The Psychology Behind The Dumb Money Effect: Mauboussin

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Credit Suisse Global Financial Strategies analysts Michael J. Mauboussin and Dan Callahan shed light on how our minds confuse skill and luck in their work “Outcome Bias and the Interpreter” of October 15, 2013.


What is Outcome Bias?

People are guilty of outcome bias when they blindly ascribe a good outcome to a good decision and a bad outcome to a bad decision, regardless of the real quality of the decisions taken.

A football coach, faced with a split-second choice, may have made the correct decision given the circumstances, but the outcome could be unfavorable. A third person, not having all the information available to the coach, may unfairly blame the loss of the game on the coach’s ‘bad judgment.’ This is outcome bias at work, and it is chiefly caused by a portion of our brains called the ‘interpreter.’

The Psychology Behind The Dumb Money Effect: Mauboussin

The role of the ‘interpreter’

Mauboussin and Callahan cite research by neuroscientist Michael Gazzaniga for the discovery that each of us has a module in the left hemisphere of our brain called the ‘interpreter.’ This module is totally logical and seeks to continuously explain the subject’s current surroundings and situation, and importantly, may come to a defective conclusion that is made to fit the contours of incomplete information.  “The interpreter will come up with a correct story if it has the proper information. But it is willing to make up a story, imposing order on the world, even if it doesn’t have all of the proper information.”

The interpreter is very much at sea in a situation where outcomes are decided not logically, but happen randomly. Even rational persons acquainted with probability theory often fall prey to the machinations of the interpreter in their brains.

In one experiment, it was proved that qualified finance students, well-acquainted with randomness, were willing to pay to switch to their candidate of choice in a coin-tossing game, even though the outcome was known to be random.

Clearly, their ‘interpreters’ refused to accept ‘randomness’ and instead conflated coin-calling ‘ability’ and coin-calling ‘luck’ of the candidates.

In finance it’s called the ‘dumb money effect’

The authors draw a parallel to the above phenomenon in the world of finance. We are aware that investors tend to switch their under-performing investments to those that are top performers. This is known as the ‘dumb money effect’ and is born out of the same misconception suffered by the subjects in the coin-calling experiment above.

How to control outcome bias

The authors suggest that every situation should be assessed for the amount of randomness that contributes to its outcome – the more ‘random’ it is, the more you need to watch your interpreter.  Secondly, where luck plays an important role, you need to watch your decisions for outcome bias.

The full PDF can be found here.

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