We Are All Students of the Same Game by Stephen Duneier
Students in my Decision Analysis class have to create one Decision Log per week. The assignment requires that they analyze an actual decision they have faced or are currently facing. The decisions they choose to analyze include whether they should break up with their girl/boyfriend, where they should go for spring break, what job to accept and how much to spend on their wedding. Initially, I provide very little guidance, so they do their best to produce an analysis that they believe will show me they are methodical and deliberate in their approach. Even when it is clear that they simply went for the path of least resistance, they will attempt to generate a narrative that explains their approach as rational and thoughtful.
Much to their chagrin, I actually provide very little guidance as it specifically relates to the assignment throughout the entire semester. At least that’s what many of them believe. Truth is, the entire course, including reading material, case studies, and lectures is about the process of decision making. We cover statistical concepts such as probabilities and Bayes Theorem, mistakes some very smart people have made in applying these concepts, the components of a decision, and real-world examples for applying it all to actual business and policy decisions. Students are also exposed to esoteric terms used to describe proper process and systematic errors. I purposely provide little guidance for the decision logs so that I can ascertain whether or not they are making the connection between the material they are studying and the concurrent decisions they are facing.
Before going further, let me be clear. These students are some of the smartest, most driven individuals among their contemporaries around the world. They finished high school with highly competitive GPA’s and standardized test scores, are graduating seniors or graduate engineering students at one of the finest engineering programs on earth (UCSB’s College of Engineering has more nobel laureates on the faculty than any other). Despite these qualifications, it typically takes many weeks before they are able to make the direct connection between the material and their own actions. Regardless of how long it takes for it to click that these aren’t merely theories we are covering and that this course isn’t simply about memorizing a bunch of terms they’ll never use again, the progression toward that realization follows a very consistent pattern.
Stage 1: Auto-pilot. In this phase, students follow the protocol that’s served them well up until this moment. Very little thought is put in. Instead, they rely on their intuition to produce just another in a long line of documents meant to satisfy yet one more course requirement.
Stage 2: Cognitive Ease is maintained. Even though they are incorporating the proper terminology into the log, they aren’t actually applying the ideas. In other words, they are attempting to satisfy what they believe I want to see by effectively delivering the same decision analysis, except this time they've swapped out layman’s terminology in favor of the more technical terms. Effectively, nothing about their approach to decision making has changed, except for how they describe the process. It is a superficial adjustment; a waste of their time, and mine.
Stage 3: Stress. After a number of logs have been submitted, all of which have likely received grades below what they’re used to, the stress sets in. They worry about the final course grade based on the current trajectory. Office hours become more crowded and pleas for extra credit opportunities flood in. My response is the same every time. Spend less time worrying about grades and more effort applying what you are learning to your own decisions. Invite cognitive strain. Dig deeper, ask tougher questions and replace leaps of faith with statistical analysis. This is the phase that can act like quicksand, even for many of the top students. They will dig in their heels, working harder to argue their case than applying the concepts. They will complain, beg me to just tell them what I want so they can deliver it, pass blame and claim too little time available before finally dropping their defenses. Hopefully, it happens before the semester comes to an end, and when it does…fireworks!
Stage 4: Cognitive Strain. This is the phase that keeps me coming back for more each semester. When students drop their defenses, when they stop fighting cognitive strain and instead invite it, well, that’s when the magic happens. They begin seeing the whole world through new, high-powered lenses. Some have described it as similar to that moment in The Matrix when Neo (Keanu Reeves) takes the blue pill. Make no mistake, though. While the benefits are amazing, they require hard work to achieve, and that is perhaps one of the best lessons they will learn. Thankfully, most of them seem to know it. The evidence can be found in their course feedback…
“Taking this class has changed my life! I learned the importance of questioning everything. It helped me quit smoking, deal with rejection, among other serious negative outcomes and more than that, it allowed me to open my mind to possibilities. This is the most rewarding class I have taken, but demands you putting in work. Please utilize this with an open mind and do not be very sticky to what you believe in.”
“If I could I would take this course every term. What you learn here is something to be used every day. It is difficult to master the subject, but you will feel the difference in your life if you make the effort.”
“Incredibly challenging course, but I enjoyed every single class. Duneier really cares about bringing out the best in all of his students. Duneier is the GOAT.”
“If taken advantage of and if you delve yourself into applying concepts of this class to real life, very valuable stuff! Thank you!”
“Loved the class, it was a pleasure to see a class with different priorities than just doing work and being tested. I learned a lot that I believe will have a measurable impact on my life.”
“Best course ever! Very challenging and practical course. By far the most interesting class I’ve taken with a noticeable change in personal decision making.”
“The most interesting / insightful course I have taken in college. Extremely practical and applicable to real world apps. Course is challenging and encourages students to think.”
I share this with you, because the stages are very similar to what I’ve discovered in working with clients. We all want to avoid cognitive strain. Our brains are phenomenal at convincing us that we are invoking it even when the reality is, we are simply using more technical terms or codifying poor process so that it appears more systematic and rational. Thanks to technology, we can gather all kinds of data, run all kinds of analysis, but if we don’t ask the right questions at the right moments, we risk turning sporadic mistakes into systematic flaws.
Over the past week, I was interviewed by a number of magazines about the rise of artificial intelligence and machine learning in the world of finance. Here’s the thing about the ease with which we can gather data and run massive analytical programs, not to mention the ability to effectively outsource optimization to machines that can think and process far faster than we could ever hope. Optimization requires that you properly define the outcome you desire, and that is what I’ve discovered is so often ignored by decision makers at the university and CIO level.
As an example, when my students submit a decision log about where they should go for spring break, they will typically present three potential destinations from which they must choose. Often, the choices are something along the lines of Acapulco, Las Vegas or New York City. Three terrific options for your typical spring breaker. The problem is, they don’t have much in common. The fact that they are the options being considered tells me that very little work has been done as it relates to properly defining what it is they hope to achieve, what the important factors are and how they will choose from among them. In other words, what gives them pleasure? What are the key factors by which they will judge the trip a success or failure?
They will express frustration in quantifying the difference in utility gained by lying around a pool as scantily clad, beautiful people circulate around them and enjoying a beer at a trendy restaurant in SoHo. They have difficulty comparing a $5 margarita on the beach to a “free” cocktail served at the blackjack table. Instead, they choose to imagine a moment of peak pleasure in each location and compare the utility gained in each of those scenarios, as judged in the moment of contemplation. If they happen to be sitting in the hot sun, struggling with the humidity as they are weighing their options, it’s likely a trip to humid Acapulco will be less desirable than a visit to bone dry Las Vegas, and so on.
You can see how quickly all these considerations become burdensome, and perhaps unnecessarily so. That’s when we say things like, “we could think about this forever, but ultimately, we just need to make a decision. After all, all three are phenomenal options and I'm sure I’ll enjoy any of them.” That’s when the brain’s desire to maintain cognitive ease has officially won.
The same goes for investing. It seems like such a simple process. Find a machine that can generate the best returns and allocate to it. Oh, if only it were that simple. You see, the best a machine can do is improve the accuracy of our predictions, and it does so by gathering more information and considering more factors in its analysis. Given that most in this industry do little more than the bare bones minimum in this area, it's easy to see how depending on machines for this part of the job will yield great improvement. Still, producing more accurate odds of success is only a small piece of the decision making and investment process. An investor must define and understand their risk tolerance, for a machine doesn’t guarantee results, it simply optimizes its predictions of the future based on how the investor defines their objectives. Therein lies the potential glitch. A machine is unemotional. It understands that it is playing the odds, that it will have bad runs and good ones. It is unemotional about those runs, but investors are not.
Just as students should take the time to understand what they enjoy, what their monetary constraints are (beyond simply, “how much is in my bank account today”) and what aspects of each of their options can affect their ability to achieve the outcome they desire, so too should investors consider what it is they desire, before choosing between a systematic, long-short equity fund, a 30 year US treasury and an equity index ETF.
Yeah but…. On a related note, someone recently mentioned that one of the major stock market indices is on a multi-year run that has never occurred before. As a result, he was considering going short the index. This is a cognitive mistake that should be easily refuted with a simple statistical analysis. However, the argument rarely changes anyone’s mind. Nonetheless, I feel compelled to make the case.
Since October 1959, the DAX index has had 671 rolling twelve month periods, of which 62% have been positive. The DAX index has been positive for the past 4 calendar years. Throughout its history, we’ve only seen the DAX up 5 years straight, 8% of the time. One might leap to the conclusion that based on historical results, there is a 92% chance that the DAX index will be negative this year. However, they’d be wrong.
You see, the hard part of a five year run has already occurred. The DAX has only had 4 straight up years 13% of the time. In this case though, the odds of the DAX being up 4 years straight is 100%. I can say that because it has actually happened. Now you might think that it makes the odds of it continuing to extend another year a long shot, but statistically speaking, that’d be incorrect. You see, historically speaking, the odds of the DAX index ending a twelve month period higher than it began is 62%. Even after four straight positive years. Truth be told, the consistency of the return profile is quite remarkable. See the table below for a comparison between the actual percentage of times the index has experienced different winning streaks versus what the expectations would be if every single year was a constant 62%.
What I’m saying is, based on historical data, the odds of the DAX index being up this year, given that it has been up the last four straight calendar years, remains 62%. That’s what a machine would tell you. Question is, would you listen?
A Fair Question A perfectly calibrated machine tosses a fair coin six times. Which of the following set of outcomes is most likely? Least likely?
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 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.