Working Smarter, Not Harder by Stephen Duneier
Recently, one of the best investors in the world, someone who has had entire book chapters dedicated to understanding his process, asked a very thoughtful question. After reading “The A, B, Q’s of Research” he put these questions to me. “Given that today we are flooded with information and stories, how do you cut through the information noise and figure out which stories to spend time approaching analytically? How do you force rank all the things that you could think about today so that you get the best ‘bang for your buck’ from exerting this effort?” Here is my response. (Aside: I believe the fact that he still asks these questions has a lot to do with why he is so good at this.)
Cognitive science is essentially the study of how we gather, process, draw conclusions from and ultimately use information to make decisions. It’s important to note, our brains take in information at an extraordinary pace. We see it, read it, hear it, feel it and taste it, and as soon as we come into contact with it our brains automatically go to work integrating it with everything that came before, in an effort to maintain a clear, consistent and cohesive picture of the world in which we live.
The problem is, our brains can’t thoughtfully process all of that data at such a rapid rate. Neither can we set any of it aside until we have the time to give it our full, undivided attention. It is an automated response that we cannot turn off. The evolutionary solution we’ve developed is known as heuristics or mental shortcuts, and most of the time they work just fine. That’s what cognitive scientists tell us at least, but it’s a bit misleading. It is true, most data can and should be handled by employing heuristics. We don’t need to contemplate why the light is red, we simply need to stop. The identification of a tree as a source of shade when we’re hot and water as something that can satisfy our thirst should be left to our automated system, and incoming data like that does in fact make up the majority. However, we should not take that to mean that our automated systems do a similarly satisfactory job with processing information we readily depend upon to make decisions of real consequence. You see, what cognitive scientists also agree on is that more often than we’d like to believe, heuristics result in systematic errors in judgement, otherwise known as bias, and worst of all, we are almost always oblivious to when they are occurring or what triggered them.
Our best defense is to recognize when we will be most vulnerable and take action to defend ourselves at those moments. This requires being proactive. It means you must first acknowledge a future moment as one of vulnerability, and one which you are unlikely to recognize as such at the moment it is occurring.
Unfortunately, much of the information we gather is processed by our automated system, what Kahneman and Tversky call System 1. Fundamentally, System 1 seeks cognitive ease. It doesn’t contemplate questions like “How”, “Why” or “Is that accurate” when it is processing incoming data. It simply picks out what it wants, what feels right. It seeks confirmation of the world order as you have already firmly established it. It perks up when it identifies something as familiar and gives it priority. What are things that will feel familiar to you? Things you heard first. What you read last. Things you've heard repeatedly. Information delivered via sources which have established themselves in your mind as trusted sources will be treated as familiar-by-proxy, thereby being attributed a higher level of importance and value. To be honest, System 1 isn’t very discriminating. The right word grouping and even carefully selected color hues can evoke a sense of familiarity, thereby keeping System 2, the more skeptical, thoughtful part of your intellectual process, at bay. Once that information gets in, it automatically has priority over anything new. It becomes the standard by which all new information is assessed.
What this means is that all future information you gather will be affected, tainted even, by what you have allowed in previously. All decisions you make going forward will be similarly affected, tainted even, by what has become an integral part of that clear, consistent and cohesive picture of the world you have drawn for yourself. So you can see, as much as we’d like to believe we have properly analyzed every bit of information that we use as a basis for judgement, it’s just not true, or even possible.
What can we do then to improve our decisions? Well, as the saying goes, "Garbage in. Garbage out." Meaning, if the information you've gathered is subpar, it's very likely that the decisions based upon that information will also be subpar, no matter how smart you may be. Therefore, in order to improve your decisions, invest time in assessing and improving your process for gathering information. Here is an incomplete list of tips for doing so. First and foremost, it all begins with one seemingly obvious realization. You cannot and will not ever know everything. You can't read, see, hear, feel and taste everything there is to experience. So, stop pretending you can. No matter how many news feeds you subscribe to, newsletters you read, analysts you speak to and policymakers you have on speed dial, there will be a nearly infinite number of things you will not know. That means the time and energy you are wasting (or worse) skimming information cursorily in order to convince yourself you are in fact well informed, can be reallocated to endeavors that will deliver significantly better returns on effort.
The halo effect is a cognitive bias we employ constantly, though we'd rarely admit it. Essentially, it describes how we let our overall impression of a person, firm, news source, etc affect our feelings and thoughts about other aspects of that entity. If we like one aspect of something, we will have a positive predisposition toward everything about it, and even things associated with it. This works in both directions, both positive and negative. Know this: anyone who seeks your attention is well aware of your penchant for heuristics and bias. Particularly this one, so be on your guard.
There is little we can do about how often we are affected by this bias, however, in knowing this we can take special care to be certain we are properly appraising people and entities. If you refer to an analyst as "Goldman's US guy" for instance, you can be fairly certain you've outsourced your appraisal of that analyst's skillset and the dependability of his accuracy to those who hired him. We joke all the time about how laughable it is to trust something we read just because it's on the Internet, while doing exactly that all the time with so many other sources. The goal here is to put in the time and effort to properly appraise our sources, like any good detective. Then, in those moments when we do unwittingly fall prey to the halo effect (and it will be often) we will have lowered the odds of it doing serious damage. Here are some ways attention seekers will capitalize on the halo effect, effectively gaining credibility by proxy without you even realizing it.
Articles with the name of a highly regarded individual in its title. EX: "What Warren Buffett is Doing Today".
Ads with celebrity endorsers.
Products distancing themselves from things perceived as bad. EX: "No high fructose corn syrup!"
Articles written by a highly regarded individual, particularly on a topic unrelated to the basis for that high regard.
Analysts quoting key policymakers or even implying an inside connection to them.
If you do a proper cost / benefit analysis on skimming articles, reading headlines, even having conversations while watching your screens, you'll stop doing all of the above in an instant. The reasons are confirmation bias and the impact of familiarity. When we skim, our brains don't contemplate meaning or develop new context. We simply pull out words and word groupings that look familiar, that enable cognitive ease and that fit neatly with our world view. Have you ever noticed that when something relatively obscure to you enters your consciousness, suddenly it appears everywhere?
When my sister had become engaged to a man from Costa Rica, it suddenly appeared to my family and I as though this tiny little country was being mentioned everywhere. Truth is, it hadn't suddenly taken on global significance, it had simply become familiar to us and System 1 was now automatically drawn to any mention of it. The more we heard the country's name, the greater it's weight in our world view. The same happens in our research. If your information sources are all highly connected, they will become highly correlated for this very reason. (It helps explain why the greatest factor in determining correlation among hedge funds is geography.) If all your sources are mentioning the same thing, that thing's weight will increase dramatically in your world view. It is a phenomenon known as the "mere exposure effect". If instead of skimming, you select only a very few uncorrelated, highly reliable sources of information to truly engage with, to contemplate and further investigate on your own, your world view will be far more balanced and reflective of reality. In those moments when connections develop between seemingly disparate topics covered by those sources, you'll know you've hit on something worthy of serious investigation.
What I mean by contemplation is the act of stepping away from everything. Having accepted that you can't read everything or speak to everyone, you should be free to truly absorb the information you have identified as worthy of gathering. Away from the scrolling headlines and incessant display of tick data, you are better able to see the world as it actually exists. Most importantly, you develop the patience and space to better understand context and connections. You will formulate better questions, which will lead to more informed investigations.
Taking Care of Yourself
Studies have shown that our brains function similarly when we are sleep deprived versus when we are intoxicated. Israeli judges have been observed doling out radically different sentences just before lunch versus immediately afterwards. We know we are affected by things like sleep and nutrition, but very often we sacrifice these things in favor of reading one more research piece or taking one more "peek" at the markets. The rational you knows the marginal gain of checking your email for the fifth time before ordering appetizers is nearly zero, but the habitual System 1 isn't rational. It is impetuous. Hand your phone to your child at the dinner table. Leave your desk to read the research you value. Go on a hike. Eat a proper breakfast. Read a good novel. Learn a new skill. Unplug.
Stop-Loss Trade Entry
On June 12, 2015 I wrote the following: “I remain bullish 30 year US Treasuries, but am of the opinion that they should be treated as a trading instrument until one to two months after the Fed raises rates, or it becomes apparent it is off the table. Use the taper tantrum period, when we saw rates ebb and flow around Fed meeting dates, but with an upward trend bias, as your guide.”
Ideas like this are easier said than done. When stocks are rallying, we often hear people say, “If the S&P goes down to (insert level here) I will get very long.” Then, when it gets to that level, the plan goes right out the window. Why? Because something will have happened to push it down to that level. Something negative for stocks. That’s the part we rarely consider when devising the plan. The same lack of foresight also tends to occur when we reach our take profit levels (what I call a reassessment trigger).
Here is an actual response from a very experienced portfolio manager I coached a few years back when I inquired about his lack of action when a trade hit his predefined take-profit.
PM: “1336 re-assesment trigger is here, but given weakness in Asia, sovereign spreads in Europe, political uncertainty in Europe, monetary policy paralysis in US (as it currently looks), I’m not really inclined to take trade off, more tempted to add to position on break, looking for 1300 initially. I’ll update sheet if needed when in office (going to see a show).”
ME: “No opinion re: the 1336 level being right or wrong, but I will say its unlikely you would have hit your reassessment trigger on a bearish S&P trade without some bearish news getting you there.”
He wound up unwinding at 1367, his new stop-loss reassessment trigger. The reason I bring this up is that you were just given an opportunity to sell 30 year US treasuries as part of that plan I suggested on June 12th. We didn’t know what would provide that opportunity, but it was highly likely it would be something related to Europe. So, did you take advantage or did you second guess? Still think this job is all about having the right view?
"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 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.
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