Michael Mauboussin on investor psychology

When I was in business school in the mid-1990s I took a securities analysis class with Michael Mauboussin, who was an Adjunct Professor then working at Credit Suisse First Boston (he’s now at Legg Mason).  The class, which focused a lot on investor psychology, heuristics and the like made an indelible impression on me and cemented my aversion to the whole random walk, efficient market hypothesis claptrap.

Mauboussin would give us little experiments that proved his points. I pointed to one on investor overconfidence in a post I wrote in December 2008.

All of us have a bias that reinforces a false belief in the certainty of what we believe to be true. It’s called the overconfidence effect. Basically, we construct a mental map in our minds of what is probable and what is improbable. Over time, these beliefs harden and become what is certain and what is certainly not. I got a true test of this in business school.

My professor asked us some off the wall question like how much does the earth weigh. After we wrestled with the question and wrote down our answers, he then asked us to put a 95% confidence interval around the answer. He said give me a range of numbers that you believe the earth’s weight is 95% certain to be in. We mulled this over and answered. Result? Our 95% confidence interval was wrong something like 40% of the time within the class. Why?

Basically, by asking us the first question: how much does the earth weigh and giving us a chance to think about it, our professor was secretly giving our little pea brains a chance to become overconfident. By the time he asked us the second question, we had become anchored to the first answer. Essentially, he asked us to think outside the box and the mix of our overconfidence and anchoring caused us to make catastrophically wrong answers.

That’s how humans work. And this was a 10-minute exercise. Just think if you spend your life looking at economic events and making predictions. The likelihood of your being anchored to a specific prediction is that much greater. Eventually, you become so overconfident about this prediction that you are willing to bet the farm on the outcome.

See a recent article "How Men’s Overconfidence Hurts Them as Investors" from the New York Times. It gets to a lot of this. I personally witnessed a lot of the behaviours which Mauboussin in action during the TMT and housing bubbles. So I was pleased to see Mauboussin expounding on the same behavioural economics themes in a recent interview with James Surowiecki of the New Yorker and Wisdom of Crowds fame. Listen to his stories on human psychology at work in investing. They are remarkable and speak to irrationality at the very core of some of our investment decision-making.

His comments about stress inducing myopic, short-term oriented decision-making sometime after 14 minutes definitely apply to the macroeconomic environment that our political leaders are now navigating. I see this as a major reason that tremendous downside risk remains two years after the global recession began.

The video is below and runs about 20 minutes.