Season Investments


Thinking in Probabilities

Posted on September 18, 2018

“It’s a lot harder to spot your mistakes when you win.” – Annie Duke

2018-09-18_Multiple_Doors_to_Choose.jpgLast week we published a post entitled Why We Scapegoat which was inspired by a podcast I listened to with world renowned poker player Annie Duke about her book with the same title as this post. We unpacked how the human brain can fall prey to a number of cognitive biases which lead to less than optimal decision making. One of those biases includes our tendency to make excuses or find a scapegoat when we experience a bad outcome. If you didn’t read last week’s post, I highly recommend you do so now as we will continue building on this frame work in this week's post.

As stated last week, “the human brain is inherently lazy.” What we mean by this is that we tend to gravitate toward the path of least resistance by developing rules of thumb rather than taking the time to analyze all the information we are presented with on a daily basis. One such rule of thumb is to judge the quality of a decision based solely on the outcome it produces. This is known as a resulting bias where we use the benefit of hindsight to judge the merits of a decision that was made under uncertainty about the future.

The problem with this short-cut is that it completely ignores the role that chance/luck can have on any particular outcome. For example, let’s pretend someone offers us the following bet on the flip of a fair coin: 2018-09-18_Nickel_on_a_desk.jpgheads we win $200; tails we lose $100. Putting aside any moral convictions on gambling for the moment, most people should take this bet because the expected value is a positive $50 ($200*50% - $100*50% = $50). For those with an appropriate risk tolerance (e.g. can you afford/stomach losing $100), the right decision is to accept the bet. But now let’s pretend that we flip a tail and lose $100. Does the bad outcome somehow mean that we made the wrong decision on the front end? Absolutely not! Given the amount of information at the time and accounting for the impact of chance/luck, we determined that the right choice was to take the bet knowing that we had a 50/50 chance of experiencing a bad outcome.

The other problem with this short-cut analysis is that it ends up being an innovation killer. One sport where we see this in spades is the NFL. As big data has become more and more popular and infiltrated its way into professional sports, questions have arisen about the merits of some of the more conventional strategy decisions. One of those being the decision to almost always punt on 4th down. The argument, with the data to support it, was made that the optimal decision is to not punt and to go for the first down on most 4th and short situations. This analysis was done close to a decade ago, and although we have seen some coaches decide to go for it more often on 4th and short, by and large, the conventional wisdom is still that the correct choice is to simply punt.

So why hasn’t the game adapted to the more optimal choice? The reason is because coaches are also managing their own job security risk. It is better for a coach to punt the ball away and lose then it is for them to fail on a 4th down conversion and still lose. In other words, the risk of a failing unconventionally far outweighs the benefit of success. Or as famed economist John Maynard Keynes once stated, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” We’re not convinced that it is better to fail conventionally than to succeed unconventionally, but we can say with a fair degree of certainty that the world is not kind to those that fail unconventionally!

Look no further than the Super Bowl from three years ago when Pete Carroll decided to have Russell Wilson throw a pass on second and goal from the one yard line. Anyone with even a remote interest in football knows that the pass ended up being intercepted and cost Seattle any chance at winning the game. The media was quick to label Carroll’s decision as the worst play call in Super Bowl history. But what if the play had worked and the Seahawks ended up scoring a touchdown and winning the game? Would everyone still think Carroll was an idiot for calling up a pass? Well, we need not look any further than last year’s Super Bowl when Doug Pederson decided to call a trick play known as the Philly Special on 4th down from a similar position on the field. Unlike Carroll’s call, Pederson’s worked beautifully, resulted in a touchdown, and helped the Eagles win the game. Both coaches decided to go against the grain with an unconventional call, but because we are so quick to judge decisions based on outcomes due to the resulting bias, Pete Carroll’s decision is considered to be moronic while Doug Pederson’s has vaulted him into the stratosphere of a football genius.

Instead of looking at two binary outcomes (e.g. good or bad) to judge the merits of the decision, we should try to divorce our opinion from the outcome and judge the decision based on the merits of the process. But how do we do this? In Annie Duke’s case, she made a point not to tell her poker peers the outcome of any particular hand she had questions about. Instead she would simply retell how the hand unfolded and her decision process at each step along the way without giving away the ending. By doing this, it allowed her peer group to judge her decision process and provide feedback without being influenced by an inherent resulting bias.

Annie also talks about how businesses can foster innovation and encourage non-conventional thought by doing something called a pre-mortem analysis where everyone comes up with a list of reasons why a certain decision might lead to a bad outcome. Not only does this change the dynamic because those that come up with the most creative failures are applauded, but by giving voice to these potential paths to failure, people start to view the world through a lens of probabilistic outcomes. In doing so they simply weigh the good (flipping heads and winning $200) versus the bad (flipping tails and losing $100) rather than judging the merits of the decision based solely on the outcome.

Finally, I’ll wrap up with a personal story which made me beam with pride. The other weekend I had the Colorado – Nebraska football game on while I was getting some work done on the computer. My oldest daughter Eliana loves to watch sports with her dad, so she sat down with me to watch the game. It ended up being a nail biter where CU drove down to score the go ahead touchdown with 1:06 left in the game. Being down by 5 points and needing a touchdown, Nebraska managed to take the ball all the way down to the Buff’s 20 yard line with only 3 seconds left in the game. At that point I turned to Eliana and asked her if she thought the Cornhuskers were going to score. Expecting her to give me a simple “yes” or “no” I was pleasantly caught off guard when she responded, “I think it’s about 80% that they don’t.” Couldn’t…be…prouder!

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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