On our Amer­i­can episode this week, while talk­ing about Colom­bian oil explo­ration out­fit GeoP­ark, we had rea­son to men­tion the clas­sic val­ue invest­ing book “What Works on Wall Street: A Guide to the Best-Per­form­ing Invest­ment Strate­gies of All Time” by James P. O’Shaugh­nessy (his cousin was a co-founder of GeoP­ark — their grand­fa­ther was an OG Amer­i­can wild­cat­ter).

This prompt­ed me to pull out WWOWS again and review it. This caught my eye.

In Chap­ter 2 “The Unre­li­able Experts: Get­ting in the Way of Out­stand­ing Per­for­mance”, he talks about deci­sion mak­ing, and the two basic mod­els peo­ple use to make deci­sions.

model-machine-scaled

“Gen­er­al­ly, there are two ways to make pre­dic­tions. Most com­mon is for a per­son to run through a vari­ety of pos­si­ble out­comes in his or her head, essen­tial­ly rely­ing on knowl­edge, expe­ri­ence, and com­mon sense to reach a deci­sion. This is known as a “clin­i­cal” or intu­itive approach, and is the way tra­di­tion­al active mon­ey man­agers make choic­es. The stock ana­lyst may pore over a com­pa­ny’s finan­cial state­ments; inter­view man­age­ment; talk to cus­tomers and com­peti­tors; and final­ly try to make an over­all fore­cast. The grad­u­ate school admin­is­tra­tor might use a host of data, from col­lege grade point aver­age to inter­views with appli­cants, to deter­mine if stu­dents should be accept­ed. This type of judg­ment relies on the per­cep­tive­ness of the fore­cast­er.
The oth­er way to reach a deci­sion is the actu­ar­i­al, or quan­ti­ta­tive, approach. Here, the fore­cast­er makes no sub­jec­tive judg­ments. Empir­i­cal rela­tion­ships between the data and the desired out­come are used to reach con­clu­sions. This method relies sole­ly on proven rela­tion­ships using large sam­ples of data. The grad­u­ate school admin­is­tra­tor might use a mod­el that finds col­lege grade point aver­age high­ly cor­re­lat­ed to grad­u­ate school suc­cess and admit only those who have made a cer­tain grade. In almost every instance, from stock ana­lysts to doc­tors, we nat­u­ral­ly pre­fer qual­i­ta­tive, intu­itive meth­ods. In most instances, we’re wrong.

Jack Sawyer, a researcher who pub­lished a review of 45 stud­ies com­par­ing the two fore­cast­ing tech­niques: In none was the clin­i­cal, intu­itive method—the one favored by most peo­ple-found to be supe­ri­or. What’s more, Sawyer includ­ed instances where the human judges had more infor­ma­tion than the mod­el and were giv­en the results of the quan­ti­ta­tive mod­els before being asked for a pre­dic­tion. The human judges still failed to beat the actu­ar­i­al mod­els!”

As the Sawyer study was done in 1966, and is a lit­tle long in the tooth, I did some dig­ging into this the­o­ry that mod­els out-per­form human intu­ition, and found that while the orig­i­nal Sawyer review cov­ered 45 stud­ies, mod­ern meta-analy­ses now encom­pass hun­dreds of cas­es across med­i­cine, psy­chol­o­gy, finance, and crim­i­nal jus­tice, con­sis­tent­ly show­ing that mechanical/actuarial mod­els out­per­form human intu­ition by a mar­gin of 10% to 15% on aver­age.

How­ev­er, there are caveats.

  1. The “Bro­ken Leg” Rule , devel­oped by Paul Meehl, an Amer­i­can clin­i­cal psy­chol­o­gist. He point­ed out that the most sig­nif­i­cant excep­tion is when a human pos­sess­es a sin­gle, high-valid­i­ty piece of infor­ma­tion that the mod­el was nev­er designed to account for. Exam­ple: If a mod­el pre­dicts a per­son will go to the cin­e­ma tonight based on a five-year pat­tern, but you know that per­son just broke their leg, you should over­rule the mod­el. The catch, how­ev­er, is that “Experts” tend to see “bro­ken legs” every­where. They mis­take “inter­est­ing” or “salient” infor­ma­tion for “pre­dic­tive” infor­ma­tion. To beat the mod­el, the human must only inter­vene for rare, high-impact facts that tru­ly negate the base rate.
  2. High-Valid­i­ty Envi­ron­ments (Kah­ne­man & Klein). Daniel Kah­ne­man (who cham­pi­oned the mod­el-is-bet­ter view) and Gary Klein (who cham­pi­oned expert intu­ition) found a truce. They con­clud­ed that human intu­ition can be supe­ri­or, but only if two con­di­tions are met: The envi­ron­ment must have sta­ble, pre­dictable reg­u­lar­i­ties (e.g., fire­fight­ing, chess, anes­the­si­ol­o­gy). And the expert must have had years of prac­tice with imme­di­ate, high-qual­i­ty feed­back. Unfor­tu­nate­ly, they con­clud­ed that in “noisy” envi­ron­ments like psy­chi­a­try, polit­i­cal fore­cast­ing, or stock pick­ing, there is no “reg­u­lar­i­ty” for the brain to learn, and mod­els remain unde­feat­ed.

broken leg

The bot­tom line for us as investors is that there’s a very high prob­a­bil­i­ty that our intu­ition is almost always going to be wrong.

What works best over the long term is a mod­el that tells us what to do.

I might think I know bet­ter than the mod­el. My gut feel­ing might tell me I should­n’t invest in, say, APOLLO TOURISM because they have let me down time after time (a ref­er­ence our long-time lis­ten­ers will under­stand).

I should ignore my gut feel­ing.

That’s prob­a­bly the hard­est les­son to learn. Our brains suck at mak­ing deci­sions. Lis­ten, brains are great. Nice work, evo­lu­tion. Sure, it took mil­lions of years and lots of side quests, but you did some­thing pret­ty cool.

But a mod­el will beat a brain almost every time.

Yeah yeah, the brains built the mod­els. Sure. So the brains win in the end.

But only if they let go of their feel­ing of supe­ri­or­i­ty and give in to the mod­els.


QAV Myth Killers is a week­ly col­umn in the QAV newslet­ter, tak­ing apart a piece of
invest­ing con­ven­tion­al wis­dom. Read the series, or
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