Michael Mauboussin: What Have You Learned In The Past 2 Seconds?

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

Michael Mauboussin: What Have You Learned In The Past 2 Seconds? – Introduction

“Is it not reasonable to anticipate that our understanding of the human mind would be aided greatly by knowing the purpose for which it was designed?” George C. Williams

Have you ever had a bad day at work? The stocks you like are all down; you feel as though it is nearly impossible to beat the market; and you are frustrated by the stock market’s inability to grasp the key insights you see so easily. In short, you feel as though you were not cut out to understand the investment business.

Well, here is some good news and some bad news. The bad news is that you are not, in most probability, well designed to be a successful investor. The good news is that you share this lot with most every one else. The reason is simple: the mind is better suited for “hunting and gathering” than it is for understanding Bayesian analysis.

Michael Mauboussin: Darwin and Alphas

Charles Darwin formalized a theory that would change the way scientists understand the world. The underlying premise upon which Darwin’s theory builds is that there is a constant struggle among organisms to survive.1 Darwin documented two critical points. First, given competition, any advantages enjoyed by an individual would bias the pool of offspring (“survival of the fittest”). These characteristics are not a question of “better” or “worse” but “more suitable” versus “less suitable.” Second, biases created by small advantages would become amplified over long periods of time.2 The hard-to-appreciate point is that evolution is an excruciatingly slow process— measured in tens or hundreds of thousands of years, not in decades.

Most people feel comfortable with the notion that human motor skills – basic dexterity – are not very different from what they were 10,000 years ago. However, many people have a harder time accepting that our cognitive makeup – including our emotions, rationality, and decision making skills— has also remained basically unchanged over the centuries. As Daniel Goleman wrote in his best-selling book, Emotional Intelligence:

“In terms of the biological design for the basic neural circuitry of emotion, what we are born with is what worked best for the last 50,000 human generations, not the last 500 generations…The slow, deliberate forces of evolution that have shaped our emotions have done their work over the course of a million years; the last 10,000 years…have left little imprint on our templates for emotional life.”

The rapid rate of change in human society over the past 200-300 years – including the introduction of organized capital markets – has been unprecedented. If it takes tens of thousands of years, from an evolutionary standpoint, for us to “catch up” with our environment, it is fair to say that humans have no mental basis, or context, to understand how to invest in capital markets “rationally.”

Table 1 underscores this point. The table represents a time line, with the identification of the first Homo sapiens as a starting point, chronicling the approximate time when various events occurred. Further, the time line was scaled to equal one day, to provide perspective. Homo sapiens came into existence (roughly) 2 million years ago, which is noted as the stroke of midnight. Mitochondrial Eve – the common female ancestor among all living humans (apologies to any creationists) – lived about 180,000 years ago, or at about 9:50 PM. Modern finance theory, the framework to which investors are supposed to adhere, was formalized about 40 years ago, at 11:59:58 PM. It is now midnight. What have you learned in the past 2 seconds?

Michael Mauboussin Homo Sapiens

The point is clear: humans are not hard wired to rationally weigh risk and reward. We are still better suited to run like hell when we see a saber-toothed tiger than to consider potential returns of intangible assets. The simple awareness of this cognitive mismatch can help investors avoid some decision-making errors. In fact, many successful portfolio managers – those who deliver positive alphas – are often more noteworthy for what they don’t do than what they do.

Michael Mauboussin: Emotional Baggage

We owe much to our ancestors; the fact that they successfully propagated is why we exist. But they have also handed down a lot of cognitive baggage, which we have to carry around. Importantly, these hard-wired, mental shortcomings are precisely what make successful investing such a challenge. Major cerebral foibles include the following:

  • Desire to be part of the crowd. Humans have a strong desire to be part of a group: the group offers safety, confirmation and simplifies decision-making. Further, if something should go wrong, it is more comforting to be with others than to be alone – the old saying “misery loves company” rings true. However, the successful investor must be willing to separate from the crowd – to be a contrarian – even as there is a strong emotional urge to stay with the group. John Maynard Keynes addressed the power of being part of the majority, considering selfperception as well as the perception of others, almost 50 years ago. He wrote, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
  • Overconfidence. Most people are overconfident in the their own judgment and competence. Once again, we thank and curse our forebears. Their hardihood in the face of danger and travails are why we are here today, but our inherited boldness drives us to make mental mistakes daily. To illustrate the point, Table 2 shows the results of a widely-used overconfidence test. Professionals are presented with 10 requests for information that they are unlikely to know (e.g., Total area in square miles of Lake Michigan), and are asked to respond to each request with both an answer and a “confidence range” – high and low boundaries within which they are, say, 90% sure the true number lies. On average, respondents pick satisfactory ranges only 40-60% of the time.

Michael Mauboussin Overconfidence Across Industries

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