投资者的决策制定

Professor Shyam Sunder October 15, 2008

Decision Making for Investors

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

Agenda

1. Practices of the best  Process versus outcome  Odds in your favor  Understanding the role of time

2. Expected value  Probabilities  Outcomes

3. Why we are suboptimal  Pitfalls and the results  How we can benefit

The “T” Theory

 The best in all probabilistic fields  Focus on process versus outcome  Always try to have the odds in their favor  Understand the role of time

 The best have more in common with one another than they do with the average participant in their field

Process Versus Outcome

 In any probabilistic situation, you must develop a disciplined and economic process  You must recognize that even an excellent process will yield bad results some of the time  The investment community—largely reflecting incentives—now seems too focused on outcomes and not enough on process

Process Versus Outcome

Outcome Good Good Deserved Success Process Used to Make the Decision Bad Dumb Luck

Try not to confuse outcomes and process

Source: J. Edward Russo and Paul J.H. Schoemaker, Winning Decisions (New York: Doubleday, 2002), 5. 5 Bad Bad Break Poetic Justice

Decision Making for Investors

Process Versus Outcome

Any time you make a bet with the best of it, where the odds are in your favor, you have earned something on that bet, whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.

David Sklansky, The Theory of Poker, 4th ed. (Henderson, NV: Two Plus Two Publishing, 1999), 10.

www.expertpokeradvice.com

Process Versus Outcome

Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Robert Rubin, Harvard Commencement Address, 2001.

http://www.treasury.gov/press/releases/images/pr4262ls.jpg

Odds In Your Favor

 Asset prices reflect a set of expectations  Investors must understand those expectations  Expectations are analogous to the odds—and the goal of the process is finding mispricings  Perhaps the single greatest error in the investment business is a failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the price

Odds In Your Favor

The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory . . . This may sound elementary, and many players may think that they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.

Steven Crist, “Crist on Value,” in Beyer, et al., Bet with the Best http://www.thoughtleaderforum.com (New York: Daily Racing Form Press, 2001), 64.

Odds In Your Favor

I defined variant perception as holding a well-founded view that was meaningfully different from the market consensus . . .

Understanding market expectation was at least as important as, and often different from, the fundamental knowledge.

Michael Steinhardt, No Bull: My Life in and Out of Markets (New York: John Wiley & Sons, 2001), 129.

http://www.bloomberg.com/apps/news?pid=20601093&refer=home&sid=aXv9RI2Ful7w

The Role Of Time

 Because investing is about probabilities, the short-term does not distinguish between good and poor processes  A quality process has a long-term focus  The investment community’s short-term focus is costly, and undermines a quality long-term process

The Role Of Time

Over a long season the luck evens out, and skill shines through. But in a series of three out of five, or even four out of seven, anything can happen. In a five-game series, the worst team in baseball will beat the best about 15 percent of the time. Baseball science may still give a team a slight edge, but that edge is overwhelmed by chance.

Michael Lewis, Moneyball: The Art of Winning an Unfair Game (New York: W.W. Norton & Company, 2003), 274.

http://www.nytimes.com/2006/10/05/books/05masl.html

The Role Of Time

The result of one particular game doesn’t mean a damn thing, and that’s why one of my mantras has always been “Decisions, not results.” Do the right thing enough times and the results will take care of themselves in the long run.

Amarillo Slim, Amarillo Slim in a World of Fat People (New York: Harper Collins, 2003), 101.

The Role Of Time Time arbitrage

100 100 20 Trials 100 Trials 90 90 80 80

Percentage of Heads Percentage of Heads

Number of Trials Number of Trials

Source: Michael J. Mauboussin, “Capital Ideas Revisited Part II,” Mauboussin on Strategy, Legg Mason Capital Management, May 20, 2005.

From Theory To Practice

 Principles of expected value  How do you set probabilities?

 How do you consider outcomes?

Expected Value

Expected value is the weighted average value for a distribution of possible outcomes

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.

Warren E. Buffett Berkshire Hathaway Annual Meeting, 1989. http://blogs.abcnews.com/theblotter/2006/06/lunch_with_warr.html

Expected Value

Risk versus uncertainty Risk – we don’t know the outcome, but we know what the underlying distribution looks like  incorporates the element of loss/harm

Uncertainty – we don’t know the outcome, and we don’t know what the underlying distribution looks like  need not incorporate loss/harm Source: http://www.lib.utk.edu/outreach/about/hall_fame/knight.html

Source: Frank H. Knight, Risk, Uncertainty, and Profit (Boston: Houghton and Mifflin, 1921).

How To Think About Probabilities

Three ways to set probability

1. Degrees of belief  Subjective probabilities  Satisfy probability laws

2. Propensity  Reflect properties of object or system  Roll of a die: one-in-six probability

3. Frequencies  Large sample of appropriate reference class  Finance community largely in this camp

Source: Gerd Gigerenzer, Calculated Risks (New York: Simon & Schuster, 2002), 26-28.

How To Think About Probabilities

Beware of nonstationarity For past averages to be meaningful, the data being averaged must be drawn from the same population. If this is not the case—if the data come from populations that are different—the data are said to be nonstationary. When data are nonstationary, projecting past averages typically produces nonsensical results.

Bradford Cornell, The Equity Risk Premium (New York: John Wiley & Sons, 1999), 45-46.

Multiples are probably nonstationary http://www.hss.caltech.edu/~bcornell/RESEARCH.htm

How To Think About Outcomes

Frequency Distribution of S&P 500 Daily Returns Frequency Difference: Normal Versus Actual Daily Returns January 1978 – December 2007 January 1978 – December 2007

300 100

80 250

Source: FactSet.

Frequency Versus Magnitude Frequency (probability) and magnitude (outcome) both matter

Good probability, bad expected value

Bad probability, good expected value

Why We Are Suboptimal

Behavioral finance pitfall Result

Overconfidence Outcome range too narrow

Anchoring and adjustment Anchor on past event or trend

Framing effect Sell winners and hold losers

Confirmation trap Seek confirming information and dismiss or discount disconfirming information

The Power of the Situation

Brain-Damaged Patients

Source: Michael J. Mauboussin, “Aver and Aversion,” Mauboussin on Strategy, Legg Mason Capital Management, August 9, 2005; Baba Shiv, George Loewenstein, Antoine Bechara, Hanna Damasio, and Antonio R. Damasio, “Investment Behavior and the Negative Side of Emotion,” Psychological Science, Volume 16, Number 6, 435-439.

The Power of the Situation

The Lucifer Effect

Source: www.prisonexp.org. Used by permission.

The Power of the Situation

Tom Arnold, John H. Earl, Jr., and David S. North, “Are Cover Stories Effective Contrarian Source: http://sds.hss.cmu.edu/media/pdfs/Loewenstein/shivetal_InvestmentBehavior.pdf. Indicators?” Financial Analysts Journal, Volume 63 • Number 2, 2007, 73-75.

How Can We Benefit?

 Look for diversity breakdowns  We often make decisions by observing others

 Imitation has a bad name in investing but is common in everyday life  Information cascades―a reasoned or arbitrary decision by one individual triggers action by many

Social Psychology

Solomon Asch’s study of social conformity

X A B C Source: LMCM.

Source: www.web.lemoyne.edu/~hevern/psy101_04F/psy101graphics/aschconform.jpg.

Social Psychology

Asch wondered...

is it a distortion of:

Judgment?

Action?

Perception?

Source: Sandra Blakeslee, “What Other People Say May Change What You See,” New York Times Online, June 28, 2005.

Neuroscience

Greg Berns

“We like to think that seeing is believing, but seeing is believing what the group tells you to believe.”

Source: Reprinted from Biological Psychiatry, Gregory S. Berns, Jonathan Chappelow, Caroline F. Zink, Giuseppe Pagnoni, Megan Martin-Skurski, and Jim Richards, “Neurobiological Correlates of Social Conformity and Independence During Mental Rotation,” June 22, 2005, with permission from Society of Biological Psychiatry.

Takeaways

 Investing is a probabilistic exercise  Expected value is the proper way to think about stocks  There are many pitfalls in objectively assessing probabilities and outcomes  We need to practice mental discipline or else we’ll lose long-term to someone who is practicing that discipline  Markets periodically go to excesses

Professor Shyam Sunder October 15, 2008

Decision Making for Investors

Michael J. Mauboussin Chief Investment Strategist Legg Mason Capital Management

The views expressed in this presentation reflect those of Legg Mason Capital Management (LMCM) as of the date of this presentation. These views are subject to change at any time based on market or other conditions, and LMCM disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for clients of LMCM are based on numerous factors, may not be relied upon as an indication of trading intent on behalf of the firm. The information provided in this presentation should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. To the extent specific securities are mentioned in the commentary, they have been selected by the author on an objective basis to illustrate views expressed in the presentation. If specific securities are mentioned, they do not represent all of the securities purchased, sold or recommended for clients of LMCM and it should not be assumed that investments in such securities have been or will be profitable. There is no assurance that any security mentioned in the presentation has ever been, or will in the future be, recommended to clients of LMCM. Employees of LMCM and its affiliates may own securities referenced herein.