuitive, because Facebook has no serious competition in the business they dominate. 

But there was a second question that investors should have considered. Was the stock being offered at a fair and reasonable price? This question required analysis, not intuition. Analysis is hard. It involves research, and research isn’t much fun. 

But it wouldn’t have taken much effort to discover that there were some very loud voices in the investment media who were warning investors about the stock being way, way overpriced. Investors who “went with their gut” and bought Facebook shares the day they came out got burned. Investors who went to the trouble to check their intuition and look beyond the hype were rewarded by being able to buy Facebook shares at a much lower price just a few week later.

Here are some other ways our over-reliance on intuition can hurt us:

• Intuition can lead us astray when we move outside our area of expertise.
• Our intuitions are susceptible to cognitive and emotional biases.
• Media hype often obscures our ability to think rationally.
• Our mental models may be outdated, especially regarding cause and effect relationships.
• We fail to question our deeply ingrained beliefs, assumptions, and rules of thumb.

The best decision makers are good at combining intuition and analysis. Here are some of the steps you can take to improve your decision-making process.

• Stop for a moment and think about the assumptions you are making.
• Use common sense to test those assumptions (do they pass the “smell” test?)
• Use analysis to check your intuition, not simply to justify decisions you've already made.
• Use analysis to explore and evaluate intuitive doubts that emerge as you prepare to make a
decision. 
• Use the intuition of outside experts to confirm or disconfirm the validity of your analysis.
• Use rules and procedures to guide you, but don't try to replace intuition with them.

We all use mental shortcuts, called heuristics, to help move us through a complex world quickly and efficiently. But when it comes to making investment decisions, heuristics can be quite harmful.

We are hard-wired to look for patterns everywhere, and especially when we are making investment decisions.

We seek patterns because we believe in a coherent world, where events happen with predictable regularity.

We are uncomfortable with randomness because it feels chaotic, so we often assume cause-and-effect relationships between events when none exist.

In a casino, there are three kinds of gamblers: amateurs, professionals, and the “house.” Most gamblers are amateurs – weekend warriors who are out for a good time and ready to lose their stake because they know from experience that the odds of winning are slim. 

According to a 2006 report from The National Gambling Impact Study Commission: 

“86 percent of Americans report having gambled at least once during their lives. Approximately one third of the population consists of non-bettors (have not gambled in the past 12 months). About 46 percent of legal-aged adults gamble in casinos: seven in 10 also gamble in other formats.”

Approximately 5% of casino gamblers are professionals – serious, highly skilled, and disciplined. They expect to win because experience has taught them that if they stay focused and follow their plan, they will win more often than lose. 

And finally, there is the “house.” This group of gamblers consists of the casino owners, the floor managers, the pit bosses and the table dealers who control the games. They not only expect to win; they are virtually guaranteed to win over the long term, because the odds are stacked in the house’s favor.

Could the way that we frame a decision have an impact on the quality of the decision? Does the way we frame a problem cause us to narrow the range of alternatives that we will consider? 

A frame is simply the context that we use when we make decisions. When our frames are too narrow, they limit our choices and cause us to miss out on opportunities to make a better decision. The classic example of this is “binary thinking” or either/or decision-making. For example, let’s say you own a stock that announced some bad news, which caused the price to drop by 10% very quickly. A narrow decision frame would be “should I sell it or not sell it?” This either/or frame limits you to just two choices, but there is a third choice that you are neglecting. Why not consider buying more at the lower price to bring down your average cost? This alternative will require some research on your part, but if it turns out that the market has over-reacted to news that isn’t really that bad, you might have an opportunity to make a larger profit on this stock. 

Sometimes the frames we use are wrong, or outdated, and we should get into the habit of challenging them. For example, if we frame a decision in terms of what we stand to gain, we act differently than if we frame the exact same decision in terms of what we might lose. A good decision process will consider both sides of the gain/loss proposition, and also the option of doing nothing. The more options you have on the table, the better your chances of making a sound decision.

As investors, it’s in our interest to frame (or re-frame) risk and uncertainty in terms of opportunities instead of threats. We should always make an effort to recognize our underlying assumptions, and then consciously challenge them. We should think about the reference points and yardsticks we’re using, and ask ourselves if they are the most relevant to the issue at hand.

Not only are losses inevitable, they are an integral part of the investing process. Losses are our teachers. They force us to think about how to adapt and become better investors.

Do you usually choose the simple way of doing things, or do you prefer to drill down and find the best way, even though it takes much more of your time and energy?

Occam's Razor is a decision and problem-solving strategy that is widely used in the scientific community, and with great results. In this lesson I show how to apply Occam's Razor to the investing realm.