Investing Caffeine

Mauboussin Takes the Outside View

January 19, 2010 at 11:30 pm 3 comments

Michael Mauboussin, Legg Mason Chief Investment Strategist and author of Think Twice, is a behavioral finance guru and in his recent book he explores the importance of seriously considering the “outside view” when making important decisions.

What is Behavioral Finance?

Behavioral finance is a branch of economics that delves into the non-numeric forces impacting a diverse set of economic and investment decisions. Often these internal and external influences can lead to sub-optimal decision making. The study of this psychology-based discipline is designed to mitigate economic errors, and if possible, improve investment decision making.

Two instrumental contributors to the field of behavioral finance are economists Daniel Kahneman and Amos Tversky. In one area of their research they demonstrated how emotional fears of loss can have a crippling effect in the decision making process. In their studies, Kahneman and Tversky showed the pain of loss is more than twice as painful as the pleasure from gain. How did they illustrate this phenomenon? Through various hypothetical gambling scenarios, they highlighted how irrational decisions are made. For example, Kahneman and Tversky conducted an experiment in which participating individuals were given the choice of starting with an initial $600 nest egg that grows by $200, or beginning with $1,000 and losing $200. Both scenarios created the exact same end point ($800), but the participants overwhelmingly selected the first option (starting with lower $600 and achieving a gain) because starting with a higher value and subsequently losing money was not as comfortable.

The impression of behavioral finance is burned into our history in the form of cyclical boom, busts, and bubbles. Most individuals are aware of the technology bubble of the late 1990s, or the more recent real estate/credit craze, however investors tend to have short memories are unaware of previous behavioral bubbles. Take the 17^th century tulip mania, which witnessed Dutch citizens selling land, homes, and other assets in order to procure tulip bulbs for more than $70,000 (on an inflation-adjusted basis), according to Stock-Market-Crash.net. We can attempt to delay bubbles, but they will forever be a part of our economic fabric.

The Outside View

 Click here for Michael Mauboussin interview with Morningstar

In his book Think Twice Mauboussin takes tenets from behavioral finance and applies it to individual’s decision making process. Specifically, he encourages people to consider the “outside view” when making important decisions.

Mauboussin makes the case that our decisions are unique, but share aspects of other problems. Often individuals get trapped in their heads and internalize their own problems as part of the decision making process. Since decisions are usually made from our personal research and experiences, Mauboussin argues the end judgment is usually biased too optimistically.  Mauboussin encourages decision makers to access a larger outside reference class of diverse opinions and historical situations. Often, situations and problems encountered by an individual have happened many times before and there is a “database of humanity” that can be tapped for improved decision making purposes. By taking the “outside view,” he believes individual judgments will be tempered and a more realistic perspective can be achieved.

In his interview with Morningstar, Mauboussin provides a few historical examples in making his point. He uses a conversation with a Wall Street analyst regarding Amazon (AMZN) to illustrate. This particular analyst said he was forecasting Amazon’s revenue growth to average 25% annually for the next ten years. Mauboussin chose to penetrate the “database of humanity” and ask the analyst how many companies in history have been able to sustainably grow at these growth rates? The answer… zero or only one company in history has been able to achieve a level of growth for that long, meaning the analyst’s projection is likely too optimistic.

Mean reversion is another concept Mauboussin addresses in his book. I consider mean reversion to be one of the most powerful principles in finance. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. In describing this occurrence he directs attention to the currently, overly pessimistic sentiment in the equity markets (see also Pessimism Porn article). At end of 1999 people were wildly optimistic about the previous decade due to the significantly above trend-line returns earned. Mean reversion kicked in and the subsequent ten years generated significantly below-average returns. Fast forward to today and now the pendulum has swung to the other end. Investors are presently overly pessimistic regarding  equity market prospects after experiencing a decade of below trend-line returns (simply look at the massive divergence in flows into bonds over stocks). Mauboussin, and I concur, come to the conclusion that equity markets are likely positioned to perform much better over the next decade relative to the last, thanks in large part to mean reversion. 

Behavioral finance acknowledges one sleek, unique formula cannot create a solution for every problem. Investing includes a range of social, cognitive and emotional factors that can contribute to suboptimal decisions. Taking an “outside view” and becoming more aware of these psychological pitfalls may mitigate errors and improve decisions.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AMZN, but at time of publishing had no direct positions in LM, or MORN. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Education, Profiles, Themes - Trends. Tags: behavioral finance, bubble, Legg Mason, Michael Mauboussin, Think Twice, tulip.