A decision is considered rational when the decision maker does what is most reasonable given all of the relevant information that is available at the time the decision is made. Rational decisions are what we aspire to. They are optimal. On the other hand, a decision is considered right if the outcome is at least as good as all other possible outcomes. In other words, it is considered right, because the actual outcome was successful. Importantly, rational decisions are not necessarily the same as right decisions, and the decision that winds up being right may not have been rational.
Take the example of two teens, Brian and James, both of whom attended a late night party where alcohol was consumed. Brian elected to get a ride home from a friend who had been drinking heavily. James chose to ride with a friend who hadn’t had a single drink. Brian made it home without incident, whereas James was paralyzed when a distracted driver ran a red light. It’s clear to anyone reading this that James had made the rational choice, while Brian made the right one. I know, it’s hard to accept that the correct term to use for Brian’s choice is “right”, but according to the definition, it was.
In a situation like this, there is no controversy. James had made the optimal choice, even if it worked out badly. Even knowing the outcomes, you would still say that James made the rational decision while Brian had been foolish. Unfortunately, few decisions are as cut and dried as this. More often than not, we are not accurate historians of decisions, but rather revisionists. Once the outcome is known, the initial expectations are erased forever. Decisions that were once deemed rational are recategorized as suboptimal simply because they didn’t turn out to be right. Information that led us astray is discounted, while that which corroborates the outcome is elevated in value, and the “mistakes” are now glaringly obvious.
It isn’t intentional, it’s just what our brains do to help us make sense of a complex world. However, in situations like the one above, it’s simply impossible, so we deal with it in one of three ways. We question whether the sober teen was in fact sober, assume there is more to the story, or assign it to a higher power. When it comes to the decisions we make as investors however, more often than not, we play the role of revisionist historians, and that doesn’t come without consequences.
The technical term for what I’ve described is, hindsight or outcome bias. It’s when you change your assessment of whether a decision was rational simply because you know the outcome. Here’s how it gets tricky. You gather copious amounts of historical data, speak to numerous experts, listen to opposing viewpoints and develop a rational strategy given all of the relevant information. Your boss (or investors) agree that your analysis is sound and your expectations are reasonable. That’s not to say that they don’t see how it could potentially go wrong or that they are unwilling to express those concerns in the moment. Of course, there are always risks, and you’ve properly considered them. In light of the risks and rewards, given their appropriate weightings, you all agree the investment is warranted. Unfortunately, you aren’t judged by whether your decisions are rational. Your decisions, your investments, your portfolio, your fund and potentially even your own self worth are more often judged by whether or not they were right. In other words, your decisions are judged by the outcome, not the process, and that can be dangerous for a number of reasons.
A few lucky gambles can crown a reckless leader with a halo of prescience and boldness. “Thinking: Fast and Slow” by Daniel Kahneman
Allocating to Right The graphic shown here was recently posted on LinkedIn. No caption was attached. No mention of the fact that it was based on just 3 data points, nor the decision making that led to the results. But that’s what we do. If a decision turns out to be right, it must have been due to solid decision making, and vice versa.
Well, if Brian, the teenager who rode home with a drunk driver were a fund manager, he’d have been among the top performers, while James would have been in the bottom. The thing is, right can only be judged in hindsight, but investors have to make investments and allocate to managers prior to the results being known. Therefore, as investors, we must somehow make the distinction between returns that were generated by rational decisions as part of a consistent decision making process, a selection of rational decisions that are part of an inconsistent decision making process, or simply irrational decisions that happened to work out well.
Just because Brian wound up getting home safely, doesn’t mean we should have expected it, nor does it mean we should expect the same result going forward. However, since his poor decision wasn’t punished, we should expect he will likely employ that same decision making process in the future. Given that likelihood, Brian isn’t someone I would expect to survive very long.
There are two distinct difficulties in conducting a proper assessment, and this applies not just to the allocator, but to the traders and portfolio managers themselves. Firstly, once you see the result, it’s nearly impossible to unsee it. When the outlier event that you had acknowledged beforehand actually comes true, the immediate response is, “I knew it!” However, the truth is, you didn’t know it. You simply thought it was a possibility. But with the benefit of hindsight, that outlier possibility appears to have been all but inevitable, not just to the outsider judging them, but to the decision makers themselves. The same goes for decisions that work out well. When the stock markets rally, investors often ask, “Why should I invest with a hedge fund and pay 2/20, when I could get that kind of return just being long the S&P?” That comment, as well as the inability to acknowledge that when a hedge fund manager goes long equities the resulting returns are alpha, both serve as evidence of hindsight bias.
The only true way to overcome this bias when assessing a manager, or your own trades, is to keep records of the decision making process, complete with all of the evidence gathered, the probabilities assigned to different outcomes, the drivers for those probabilities and the triggers for meeting/missing those expectations. In so doing, a trader who has a cold streak or who misses an opportunity they had once considered, can maintain a state of equanimity. That improves the odds that they will continue to make decisions that are probabilistic in nature, rather than emotionally driven by p&l. It also provides evidence of rational decisions being made as part of a consistent decision making process. That’s important because it means it is repeatable.
Here’s the problem with having decisions judged by the outcome. If my boss and I agree that I am making a rational decision by investing in XYZ and it doesn’t work out, but he maintains his opinion of me based on the fact that my decision was rational, then I will continue to make decisions in the same manner. If however, in light of the outcome, he changes his opinion of me, then he has just injected uncertainty into my decision making process. An uncertainty that cannot be resolved, which leads to a more bureaucratic and risk averse approach.
Going back to our teens, how would either of them adjust their behavior if James, having arrived home safely, is rewarded by his parents for making the right decision, while Brian is punished for having been in an accident. Of course it sounds silly, but how is it different from what is done by allocators and traders, every day?
The truth is, rational decisions provide the best odds of success over time. If I want to lose weight, I will reduce the number of calories I take in and increase the number of calories I burn. In doing so, I improve the odds that I will lose weight. Does it mean I will lose weight every day, every week or even every month? No. Is it possible I can gain weight at some point along the way? Yes. Should I change my approach in those moments? Of course not.
There are kids who drive drunk without incidence, for a time. There are people who chew tobacco for many years without any problems. There are people who can eat whatever they want without gaining weight, while they’re young. There are investment managers who make irrational decisions or lack a consistent investment process of any kind, yet generate positive returns for a while. Yet, none of them represent good bets.
Right, is not the same as rational. Rational decisions simply improve our odds of being right. If rational decision making is repeated in a consistent manner often enough, you should expect to be more successful than someone who does not. Is it guaranteed? No, but we are in the business of playing the odds. It’s true, past results do not necessarily guarantee future performance. However, rational decision making is certainly more predictive of success than those that have simply been right for a time.
Remember, there will be times when you are right and times when you will be wrong. All you really control is whether or not you are being rational.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.