Practical analysis for investment professionals
18 July 2012

Warning: These Three Decision-Making Errors May Be Hurting Your Investment Performance

Posted In: Economics

As an investment professional, how can you make better decisions in a complex and uncertain world?

At the recent CFA Society of the UK Annual Conference in London, distinguished economist Noreena Hertz, professor of globalization, sustainability, and finance based at Duisenberg School of Finance; Rotterdam School of Management, Erasmus University; and the University of Cambridge, offered some answers. Professor Hertz argued that we typically fall prey to three errors when making decisions, and she outlined five “active thinking” strategies that can help practitioners overcome these errors in order to make better choices.

Three Common Decision-Making Errors

  • We trust experts too much. Professor Hertz referenced Bernie Madoff, Alan Greenspan, and credit rating agencies as examples — and emphasized that claims made by so-called experts such as these have often been taken at face value during the ongoing financial crisis and not subjected to due scrutiny. She said that research has found that experts can be terrible at making predictions, yet the thinking part of people’s minds tends to switch off when they believe that an “expert” is providing their views.
  • We have blind faith in anything that seems scientific in form. Case in point: quantitative models used in finance. We live in a fast-moving and highly interconnected world where the economic effects of a tsunami or a “toxic asset” originating thousands of miles away can be felt locally. Professor Hertz explained that in such a world, quantitative models that assume linearity and/or that the future will mirror the past have limitations, as was amply demonstrated during the financial crisis.

  • We resort to problematic shortcuts, such as stereotyping and finding patterns. Professor Hertz thinks we resort to such shortcuts because we are exposed to far more information than we can cope with. She told the audience that a single edition of the New York Times contains more information than a person living in the 17th century would have been exposed to over a lifetime. By 2020, she added, we will have to deal with 40 times the information that we are dealing with today. However, because the human brain can deal with only seven pieces of information at once, we have to rely on these shortcuts.

Five Active Thinking Strategies

Professor Hertz outlined the following strategies for making more effective decisions:

  • Expose ideas to dissent. People make better decisions when they are exposed to diverse and conflicting views. Discordant groups are likely to make better decisions. Professor Hertz highlighted decision making at Google as an example where dissent is actively brought into the discussion to make better decisions.
  • Embrace useful knowledge of the lay experts. Professor Hertz said that in 1986, the British government was worried that clouds carrying radioactive matter from Chernobyl were moving over Wales. The British government relied on scientists who carried out their work using samples of soil from the lowlands. However, it was the local shepherds, the lay experts, who saved the scientists from making a key mistake by overlooking the difference between soil in the highlands and lowlands.
  • Think holistically. Professor Hertz explained that when analyzing the impact of austerity measures in a country, we should not focus narrowly on reduction in budget deficits but also take into account other things, such as the impact of austerity on society. She gave the example of an experiment where Chinese and American students were shown a variety of images — for example, a horse in a paddock. The American students focused on the main object, the horse, but largely ignored the environment, whereas the Chinese students were holistic in their approach and looked at the entire picture.
  • Be aware of your state of mind. A person’s state of mind affects decisions and may be influenced by factors that are easily overlooked, such as hunger and lack of sleep. Professor Hertz said an experiment showed that parole decisions by judges were influenced by whether or not the judges had eaten before the decisions.
  • Be willing to unplug. Take time out. Our brains cannot deal with the deluge of information we are facing. Professor Hertz said that it takes 24 minutes to restore an individual’s level of concentration after getting distracted by an e-mail! She added that research carried out with doctors in a high-stress environment showed that taking time out led to better decision making.

Professor Hertz gave a final word of advice to investment professionals: Be willing to “adapt and change.” She said that we should commit to thinking differently and take to heart the quote by British economist John Maynard Keynes, “When the facts change, I change my mind.”

About the Author(s)
Usman Hayat, CFA

Usman Hayat, CFA, writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals;" the literature review, "Islamic Finance: Ethics, Concepts, Practice;" and the research report "Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in development economics. He has served as a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP) and former CEO of the Audit Oversight Board (Pakistan). His personal interests include reading and hiking.

4 thoughts on “Warning: These Three Decision-Making Errors May Be Hurting Your Investment Performance”

  1. Troy says:

    I think this is a very insightful post, Usman. I am currently reading The Black Swan by Nassim Taleb which resonates very well with Noreena Hertz’s views. It’s amazing to find out about all the bias’ that are involved in our thinking and we don’t even know it.

  2. Joel says:

    I guess the author make sense since the issue is over rated. Solutions are simple but some one has to take tough decision.

  3. Graham Laird says:

    Insightful and perceptive discussion which should provoke provoke debate, and perhaps a reorientation, on decision-making. However, I do have a minor quibble on the Keynes attribution: “When the facts change, I change my mind.”

    Perhaps it is more accurate to state that when forecast outcomes change, one changes one’s mind. Facts do not change. Statistics, particularly government fiscal statistics, are frequently revised. JM Keynes with his long public service may have been alluding to this!

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