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More Decisions Under Uncertainty

Posted on May 31, 2016

With the short week and on the heels of last week's post, we thought it would be a good time to re-post on the topic of Decision Analysis. As last week's post pointed out, with the luxury of hindsight, we can judge whether decisions were good or bad but not whether they were right or wrong since decision making should be evaluated based on the process rather than the outcome. This week's post unpacks the process of rational versus emotional decision making.

Incorporating the principles and philosophy of decision analysis is not just learning the subject, but more like installing a new operating system in your brain.” – Ron Howard, Professor at Stanford University

2015-09-15_decisions.jpgOne of my favorite classes I took during my graduate studies at Stanford University was on decision analysis, which was taught by Ron Howard (no, not the famous film director) who pioneered the field with his doctoral thesis back in 1965. The premise of decision analysis, which would now be considered part of the larger field of behavioral finance/economics, is that decisions under uncertainty can be mapped out in order to optimize each decision based on the probability of different outcomes. In today’s post, we will walk through a brief example on decision theory and show how it relates to investing.

Pretend with me for a moment that it is your birthday and that you have a very rich friend/family member who wants to give you a unique present on your birthday. Instead of buying a traditional gift that you may or may not like, your well-to-do friend/family member decides to offer you a game. The game is simple and offers you two choices. Option A is you flip a fair coin one time and if comes up heads you win $25,000 but if it comes up tails you get nothing. Option B is that your wealthy and obviously quirky friend/relative simply writes you a check for $7,500. Which option would you chose?

Quarter_small.jpgThe expected value of Option A is $12,500 since 50% of the time you will win $25,000 and 50% of the time you will walk away with nothing (50% * $25,000 + 50% * $0 = $12,500). This is known as the “risk neutral” outcome. A risk neutral decision maker like a computer program which is purely logic based, will choose Option A over Option B every time because the expected value is much higher ($12,500 vs. $7,500). But not many human beings are wired to be risk neutral decision makers even though this is the optimal choice from a pure monetary standpoint. Most of us are wired to be risk averse, which means that the decision to prefer Option B (a bird in the hand) over Option A (two in the bush) is also perfectly justifiable. In fact, someone who is extremely risk averse may prefer Option B at a much lower payout in order to avoid the possible pain of receiving nothing in Option A.

Now let’s again pretend that this time you have done something wrong and find yourself pleading your case in front of the judge. The judge finds you guilty of whatever law you broke and decides to offer you the following options. Option 1 is you pay a fine of $1,500 or Option 2 is you roll a fair dice and if it comes up with a six you pay $12,000 but if it comes up anything else, you get off Scott free without paying anything. In this situation, which option would you chose?

Dice_small.jpgWorking through the numbers, the expected value of Option 2 is -$2,000 (-$12,000 * 1/6 + $0 * 5/6 = -$2,000) versus the known value of Option 1 of only -$1,500. Oddly enough, in this situation many of the same risk averse decision makers who chose the sure thing in the first example (Option B) will now surprisingly chose Option 2 when the script is flipped (payouts versus windfalls) with a worse expected value because they want to avoid locking in a sure loss with Option 1.

We human beings are a hopeful bunch, which is a great thing. Without this characteristic, none of the amazing advances throughout human history would have ever been accomplished. But this characteristic can also be our worst enemy when it comes to investing. Hope is the reason people chose to roll the dice on Option 2 rather than take their medicine with much better Option 1. After all, there are 5 different dice rolls that can come up in which I win and get off Scott free with Option 2! In behavioral finance terms, this is known as loss aversion. Loss aversion is why people will ride stock picks down to $0 because they don’t want to lock in a loss on their original purchase price. The problem with this ”logic” is that the stock market (e.g. the collection of other investors and traders) doesn’t care about your purchase price, so why should that factor into your decision on the future prospects of the investment and whether or not you should sell, hold, or buy more of the stock?

On the flip side and going back to the first example, humans collectively are also risk averse which means they prefer a sure thing over an uncertain outcome with a higher expected value. Because of this, when it comes to investing, we have a tendency to cut our winners short. I’m sure everyone either knows someone or can personally relate to the story of buying XYZ stock at $10 a share, later selling it at $20, and is now kicking themselves over that decision because the stock trades at over $500 a share (Apple, Netflix, Google, or Tesla are a couple likely candidates). The desire to lock in a sure gain on an investment rather than take the chance of all those gains evaporating if the stock where to drop in price, is very common for most investors.

Flowers_small.jpg

Collectively, the two human characteristics we’ve outlined in this post (loss and risk aversion) is known in the investment world as “pulling out the flowers and watering the weeds.” In other words, if left to our human devices we will sell out way too early on our good investments and hang around way too long on our bad ones. This is yet another Cost of Being Human when it comes to investing.

It is for these reasons that we continue to believe that the most effective way to invest is through a disciplined, quantitative approach. For us, that means relying on MarketVANE to guide us through the good, bad, and turbulent times in the market. Following a disciplined buy & sell process such as MarketVANE can be difficult as there will be times where the model is wrong (right now may be one of those times for MarketVANE STOCKS which is currently on a yellow signal to use our stoplight analogy) and it doesn’t feel right to follow it. But this is exactly why we have these types of processes in place, because we don’t trust nor can we rely on our gut or feelings when it comes to long-term investment success. As such, we will continue to rely on our risk management protocol and trend following models with the understanding that a string of head fakes where we miss out a little will more than come back to us in spades during a large sell-off in the market.


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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