May 2023
IN THIS ISSUE
The Debt Ceiling is really stupid
“Never bet against America”
Confidence, Uncertainty, and Pigeons
I named this firm Likely Capital Management to emphasize my reliance on probabilistic thinking in an investment management industry flush with overconfident “experts” offering certitudes. Projecting (false) confidence sells, but - unfortunately for investors - also underperforms.
The work of accurately assigning probabilities and measuring confidence within highly uncertain markets is where managers can add value. To do this, one must understand the relationship between confidence, probability, and how to appropriately update one’s subjective probabilities when presented with new information.
I love Robert Rubin’s quote:
“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”
My only modification is to correct his misspelling of “Likelyhood”.
Anyway, back in March Michael Mauboussin and Dan Callahan of Morgan Stanley put out this research note Confidence: Methods to Assess Confidence Under Uncertainty and make an important observation that additional data in the absence of a reliable process can cause increased overconfidence rather than increased accuracy:
Experiments have shown a noteworthy link between accessing additional information and confidence. Researchers measured the accuracy and confidence of participants making bets on college football games. Accuracy is the proportion of correct predictions, and confidence is the subjective probability of being correct. A participant is well calibrated when his or her subjective probabilities match the outcomes. When subjective probabilities are higher than the outcomes, the participant is overconfident. When subjective probabilities are lower than the outcomes, the participant is underconfident.
As participants gained access to more information about the teams playing, their accuracy remained flat, but their confidence increased. This means that the gap between subjective probability and the results widened. Additional data made the participants overconfident rather than smarter.
Nassim Taleb makes the same point in The Black Swan:
“Finally, in another telling experiment, the psychologist Paul Slovic asked bookmakers to select from eighty-eight variables in past horse races those that they found useful in computing the odds. These variables included all manner of statistical information about past performances. The bookmakers were given the ten most useful variables, then asked to predict the outcome of races. Then they were given ten more and asked to predict again. The increase in the information set did not lead to an increase in their accuracy; their confidence in their choices, on the other hand, went up markedly. Information proved to be toxic. I’ve struggled much of my life with the common middlebrow belief that “more is better”—more is sometimes, but not always, better. This toxicity of knowledge will show in our investigation of the so-called expert.”
If additional information increases your confidence in your thesis but not your accuracy, you are Likely to mistake noise for signal, and the overconfidence bias is poised to sabotage your decision-making process.
Everyone knows the oft-cited survey that over 80% of respondents self-evaluated themselves as above-average drivers - which by definition must be 50%. Well, when James Montier surveyed about 300 fund managers, 74% thought themselves to be above average managers. Overconfidence is the norm, not the exception.
One (of many) causes of investment underperformance is the difficulty in admitting one was wrong, or at least recognizing when new information changes one’s prior assessment, and then selling a position at a loss. Effective fund managers must possess this discipline - particularly because markets are uncertain systems and being wrong is inevitable.
To develop this discipline, and avoid the overconfidence that so often suppresses that discipline, it helps to be aware of some of its root causes. The availability of noisy information, the weight one puts on that information, and the number of decisions one makes all play into overconfidence and making it more difficult to change our minds. In The Black Swan, Taleb writes:
“Show two groups of people a blurry image of a fire hydrant, blurry enough for them not to recognize what it is. For one group, increase the resolution slowly, in ten steps. For the second, do it faster, in five steps. Stop at a point where both groups have been presented an identical image and ask each of them to identify what they see. The members of the group that saw fewer intermediate steps are likely to recognize the hydrant much faster. Moral? The more information you give someone, the more hypotheses they will formulate along the way, and the worse off they will be. They see more random noise and mistake it for information. The problem is that our ideas are sticky: once we produce a theory, we are not likely to change our minds—so those who delay developing their theories are better off. When you develop your opinions on the basis of weak evidence, you will have difficulty interpreting subsequent information that contradicts these opinions, even if this new information is obviously more accurate. Two mechanisms are at play here: the confirmation bias that we saw in Chapter 5, and belief perseverance, the tendency not to reverse opinions you already have. Remember that we treat ideas like possessions, and it will be hard for us to part with them.”
I have written previously about Errors of Omission versus Errors of Commission. Making a decision brings a special attachment to our decision that makes us resist changing our mind later. We want to see ourselves as above average, as successful, as correct, and changing our mind is an active step (Commission) of admitting we were wrong. Having the discipline to objectively and reliably evaluate sound evidence, then adjust our positions appropriately, is rare but essential in this investment management business.
Which brings me to pigeons.
In January Annie Duke wrote Beaten By Pigeons? - The Monty Hall Problem and why calling someone a bird brain may be a compliment:
In the Monty Hall Problem, sticking with the door you already picked is sticking with the status quo, an omission. Switching is an active choice. Like pulling the lever in the Trolley problem. And a bad outcome from switching doors (pulling the lever) is felt much more keenly so humans stick with their door to avoid that regret.
This is where pigeons have it all over humans because pigeons aren’t stuck with the fear of the regret if they switch doors and it turns out the reward was behind their original door.
…
Pigeons can’t think far enough into the future to imagine the car they almost had if they just didn’t switch to the new door. Pigeons are more purely frequentists, not plagued in the same way by these biases or by fear of regret.
So maybe calling a person “bird-brained” is actually insulting to birds rather than the other way around.
I’m with the pigeons.
ONE MORE THING…
The Debt Ceiling is really stupid. Just ask Warren Buffett: The Debt Ceiling Argument Is Really Stupid.
“Never bet against America”. Ask Warren Buffett, but don’t ask Carl Icahn: Carl Icahn bet on America to fail. Instead he lost $9 billion.
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