It’s estimated that in an average day, you will make somewhere around 35,000 decisions. Many of them are unconscious, but the sheer volume is staggering. What to wear, where to eat, how to get to work, who to call when you get there, all of these little things add up. You could easily argue then, that learning a bit more about the decision making process, and improving your decision making, is a worthy investment.
To be an intelligent investor and portfolio manager, understanding the fundamentals of decision making is essential. After all, capital allocation is a form of active, practiced, and calculated decision making. At any given moment in time, a portfolio manager sitting on cash is confronted with the question: “What’s the most efficient application of this capital?” Those investors who can answer this question with conviction and back it up with outstanding returns are in high demand.
Expanding Your Universe to Develop Your Taste
One way we all make decisions in life is to start the process by gathering as many options as possible. Whether this is investing related, or just a normal, everyday life decisions like looking for a new car, an intelligent consumer seeking the best deal knows to shop around before making a brash choice. Even though the consumer might already have her final decision in mind, it helps to affirm this choice by engaging in the act of evaluating options.
For more commodity-type products, like which brand of toilet paper to purchase, this evaluation process may be unnecessary, as there are generally few consequences of a wrong choice and small differentiation between products. But when it comes to big decisions, like choosing your husband, job, or home, it pays to invest the time. With high-consequence decisions, it’s usually not enough to know that you like something, you must also be able to articulate your reasoning.
There’s a brilliant essay written about this exact idea written by the highly successful and influential technology startup investor, Paul Graham. In Taste For Makers, Graham writes, “The recipe for great work is: very exacting taste, plus the ability to gratify it.” Developing this taste requires commitment, practice, and repetition, but in doing so, you really do start to notice things you never thought about before. It’s only after you’ve honed in on this ability to articulate your preferences, can you begin to gratify them.
Narrowing the Options
Once your pallet has been established, the next most common step in the decision making process occurs by narrowing the option pool down into a smaller, more manageable group. As I mentioned earlier, you make 35,000 decisions every day, so picking between fewer options actually helps improve the quality of your final choice. Basically, the fewer decisions you have to make, the better. The reason, is to avoid what psychologists call, decision fatigue. For example, after a day of exhausting decision making, your brain slowly loses the stamina for peak critical thinking. In other words, you might get crushed if you played the world champion in chess fair and square. But arrange the match so that you’re the last person in line to play the champ after a nonstop 24-hour chess marathon, and you might stand a better chance.
One recommended way to narrow your options is to automate as many decisions as possible. Habit formation becomes an increasingly useful tool, because it allows your brain to operate on a set routine that requires very low level decision making. Even automating little things like what you eat for breakfast, what you wear every day, and when to go to bed, all help you reduce the amount of decision fatigue.
The bottom line here is that while an initial enormous pool of options ensures quality candidates, narrowing the field is a must in making a final selection. Just as an animal freezes when it sees a predator, humans react to the bombardment of too much information with paralysis, a concept Swarthmore psychologist, Barry Schwartz writes about in great length in his book, The Paradox of Choice.
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Guy Spier, founder and chief investment manager of Aquamarine Capital is an outstanding contributor to the value investing community with a track record that volumes to his wisdom. In the video above, Guy shares his thoughts on reducing decisions:
Perhaps part of the wisdom I’m trying touch on and reaching for, which I don’t think is in the book and it’s part of this willpower idea of trying to reduce the number of decisions you make. I actually think it’s quite possible that my returns would not be much worse and might even be better if I was only allowed to trade on one day a year, so every January 1st or the first week in January, make all my trades and then not do anything for another year and just let those decision build up.
“You must choose, but choose wisely” – Indiana Jones and the Last Crusade
Once the pool of options have been narrowed, the next step for making higher quality decisions is to remove emotion from the equation. In general, your decisions are highly personal, as they originate from your own mind. However, that doesn’t mean all decisions should be taken personally. Often times, we find ourselves torn between emotion and logic, but what’s really going on?
The answer to that question can be found in Daniel Kahneman’s book Thinking Fast And Slow. Not only is Kahneman’s book among the top recommended by investors, the ideas and examples offer striking clarity to this complex and fuzzy decision making process. The essence of Thinking Fast And Slow is that your brain operates using two systems. System 1 is the quick-reaction, instinctive, and emotional voice in your head, while System 2 is the logical, calculated, and long-term planning voice. Intelligent investing requires the use of System 2.
Even though you may think you make the majority of your decisions based on logic, it’s surprising to discover how many choices are actually influenced by emotion. To throw another wrench into this whole process, we know that people decide differently when under pressure, or if high risks are involved–exactly the kind of scenario experienced by investors. Kahneman further explains these ideas in his paper on Prospect Theory which highlights how fear of loss or the temptation for high returns skews our rational mind.
Josh Kennedy, is the Managing Partner for Sonian Capital Management. In the video below, Josh explains how investors expend so much energy trying to avoid making hard choices by looking for an informational advantage that will guarantee them a “sure thing”. Instead, investors should focus on making better decisions.
The purpose is to make better decisions. And the real value of investing and learning about the psychological and behavioral components of investing is to recognize that your advantage is going to come from making better decisions with the available information, not coming up with better information.
You will make approximately 35,000 decisions today. But just like walking or blinking, many of these choices will be made unconsciously. And as a result, most people will never take time to think about how improving your decision making process can provide a lifetime dividend of better choices.
The process starts with casting the largest net possible to expand the universe of available options and to refine your taste for quality. The next step is in the constricting or narrowing of options. Too many choices can be overwhelming to your brain, so it’s best to make some cuts to allow for more focused thinking. Finally, you must learn to remove your emotion from your choices, even if there’s risk involved.
You Don’t Know What You Don’t Know
Before I end this article, I want to leave you with one final thought. Once you’ve got your rational decision in mind, it never hurts to ask yourself, “What am I missing?” Charlie Munger likes to take a problem and invert it, or flip it upside down to get a new perspective. The reason is to avoid events as written about in The Black Swan by Nassim Nicholas Taleb. It’s not the risk you know about that will cause you problems, it’s the risk you never saw coming. The last step to making better decisions is to reflect on what you don’t know. Most of the time, you’re initial choice will remain the same, but asking this simple question of yourself can save you from unforeseen mistakes.
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