As value investors, we are taught to take emotion out of our investing decisions. However, Michael Mauboussin, the author of "More Than You Know: Finding Financial Wisdom in Unconventional Places," has argued that emotions are a critical component of decision making.
In chapter twelve, he cited the work of neuroscientist Antonio Damasio, who observed that people with brain damage and loss of feelings had trouble making successful day-to-day decisions. For example, a patient who had all the requisite faculties for rational behavior (attention, memory and logic) but no feelings lost the ability to make good decisions.
Mauboussin also cited an idea from Daniel Kahneman’s Nobel Prize lecture. In the lecture, Kahneman outlined two decision-making systems. System 1 was an experiential system, which was “fast, automatic, effortless, associative, and difficult to control or modify.” System 2 was analytical, slower, more demanding and consciously controlled. As I understand it, System 1 includes emotion, while System 2 tries to minimize emotion (since it can’t be completely eliminated).
But as we saw with Damasio’s work, emotion is necessary for good decisions, and Mauboussin wrote:
“So the evidence suggests that you can’t separate emotions (system 1) from decisions (system 2). In fact, as Damasio showed, system 1 needs to operate normally in order for you to make good judgments. From an investor’s standpoint, two questions become central: What influences our impressions, and how do these impressions shape perceptions of risk and reward?”
Mauboussin next introduced the subject of “affect,” which refers to the “goodness” or “badness” we feel after receiving a stimulus. As examples, he used the word “treasure” which produces a positive affect and the word “hate” which generates a negative affect.
“Affect” is a part of System 1, which means it is fast and automatic. Usually affect is quite reasonable, since the things that make us feel good are generally good for us, but it also has biases, which investors need to pay attention to:
“Let’s get more concrete. The goal of an investor is to buy an asset below its expected value. Expected value is the weighted-average value for a distribution of possible outcomes. You calculate expected value by multiplying the payoff for a given outcome by the probability that the outcome will occur.”
Regarding expected value, Mauboussin reported that research on affect shows two important principles:
- When the outcomes of an opportunity do not have a strong affective (emotional) meaning, we tend to overweight the probabilities.
- If the outcomes do have strong affective meanings, we tend to overweight the outcomes.
Think of lotteries and the advertising that promotes them. Marketers paint a vivid picture of how wonderful life would be after winning a lottery, and the picture is so vivid that players ignore the probabilities and focus on outcomes. In fact, research has determined that players have the same feelings about lotteries whether the probabilities are one in ten million or one in ten thousand.
At the other end of the spectrum, some people are afraid to travel by airplane because the negative affect is so strong; the probability of dying in a plane crash is extremely low, but if the outcome occurs, it will be devastating.
As Mauboussin noted, our experiential systems generally work well, but they sometimes fail. For example, we may be affected by advertising, with its enticing prospects that draw our attention to outcomes and downplay the probability of negative results.
He added that experiential systems can fail in non-linear and nonstationary systems. One such system is the stock market. “Accordingly, investors must take a very methodical and self-aware approach to judging expected values.” Still, he pointed out markets are not necessarily inefficient because of affect; there are millions of diverse individuals and so affect-driven biases may offset each other. He concluded the chapter with this warning:
“A dominant idea in Western society is that we should separate emotion and rationality. Advances in science show that such a separation is not only impossible but also undesirable. Yet successful investing requires a clear sense of probabilities and payoffs. Investors who are aware of affect are likely to make better decisions over time.”
Conclusion
In chapter twelve of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Mauboussin made his point that emotion must play a part if we are to make effective investment decisions.
As I understand the case, emotion as expressed in “affect” will influence the way we approach probabilities and outcomes. When affect is strong, as in the case of visualizing a million-dollar lottery win, we will tend to overweight the outcomes; if there is no strong affect, then we will likely overweight the probabilities.
To correctly assess expected values, we need to balance between positive and negative affect. This is what Mauboussin called, “a very methodical and self-aware approach to judging expected values”. Recognize emotion, recognize it has a place in investing decisions and proceed knowing that it may affect your judgment.
Read more here:
- More Than You Know: Influence
- More Than You Know: Investing and Stress
- More Than You Know: The Management Factor
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