Despite our best intentions, we all make some really bad decisions; ordering up that extra large chili cheese fries, not refinancing when the rates were really, really low, telling Americans it was their patriotic duty to go on a spending spree, letting everyone believe the American Dream of owning a house was a God-given right, and – ok, ok I’ll stop, you get the point.
We’re human – and no matter how many degrees we have or how many years we have on the job, we make some pretty bone-headed – and COSTLY decisions.
In the new book, Think Twice: Harnessing the Power of Counterintuition author Michael Mauboussin shows us how the actual process for making good decisions – especially when the stakes are high – actually conflicts with how our minds naturally work, but you can now teach yourself how to make better decisions in life and in making investment ideas.
Guest Author Blog: What Can We Learn from Big Brown’s Big Bust? by Michael Mauboussin
June 7, 2008 was a steamy day in New York, but that didn’t stop fans from stuffing the seats at Belmont Park to see Big Brown’s bid for horseracing’s pinnacle, the Triple Crown. The undefeated colt had been impressive. He won the first leg of the Triple Crown, the Kentucky Derby, by 4 ¾ lengths and cruised to a 5 ¼-length win in the second leg, the Preakness.
Oozing with confidence, Big Brown’s trainer, Rick Dutrow, suggested that it was a “foregone conclusion” that his horse would take the prize. Dutrow was emboldened by the horse’s performance, demeanor, and even the good “karma” in the barn. Despite the fact that no horse had won the Triple Crown in over 30 years, the handicappers shared Dutrow’s enthusiasm, putting 3-to-10 odds—almost a 77 percent probability—on his winning.
The fans came out to see Big Brown make history. And make history he did—it just wasn’t what everyone expected. Big Brown was the first Triple Crown contender to finish dead last.
The story of Big Brown is a good example of a common mistake in decision making: psychologists call it using the “inside” instead of the “outside” view.
The inside view considers a problem by focusing on the specific task and by using information that is close at hand. It’s the natural way our minds work. The outside view, by contrast, asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.
Dutrow and others were bullish on Big Brown given what they had seen. But the outside view demands to know what happened to horses that had been in Big Brown’s position previously. It turns out that 11 of the 29 had succeeded in their Triple Crown bid in the prior 130 years, about a 40 percent success rate. But scratching the surface of the data revealed an important dichotomy. Before 1950, 8 of the 9 horses that had tried to win the Triple Crown did so. But since 1950, only 3 of 20 succeeded, a measly 15 percent success rate. Further, when compared to the other six recent Triple Crown aspirants, Big Brown was by far the slowest. A careful review of the outside view suggested that Big Brown’s odds were a lot longer than what the tote board suggested. A favorite to win the race? Yes. A better than three-in-four chance? Bad bet.
Markets are another realm where people rely too much on the inside view to anticipate the future. Let’s be clear: no one knows what the future holds. The evidence shows that experts are notoriously poor at forecasting the market or the economy. But the outside view can offer a perspective that runs counter to the prevailing wisdom.
Let’s look at three widely held views—inside views—where the outside view offers a different take.
The new normal suggests moderate GDP growth. There are a lot of reasons to believe that the recovery from the recent recession will be more muted than past recoveries, including a slack labor market, a retrenching U.S. consumer, and cautious corporate spending. This is the inside view. The outside view, on the other hand, suggests that the magnitude of the recovery is a function of the severity of the retrenchment. Michael Darda, an economist at MKM Partners, writes, “[T]he most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-39 period.” There is currently a yawning difference between consensus GDP forecasts for 2010 of about 2.5 percent and the 8 percent-plus growth that past recoveries suggest. Time will tell.
A retrenching U.S. consumer portends poor market returns.This one seems obvious. The U.S. consumer is over 70 percent of GDP, having spent excessively during the last expansion by piling on debt. As the U.S. consumer goes through a belt-tightening phase and ends up representing less of GDP, the market will struggle. The outside view offers a slightly more sanguine picture. There have been eight periods since the 1930s when the consumer share of GDP declined, and during five of those episodes (1932-37, 1949-51, 1958-60, 1960-67, 1982-84) the Dow Jones Industrial Average went up. Since market prices are based on expectations, the operative question is not where consumer spending will go, but where spending will go relative to what’s reflected in share prices.
Stocks for the long run no longer holds. Coming off a difficult decade for the returns of the S&P 500, pundits have cooled their outlook for future returns. This is consistent with the inside view: people have a strong tendency to extrapolate either good or bad performance into the future. For example, Robert Shiller, an economist at Yale University, maintains a Stock Market Crash Confidence Index, which is the percentage of respondents who believe the probability of a crash is low. So the higher the index, the lower the perceived probability of a crash. Since November 2007, the S&P 500 has declined by over 30 percent, while the Crash Index is down 24 percent. In other words, after the market has lost about one-third of its value, institutional investors deem the probability of a crash to be higher than before. The outside view provides more comfort. Following poor 10-year returns (besides the current period, other occasions were 1920, 1974, and 1978) the market has delivered above-average real returns in the subsequent decade.
Forecasting is an inherently difficult task.
When you consider the future, keep in mind the story of Big Brown. While the inside view will sound and feel persuasive, the outside view generally provides crucial perspective. Today, the inside view is painting a very cautious picture. Keep in mind a quote attributed to Arthur Pigou, the economist: “The error of optimism dies in the crisis, but in dying it gives birth to the error of pessimism. The new error is born not an infant, but a giant.”
Michael J. Mauboussin is chief investment strategist at Legg Mason Capital Management and is on the adjunct faculty at Columbia Business School.
His latest book, Think Twice: Harnessing the Power of Counterintuition, was recently released by Harvard Business Press.
You can read more at www.michaelmauboussin.com.
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