Human Foibles and Investment Decision Making
Driven by animal spirits
In this post I want to compare quantitative approaches to investing with the use of intuition. We can think of quantitative as focused on the use of numbers. It ranges from the use of simple metrics like price earnings ratios and price to book ratios to the use of mathematical models including statistical probability models. Intuitive thinking includes intuitions learned through study and experience.
It’s all about probabilities
At first blush, quantitative would seem to fit with Warren Buffett’s thinking expressed at the Berkshire Hathaway Annual Meeting in 1989: “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.” In fact, he is essentially talking about intuited probabilities not mathematically calculated ones. Let’s look at the difference.
When we are talking about probabilities in cards or on the roll of dice, statistical probabilities based on math work very well. The problem in investing is that, for the most part, statistical probabilities can’t be used without making a lot of intuition based assumptions. Some quantitative investors try but they are really fooling themselves. Let’s see why.
The first behavioural economist and investor
Writing in the introduction to the 2007 edition of Keynes’ The General Theory, Paul Krugman, who won the Nobel Prize in economics in 2008, wrote: “[Maynard] Keynes was a shrewd observer of economic irrationality, a behavioral economist before his time, who had a lot to say about economic dynamics.” (Keynes, The General Theory of Employment, Interest and Money 1936,2007) p.xxxiv. (emphasis added)
Keynes was also an extremely successful investor, both in his personal investments but also on behalf of others. The level of his success in suggested by the investment performance of the Kings College Cambridge investment fund he managed. During the years from 1927 to 1946 the Chest grew at an annual compounding rate of 9.1 per cent while the general British stock market fell at an annual compounding rate of slightly under 1 per cent. (maynardkeynes.org)
Keynes tells us: “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” (Keynes, 1936,2007)p.161. (emphasis added)
Keynes goes on: “We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.” (Keynes, 1936,2007) p.163 (emphasis added)
Interestingly, Keynes was trained as a mathematician at Cambridge before he became an economist.
Bernstein references Keynes views written in 1937: “By ‘uncertain’ knowledge… I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty… the sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention…About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know!” (Bernstein, Against The Gods – The Remarkable Story of Risk 1996) p.229. (emphasis added)
Intuitive rather than analytical
George Akerlof is a Professor of Economics at the University of California in Berkley. He won a Nobel Prize in 2001. In 2009 he co-authored with Robert Shiller, who won a Nobel Prize in 2013, a book titled Animal Spirits. In the book Akerlof and Shiller write: “Theoretical economists have been struggling ever since to make sense of how people handle such true uncertainty. As time goes by, their efforts seem to be converging more and more on behavioral economics. Jack Welch’s phrase “straight from the gut” sums it up: decisions that matter for investment are intuitive rather than analytical. That intuition is a social process that follows the laws of psychology – and in particular, since group decisions are being made, social psychology.” (Akerlof & Shiller, Animal Spirits 2009) p.144.
Using intuitions and mental short cuts can put investors on slippery ground
Investors will often consult their intuitions when buying a stock. We love Apple (AAPL) products. We think it must be a good stock. We think the price must be ok since we (mistakenly) believe prices on the stock market are about right. We make a decision ‘straight from the gut’. We go ahead and buy and could be making a big mistake. I use Apple as a case in point because I don’t own Apple stock and never have.
Buying a stock because you like the product is a classic problem of a behavioral bias at play. See my post: The worst behavioral bias – jumping to conclusions
The problem in going ‘straight from the gut’ is that we have no information on the business prospects for the company, none for the financial performance of the company, no information on the financial strength of the company, and no information on the intrinsic value of the company stock. So, at the very least, we have to look at a quantitative analysis. Here’s where things get tricky.
The best quantitative input on intrinsic value that investors can obtain is a discounted cash flow analysis (DCF). The reality is that opinions of fair value based on DCF calculations are necessarily inexact (rightly vague?). But, at least they at least ask the right question. But, there are many uncertainties in the inputs and many uncertainties in the assumptions. The issues in this regard are brought out in my post: The dangers and benefits of using Discounted Cash Flow analysis reports
Back to loving Apple stock
It seems clear to me that the most sophisticated quantitative stock analysis can only be based on what might be called learned business intuitions.
Let’s look at one input in an assessment of AAPL. A critical input to a DCF is the strength of the company’s business franchise.
Morningstar, one of the world’s leading independent investment research agencies says in a report: “Apple’s competitive advantage stems from its ability to package hardware, software, services, and third-party applications into sleek, intuitive, and appealing devices. This expertise enables the firm to capture a premium on its hardware, unlike most of its peers.”
This assessment is one of the keys that enables Morningstar to carry out a DCF valuation to assess the fair value of AAPL. It articulates one of the assumption behind its valuation of the stock. It’s pretty obvious that this assumption falls into the category of uncertain knowledge that is based on learned business intuitions. A DCF analysis is also necessarily based on a good number of other intuited assumptions.
I think it highly likely that there are assumptions based on intuitions at the heart of every quantitative stock analysis and strategy.
By the way, we view ourselves as business analysts
Morningstar’s analysis of AAPL’s competitive advantage is simply a business analysis. It is a vitally important step in doing due diligence before buying a stock.
Warren Buffett says that his attitude when buying common stock is to “approach the transaction as if we were buying into a private business…..When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p.63 Learned business intuitions have to be central to any business analysis.
I started this post talking about intuited probabilities. We noted Keynes’ belief that for most investment decisions we calculate where we can but most often have to fall back on learned intuitions. These learned intuitions can cover anything from the strength of a company’s business franchise to intuited probabilities of the company failing to thrive. The main takeaway is that even the most sophisticated business or investment analyses are based on uncertain knowledge. Uncertain knowledge in this situation is essentially learned intuition based on investing and business experience.
Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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