Three ways to make better decisions – with Michael Mauboussin, Part 1

January may an obvious time to think about the future but, in an uncertain world, few will need much encouragement to do so all year round. Where investors – and people in general – often fall down, however, believes Michael Mauboussin, our latest guest on The Value Perspective podcast, is in failing sufficiently to consider just how many potential outcomes an uncertain future can hold.

As one would expect from an expert on decision-making, probabilistic thinking and the role of luck in investing, Mauboussin – one of our favourite value thinkers, who has held a number of senior positions in leading financial firms as well as teaching at Columbia Business School since 1993 and writing books such as The Success Equation, Think Twice and More Than You Know – had plenty of insights into the issue.

Mauboussin begins by touching on the principal reason people fail to factor in enough outcomes into their decision-making when they are thinking about the future. In a word, it comes down to overconfidence – although he adds this will typical have multiple components, continuing: “The first of these would be ‘overestimation’, which means we think we are better than we actually are at doing a particular task.”

Second is ‘overplacement’ – in effect, how we judge ourselves relative to other people. As we have discussed in pieces such as Word to the wise, here on The Value Perspective, this is most easily illustrated by the well-known psychological study undertaken in Sweden in the early 1980s that found more than three-quarters of participants rated themselves in the top 50% of all drivers for both skill and safety.

The final component of overconfidence is ‘overprecision’ – the idea that people can become too certain they know the truth of something and a behavioural sin investors can be particularly prone to committing. “We’re too sure we know how the future is going to unfold and, as a consequence, we don’t consider a sufficient number of outcomes,” says Mauboussin. “So the question is – what is the antidote to that?”

To his mind, investors should look to incorporate three tools into their decision-making process, the first of which relates to base rates – a topic we have previously touched on in articles such as Beyond the evidence of your own eyes. “The classic way to take on tasks or to try to solve problems is to gather lots of information, combine it with your own experience and point of view and then project into the future,” says Mauboussin.

“Psychologists, led primarily by Danny Kahneman, have suggested, however, we should integrate this idea of base rates, which involves looking at the past to try to anticipate the future. So a base rate would help you think about your problem as an instance of a larger reference class and then ask a very simple question: what happened when other people were in this situation before?”

In a business context, Mauboussin suggests this can be “fairly straightforward”, adding: “We could look at a company of a certain level of sales or turnover and then just say, of all the companies of similar size, what was the distribution of one, three, five and 10-year growth rates in sales or turnover? That allows you to understand to some degree if your estimation in your own model seems to make sense or not.”

Next up is the ‘premortem’, which was conceived by US psychologist Gary Klein and is gaining in popularity. “The idea is to launch yourself into the future,” Mauboussin explains. “Let’s say you plan to buy a stock or overweight a particular sector – pretend that you have made the particular decision, it has turned out disastrously and it’s now a year from today.

“Each of us independently – and that point is really crucial – then writes down why we think this decision worked out so poorly. It turns out there are some psychological mechanisms that make thinking ‘future-to-present’ more mind-opening then ‘present-to-future’ so a premortem is a great mechanism, again, to highlight these ranges of outcomes that do not always come up in conversation.

Mauboussin’s third decision-making technique is the deceptively simple idea of keeping track of what actually happened after the event. “This does require a degree of self-discipline but it is extraordinarily valuable,” he says. “When you make an investment, just write down what you expect to happen and why you expect it to happen.”

The key point here, Mauboussin adds, is to quantify these aspects in probabilistic terms. “Do not use vague phrases like ‘there’s a good chance X will be up next year’ or ‘we think it’s likely Y will be acquired’,” he counsels. “All your views should be written down using probabilities. One of the powers of tracking decisions in this way is it allows you to get honest feedback on your decision-making process.”

As Mauboussin observes in our podcast, the whole subject of decision-making remains undertaught, even in masters programmes and at business schools – but he concludes: “These three ideas – the application of base rates, using premortems and tracking your decisions – are readily doable, not super-expensive and very powerful techniques to allow people to improve the quality of their decisions.”

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