How a Mistake Made Me a Better Investor by Stephen Duneier
It's been a hectic 10 days, having given 3 talks at 3 conferences in 3 cities on 3 very different topics, not to mention 3 lectures to my class at UCSB. I spoke to one group about the impact that wealth disparity is having on central bank policy around the world. To another, I provided historical context for the particular combination of macro factors we are experiencing today, and how we can use it to better assign probabilities to future outcomes. Finally, I just returned from a conference in Boca Raton, where I shared how investment managers can benefit from what cognitive science has taught us about how our brains gather and process information, how we deal with uncertainty and what we can do to avoid systematic errors in judgment.
I'm now enjoying a brief respite back home in the mountains of Santa Barbara, before I repeat a similar tour in June. As I sit here on Gibraltar Rock looking down on the town and out over the water, being serenaded by a chorus of songbirds while catching up on work, it's easy to appreciate just how beneficial it can be to apply what cognitive science has taught us. Unfortunately, while many will read from among the plethora of books on the subject, few will ever actually practice what it preaches, and understandably so.
Daniel Kahneman, one of the leading experts in the field and author of some of the most widely read books on the subject discusses the futility of teaching his findings in a section of Thinking: Fast and Slow, titled "Can Psychology be Taught." You'll have to read the book to learn why he came to "the uncomfortable conclusion that teaching psychology is mostly a waste of time," but I will share with you how I arrived at that same conclusion, as well as the mistake I made more than 20 years ago that enabled me to break through the barrier, and become a practitioner.
One of the fundamental tenets of cognitive psychology is that we essentially have 2 systems at work in our brain. Kahneman calls them "System 1 and System 2", while Thaler and Sunstein refer to them as "Planner and Doer". What you call them isn't nearly as important as recognizing that there is a part of your cognition that is automated, intuitive, and quick to draw conclusions, while the other part is more deliberate, methodical and intellectually demanding. When you read about these abstract characters, you may or may not agree that they relate to you, but you undoubtedly recognize their existence in others. Even if you do see these two distinct systems playing a role in your decision making, it's unlikely you could do so in real time. Of course, with the benefit of hindsight, your task is made much simpler. If your decision resulted in an unfavorable outcome, you're more likely to attribute the decision to System 1 thinking, a temporary lapse in judgment. (Although, research tells us we're more likely to put the blame on luck, or another person.) If the result is positive, of course, we rarely seek an external source to apportion blame, least of all, luck.
In the moment, though, when we are gathering information, interpreting it, processing it, drawing conclusions from it or making decisions based upon it, it is almost impossible for us to recognize whether we are employing mental shortcuts that are likely to result in a systematic error in judgment, ie bias, or we are objectively analyzing the situation, drawing upon our wealth of knowledge and experience to reach a thoughtful conclusion. I mean, how do you define an action as dogmatic versus disciplined, before the outcome is known? How do you differentiate between an impulsive decision and one based on educated intuition, until the result is experienced? The truth is, while the difference may appear glaringly obvious with the benefit of hindsight, it can only truly be objectively judged at the moment of inception. Those who have difficulty coming to terms with that subtle, yet significant difference likely have a great distance to cover before becoming a practitioner of cognitive science themselves.
So, how was I able to make the leap from someone who had spent years simply studying cognitive science to becoming a practitioner? I owe it all to my mother-in-law and a simple mistake I made on March 24, 1994. I know the exact date because it occurred in the hospital, one day after my first child was born. My mother-in-law asked if I'd like something for lunch and I gave her my order. Forty-five minutes later, she returned, handing me a sandwich and saying, "here's your veal parmigiana hero." My hand automatically jerked away. "I didn't order a veal parmigiana hero," I stated emphatically. She insisted I had and we went back and forth before I finally introduced reason to the rhetoric. I explained that while the veal parmigiana hero had been one of my favorite foods as a kid, after seeing a video years earlier which showed how calves are treated in order to make veal, I had made a conscious decision never to eat veal again. Which is how I knew beyond a shadow of a doubt that I hadn't ordered a veal parmigiana hero this time. She apologized, I skipped lunch and life went on.
A few months later, my wife and I looked through pictures from the birth, as well as video we had taken around that time. That's when my life changed forever. It turns out, someone had been taking video in the room when I gave my lunch order. I saw a person who looked just like me, who sounded just like me say to my mother-in-law, "I'll have a veal parmigiana hero, please." It was like an out-of-body experience. I get chills to this day when I think about it. Immediately, my mind attempted to make sense of it all. "Someone dubbed over my voice." "Someone doctored the tape." "Someone went to a lot of trouble to make me look foolish." The truth, of course, was a whole lot simpler, and there was no getting around it. In that moment, my mind was engaged elsewhere, and that left System 1 or the "Doer" alone to hear the question, interpret it, process it and answer it, all without me even being aware. You see, veal occupied a much greater portion of my memory than did eggplant. Avoiding veal was a conscious decision, but on that day my choice had been made unconsciously, even though I was wide awake and conversing.
That was the last time I have ever felt 100% sure about anything that relied on my memory. It's also the moment when I truly understood what Kahneman, Thaler, Sunstein and others meant in all those books. From that moment on, I have been devising and implementing structured processes that would force me to be actively engaged throughout my decision making process, particularly at those very moments when I was most likely to be engaged elsewhere. It's also when I began writing what I call, "notes to Steve of the future." You may know them as trade write-ups though.
Having seen myself on that video, contradicting my own absolute certainty, I've seen the light of cognitive science. I know that with the benefit of hindsight I will create a whole new story to explain my earlier decisions, one that will bear very little resemblance to the truth, making any post-mortem analysis virtually useless. Unless I have videotape to go back to. The result is an extremely insightful, disciplined, highly proactive approach to research, portfolio and risk management, and trade selection and construction. It was first put on display at AIG when I launched the TIP portfolio (click here to see a snapshot from back then). I've been refining it ever since, and even had an opportunity to apply it to an entire team of very experienced portfolio managers and the business of a hedge fund back in 2009/2010. The result was equally amazing, and I say that with absolute humility. You see, I don't believe I was born with any superpower, nor do I possess any today. All I have done is take the theoretical research findings of some very smart people and applied them in a very literal manner to investing, business management, and ultimately my entire life. Beginning next month, I will reintroduce the TIP portfolio, for subscribers only.
TIP employs a macro-opportunistic portfolio management style using a combination of cash and derivative instruments in foreign exchange, rates, commodities and equity indexes, in an effort to optimize the risk / reward ratio according to my market expectations. As an opportunistic portfolio, TIP may employ any number of structures and strategies depending upon market conditions, macro view, time horizon and a host of other factors. By employing a macro-opportunistic style, TIP attempts to take advantage of pricing anomalies, dynamic shifts in market psychology, and directional views with attractive risk / reward dynamics. This can result in extended periods with little activity and periods with bursts of activity. My job is to identify an opportunity and the timing of its trigger for maximum efficiency in capital use.
As those of you who were part of this process the first time around will recall, I run my portfolios according to the “best ideas” principles. In other words, every trade stands both on its own, as well as a part of the portfolio. Therefore, no trade serves solely as a volatility suppressor, although correlation among positions is not ignored. I will not be sharing these write-ups with non-subscribers, nor will they be included in trial subscriptions. If you’d like to see examples, I have hundreds of them available for you to review, going back as far as 1999. (See examples here: commodity, rates and foreign exchange.) Of course, past performance is not an indicator of future results, nor are all of my previous trades profitable ones.
A Bad Best Idea
I must admit, "Best Idea” funds, as they are marketed, have always seemed silly to me, particularly when they are run by the same CIO / Investment Committee, or if they draw from a collection of funds under the same umbrella. It begs the question, why would I want to be invested in their other funds?
Based on the marketing pitch, the fundamental issue that a best idea type fund is meant to solve is that typical fund managers believe investors are concerned about monthly return volatility, and in order to placate those concerns, they include positions in their portfolio that are intended more for smoothing volatility than for generating returns. The best ideas fund, on the other hand, is said to include only the most heavily weighted positions held by an assortment of other funds, thereby removing those intended solely for volatility suppression. By pulling those top trades from a variety of other funds, they will reap all the alpha benefits, while removing the unnecessary drag. At least that’s the theory.
The concept is based on the oft referenced research paper titled, “Best Ideas". Unfortunately, other than the title and broad idea, there is little that connects the execution of the fund with the purview of the research. There is a wide divide between what the research presents, and how the funds that are using it as the basis for their marketing are applying it. One of the many problems that these funds overlook is the issue of overlap. You see, if a number of funds in the universe from which it draws its ideas have the same “best ideas”, then the duplication is removed. If the optimal situation occurs, however, where they have each selected different favorites, but from the same pool of possibilities, the best ideas fund can simply wind up with the same portfolio as any of the others, albeit in different proportions (see chart), and with a delay in adjusting.
A, B, Q's of Research (Always Be Questioning)
I came across an article titled, “The Fascinating Story Behind Why So Many Nail Technicians Are Vietnamese” on my Facebook newsfeed today. It was shared from a Yahoo feed, which was fed by an article on TakePart.com. In the article, the writer mentions that 80% of nail technicians in Southern California are Vietnamese and they account for 51% of the total across the United States. She then goes on to quote a number of other statistics such as the size of the nail industry ($8 billion), the GDP of Vietnam ($12 billion) and how important it is to these US based technicians to send a sizable proportion of their income back home. It’s such a feel good, fun and truly fascinating narrative, including a famous celebrity and grand historical context, it’s hard not to want to share it with others. In other words, it’s highly likely this story would spread like wildfire. (I mentioned the story to my wife and she informed me she had read about it last week in People Magazine.)
However, being aware that we are susceptible to availability bias, the part of my brain responsible for critical thinking is immediately awakened. As entertaining as it is, the entire story hinges on one important fact. The majority of nail technicians in America, and particularly in Southern California, are of Vietnamese descent, and by a very wide margin. Take that away and suddenly its significance is dramatically reduced. So, naturally I did some digging. Since neither the Yahoo version, nor the original TakePart post included a source, I had to search the web. I came across the same story on blog after blog and numerous well establish media sites, but only one, NPR, referenced the source. Turns out, the source was a poll taken by Nails Magazine which was kind enough to share the results and methodology online, in a very colorful pdf. Finally, I had the info necessary to confirm what I’d read, and could feel confident that it was factual, and therefore worthy of being forwarded. Actually, it didn’t. According to the Nails Big Book 2014-2015, one of the key sources for the most important statistic in the article that has spread like wildfire is described as follows. “We surveyed the readers of VietSALON, our Vietnamese language publication for salon professionals.”
Truth is, I don’t know how much it biased the results to have a Vietnamese language publication for salon professionals as the primary contributor to the polling, but I believe it is significant enough to make a rational reader skeptical of the findings. Now, I know what you’re thinking. Who cares? It’s just a silly story. In a world filled with far more important problems, can’t you just let us enjoy a fun one?
Imagine LeBron James chooses a diet of Twinkies and soda combined with a regimen of couch sitting in the off season. His coach chides him, complaining that he won’t be able to compete when the season begins again. LeBron, one of the best players in the league year after year, consoles his coach by saying, “Relax, it’s not like I’m going to do this when the season starts.” When I’m on the court, I’ll be in tip top shape, as always. Our brains are muscles that require exercise, just as much as any other muscle, but it is the most important one for our chosen professions. Unless you want to be susceptible to the availability bias, availability cascade or any of the other potentially damaging cognitive biases in your investment process, you must train yourself to think critically at all times. Unfortunately, you cannot simply turn it on when it’s important and off when it isn’t. Critical thinking requires serious mental effort. Even during down time.
"While everyone else is scrambling to answer who, what, where and when, Duneier is focused on explaining the 'why'."
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 and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).
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 60,000 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.
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