A conversation with the Chief Investment Strategist at Legg Mason Capital Management.

Question: Why are we wired to make bad investing decisions? 

Michael Mauboussin: The wisdom of crowds tends to work when you have you have three conditions in place. The first is diversity, so all of us are acting and thinking and operating in different ways. A properly functioning aggregation mechanism would be the second; so ways to bring our information and our varied views together. And then, finally, properly functioning incentives, which are rewards for being right and penalties for being wrong and of course, they can be monetary, but they don’t have to be. 

So when those things are happening, you tend to get very good results from groups and markets themselves tend to be pretty well functioning and "normal." Now the flipside is what happens when one or more of those conditions are violated and by far the most likely to be violated is diversity. So rather than each of us thinking independently, with our own points of view, we start to coordinate our behaviors. And this is a very, very natural human reaction. We like to be part of the group and we like to go with what is working and this, I think, is ultimately the bane of most people when they invest, which is when things are going really well, all the fibers in your body says "I want to be a part of that group and I want to be making money along with that group." And inversely, when things are going badly, you become very fearful and you want to avoid it. It’s almost a notion of disgust, you almost push it away when. in reality, we know from a lot of experience that you want to be selling when everyone’s buying and buying when everyone’s selling. 

So it's very... our innate sort of motivations are almost counter to what makes you a successful investor and I guess the last comment I’d make on that is you find that many of the great investors, very successful investors, are those that really, in some ways, can be an emotional check. They don’t tend to be swayed by the views of others around them; they tend to be very independent, which, you know, I think is a fairly unique trait that can be developed to some degree, but think it’s a very unique trait for most great investors. 

Question: Is it best to take a contrarian view of the market? 

Michael Mauboussin: I think it’s a little bit deeper than that. There’s a really successful investor in Boston named Seth Klarman, he runs something called the Baupost Group and they’ve done really great over a long period of time and he’s got a line which I just love which is "Successful investing is the marriage of a calculator and a contrarian streak." So maybe start with a contrarian streak. It really is important to be a contrarian, sort of do what everyone else is not doing. That said, that’s not enough, right, because sometimes being a contrarian for the sake of being a contrarian is a really bad idea. In other words, if the movie house is on fire, by all means, do run out the door, right, don’t run in. So sometimes the crowd is correct. 

The calculator part is the second one, which is if the group is off on one side or the other of the ship, tilting the ship, then you have to apply a calculator, which is determining whether the expectations built into the asset price, let’s say a stock to make it concrete, misrepresents the fundamental prospects for that company. So are the expectations and fundamentals mispriced relative to one another? And that does require some analytical work.  

The best metaphor for the expectations of fundamental really is the racetrack; horse racing, so you know there are two different things. One is the odds and the tote board, which dictate the probability of a horse winning or coming in at some place, and then the actual performance of the horse. 

Knowing which horse is going to win every race doesn’t make you money because, of course, it’s already reflected in the price. The key is to find mis-pricings between the tote board and the performance of the horse and it’s a very similar thing. So it’s the contrarian streak plus the calculator, I think, is the one/two combination. 

Question: Why is the "inside view" not wise when investing? 

Michael Mauboussin: The inside view says that when we face a problem, what all of us typically do is gather lots of information about the problem, combine it with our own inputs and then we forecast into the future. So that could be, you know, "How long is it going to take me to remodel my kitchen? When am I going to finish my term paper? How long will launch a new product for a company?"

The outside view in contrast says I’m going to look at my problem as an instance of a larger reference class. So it allows me to ask a really simple question which is, "When other people have been in this situation, what happens statistically or probabilistically?" There are lots of problems that we face as individuals that are unique to us, but lots of other people have been through before so there’s this thing called the database of humanity waiting for you to tap into it. 

The inside view, by the way, importantly, is the natural way to do things; it’s sort of how your mind’s naturally going to work. So the outside view requires you basically to leave aside this cherished information that you’ve gathered and your own point of view on things in order to forecast. 

So it turns out that we all tend to be too reliant on the inside view which often leads to too optimistic assessments of our futures. So you know the old things, people say "How long’s it going to take you to remodel your kitchen," and people will say to you, "Whatever you think, double the time and double the cost," right? Because you’re relying on the inside, they’re telling you, they’re reminding you to go back to the outside view. But it’s true for the world of investing as well which is we have lots and lots of data about, for example, the growth rates of companies or the return on invested capital patterns or the returns of assets over time and we tend to be caught up very much in the moment with our own points of view, we tend to leave that kind of information, valuable information, to the side. 

So the point is, when appropriate, always seek to look for the outside view and help that inform your inside view and again, more times than not, it tends to damp optimism that’s unduly generated. 

Question: How much should an investor take past performance into account? 

Michael Mauboussin: Everybody knows that the outcomes they observe are a combination of skill and luck, but I think as people, we tend to be not very good at understanding the relative contributions of the two. So one of the ways I like to think about this is there are some activities in life that are pure skill. If you and I have a running race or something like that, you know, the faster person will win almost every single time. And there are some activities that are pure luck. If you go roulette or you roll the dice, it’s going to be randomness and then almost everything else in life is in between. But what’s interesting is they're not right in the middle, they’re almost always leaning toward the skill side or they’re leaning toward the luck side. 

So the question is always when you’re observing a particular activity, where is it on the continuum? One of the things I like to think about are sports, because we have a lot of data on sports and people tend to be very familiar with them. But it probably wouldn’t come as a big surprise that things like baseball or premier league soccer in the UK tend to be a lot more on the randomness/luck side and things like basketball or tennis tend to be much more on the skill side. So it’s an interesting thing that most of us know that skill and luck combine for outcomes, but we don’t have a good sense of where things lie. 

So that has all sorts of important implications. I’ll just mention a couple of them. The first is whenever there’s luck in the system, there’s going to be lots of reversion to the mean. That means if you have an extreme event, either extremely good or extremely bad, you should expect the next thing to be closer to average. So that’s true, for example, for corporate performance. If a company’s been doing really, really well, sales growth has been really rapid, you should expect that the next growth rate should be something closer to average. 

The second thing that’s really interesting is what kind of feedback you give people. Feedback in our society tends to be very outcome-oriented, based on what we have observed, and does it really reckon with this issue of the skill/luck contribution. But if you’re giving feedback properly, it should be focused only on the skill component, only on what people can control and to the best of your ability; you should leave aside sort of the randomness or the luck component. 

Question: How does the media influence investment decisions? 

Michael Mauboussin: The media tends to be an amplifier, not surprisingly, and so when the collective tends to be tending toward optimism or pessimism, the media often will fan the flames of that. There have been studies of this, for instance, studying magazine covers from famous business magazines, some BusinessWeek, Forbes and Fortune and such. What these academics did is study cover stories and basically when the cover was really bullish and a company had done really well, not surprisingly because reversion to the mean, they tended to do much more poorly in subsequent periods. Likewise, if they had a negative cover story, you know, this company’s in the doghouse and they've done very poorly, they tend to do much better subsequently. So I think that’s one very big important instance of this. 

The second thing I’ll mention on this which is really fascinating emanates from the world study on experts and we all love to know what’s going to happen in the future. We just want someone to say "Markets are going to go up," or "Markets are going to go down," or "Here’s your future." We all pine for this. But what we know is experts in certain domains, and I would specifically mention economic and political domains, are notoriously poor forecasters. 

The best work on this is done by Phil Tetlock who is a psychologist at Cal-Berkley, and he wrote an absolutely wonderful book called "Expert Political Judgment" where he actually got hundreds of experts to make tens of thousands of specific predictions over a long period of item, and then he actually kept track and it turns out these experts really were poor, poor predictors. In fact, extrapolation algorithms did, in many cases, close to as well. 

Tetlock, though, did find two things that were statistically significant. The first is the more media mentions a pundit had, the worse his or her predictions. So this goes back to your point on the media. Turns out the talking heads on TV are among the worse predictors of our experts. So even though we love seeing them and we love to defer to their judgments, we know that they are not very good at what they do. 

The second thing he found is that it didn’t matter so much what your age was or gender or political persuasion, what mattered was how you thought about the world and he demarcated the world into what he called hedgehogs—"I know one big thing and the world view fits into that"—and foxes, these are the people that know a little bit about a lot of different things and what he found quite consistently were that foxes were better predictors than hedgehogs. 

Now the hedgehogs always had their 15 minutes of fame when their predictions came true, but navigating over time, the foxes tended to do better. 

Question: Has the financial crisis made us more risk-averse? 

Michael Mauboussin: The first important thing to articulate is that when we enjoy a gain of a dollar and the loss of a dollar which are, of course, symmetrical, we tend to suffer two to two and a half times more from the loss then we enjoy the gain, so there’s this asymmetry of suffering versus joy in financial matters that’s important to lay out. The key, though, that loss aversion ratio; there are two key points about it. Number one is its different from person to person. So you and I may differ in our loss aversion coefficients and that really is true across the population and the second is: your own loss aversion coefficient may change based on your most recent experience. So if you’ve been winning a lot lately, you may have one risk attitude; and if you’ve been losing a lot, a different risk attitude. 

There’s one study I can’t resist telling you about which is really fascinating in this regard. And what they did is they took people that were unfortunately brain damaged—this is mostly from stroke victims—and the key to that brain damage is that it did not affect their mathematical or calculation capabilities, so they could do math fine, they understood present values. The part of their brain that was damaged was their emotional seat, their ability to feel fear or greed or anguish or those kinds of things. And then they pitted that group against a group of normal people and here is the contest. They were given $20, and they were to play 20 rounds of a game and in each round, you could do one of two things. You could just keep the dollar, put it in your pocket, go on to the next round. Or you could hand your dollar over to the researcher who would flip a coin and you would get $2.50 for the correct call and you would lose your dollar if you had an incorrect call. 

If you work out the math of this, it’s not very complicated. You should hand your dollar over because its $1.25 expected value versus just keeping your dollar. And incidentally it was really cool. First five rounds pretty much everybody gets it, so everybody's handing their dollars over, right? But to make a long story short, at the end of the game, what they found was the brain-damaged people ended up with 13 percent more money than the normal people, which is a very large margin given only 20 rounds of the game and, in particular, it's because they played many more rounds than did the normal people and, specifically, twice as many rounds after having suffered a loss. 

All right, so you can imagine you’re playing this game, you’re one of the normal people, you hand your dollar over, you win some, you lose some. But if you lose a couple in a row, you can see the thought of, you know, maybe I’ll just keep my dollar in my pocket here, sit out a couple of rounds and then I’ll come back when I’m feeling better. And you can see how that ports right over to the stock market. When you’re doing well, you want to keep handing your dollars over because you’re feeling really good about things, but if you’ve lost for some time, you might say to yourself, you know what, I’m perfectly happy to put this dollar in my pocket and sort of sit out a round or two. 

So how is this manifesting? Well, the S&P 500, the widest known benchmark for the market, has been down for the last ten years. Anybody that invested for the last ten years has lost money. That doesn’t feel good. So what people do is they either put it in cash and or cash balances are really high in America, or they buy bonds, right, fixed income, a little bit more boring, less racy, but it's equivalent to having the dollar in your pocket. 

Now what allows us to turn around? I’m not really quite sure. If the markets do do better, people will slowly tiptoe back into the market. We had a much better 2009 and we’re starting to see that flow now back into equity funds and much less into bond funds. 

One interesting question is: are people scarred by this? Will a generation be scarred? And the answer may be yes. However, if you go back into history in the 1920s and 1930s where we obviously had a very difficult market, following that really difficult period, the markets did improve, so somebody was buying the stocks back in that period as well. So my own sense is if the conditions are right—valuation, economic growth and so forth—the conditions are right for markets to do better, we will indeed see better returns and that risk aversion will fade a little bit into the future. 

Question: Do emotional people have less success as investors? 

Michael Mauboussin: I will say I think you’re on to a really important thread, which is the bottom line is that people that are very outgoing and people oriented and attuned to other people’s emotions tend to have a difficult time investing because they feel most comfortable as being part of the group. People that tend to be more reserved, more independent, less attuned to people emotionally, tend to be better investors. So it’s not a judgment call because some of these—I don’t know if you want to call them skills—but these natural tendencies may not serve you well in other facets of your life. 

Question: How does what’s going on around us affect our investment strategies? 

Michael Mauboussin: A lot of us like to think of ourselves as being independent and objective and fact-based. But, in reality, a lot of what we decide is influenced by what’s going on around us and sometimes just random things can influence those things. So to give you a couple of examples to bring this point home; the first is an experiment I do with my students up at Columbia Business School. We do this the very first day of class: I ask them to write down the last four digits of their phone number—it’s a random thing and they all write that down. And then I ask them to go on to estimate how many doctors there are in Manhattan. They obviously know these are completely unconnected numbers, but it turns out, very consistently, with people who have low-ending phone numbers guess relatively low number of doctors, this year they guessed 14,000. People with high ending phone numbers guess a much higher number, this year they guessed about 26,000 and then people with middle phone numbers guess something in the middle; this year it was about 17 or 18,000 doctors. So they are clearly anchored based on their phone number, even though they know it has nothing to do with that. So there’s one example of this notion of anchoring. And by the way, that’s a contrived anchor that was one that I threw into them. 

But in life, there are many natural anchors as well, so if I asked you a question like, "At what temperature does vodka freeze?" you may not know the answer, but you’d probably know at water freezes at 32 degrees Fahrenheit, you know that vodka is an alcohol, so it’s likely lower than that and you’d probably go down, down, down. But still, you probably wouldn’t go down far enough; you’d stay too close to that anchor. So anchoring is one great example that you’re influenced by what’s happening or some recent piece of information. 

The second experiment I love on this—and this is obviously an auditory thing—is an experiment they did with wine. So researchers went to a supermarket and they set up the wine section with French and German wines, roughly matched for price and quality and they put a little French flag and a German flag so people would know and then over a two week period, they alternated playing French and German music; distinctively French and German music to see what happened. And it turned out when they played French music, people bought French wine 77 percent of the time. And when they played German music, people bought German wines 73 percent of the time. So this is a remarkable outcome. 

What’s interesting is as the consumers were checking out, the researchers went up to them and said "Hey, can we ask you a couple of questions?" Sure. "Did you hear the music today?" And they all say "Yes, I heard the music." They say "Did the music have any influence on your purchase decision?" and remarkably nine out of ten people say "No." So again, this was an extraordinary observed influence, but somehow not captured in people’s consciousness. 

So the point is that we are constantly bombarded with things like anchors or situations that deeply influence how we decide and it’s somehow below our level of consciousness. So, I mean, the question is what do you do about that? And I guess there are a couple of things I would say is one is to the degree that you’re able to do this is to be hyper-aware of what’s going on around you as you’re deciding. Really soak in the environment, soak in what other people are doing and ask yourself as bluntly as you can, "Is this influencing my decision for the better or for the worse?"

The second thing is to recognize that—and this is especially true for executives or leaders in organizations—is to recognize that you are creating a decision-making context for others. So how you set up the environment, the kinds of questions you pose, even physical layouts of offices, can influence how people decide. And again, you’d love to have the people that work with you be objective and fact-based, but that decision-making environment is very much something that can be contrived and manipulated for better or for worse. 

Question: What advice would you give to a new investor? 

Michael Mauboussin: The first thing is to really think about your own situation to the best of your ability. So, you know, how old are you? How long are you going to be investing? What is your risk tolerance? And just try to be as honest as you can. So that’s the first thing. 

The second thing is to constantly save and invest. It sounds very simple and trite, but people that consistently save, set aside part of their compensation and invest it, over long periods of time, do very well because of the power of compounding. 

The third thing is that, notwithstanding our recent difficult ten year period for equities, and by the way, we’ve had three such episodes over the last hundred years or so, so this is actually pretty unusual in a longer-term context; is it’s very likely that stocks equities will do better than bonds over time and I think that’s probably particularly true today. So if you’re young and you have a long future and you’re going to be setting aside money, equities probably does make more sense than bonds. And the last thing is to recognize it is a big world out there. The United States is obviously really important in the big world; but it’s becoming less and less relevant. So it’s important to spread and diversify your investments across the globe and to make sure that you’re participating in that ultimate economic growth, demographics and so forth. 

Question: Will China surpass the U.S. as a financial superpower? 

Michael Mauboussin: I think the future for growth is quite bright. That said, there are a couple key things for ultimate growth. One is to make sure that intellectual capital is well protected. So much of the wealth creation in our world is not going to be from agriculture or even basic manufacturing, but really the world of ideas, services and knowledge goods. And for that to really work in a society, they must be well protected. I don’t think that’s yet perfectly the case in China. 

The second thing is they’re working on their education system and its becoming much improved, but still the elite education system is based in the West, predominantly, the United States and to a lesser degree, Europe. Now that is changing, but that won’t change overnight. And what’s important about that educational system is that is it leads to ideas in services and knowledge. And that’s really important. 

And the third thing is while their stock markets are now certainly developed, they're still not a fully developed community that allows for, for example, our venture capital community; investing in new businesses, mechanisms to succeed, but also mechanisms to fail. And I think those are some important pieces of glue that allow for a sustainable long-term growth that China has yet to fully adopt. So will they grow, yes. Will they close the gap with the United States; I think the answer is yes, but it’s essential that some of those other pieces click into place for it really to be ultimately the next big superpower. 

Question: Where will the next financial crisis come from? 

Michael Mauboussin: There are a couple of areas that I think the people should keep an eye out and these are well known, so I have no particular insight about these. Certainly, the China property market is something. We’ve seen some reports and some of that’s already rolled over, but China’s had a very, very overheated property market and that could be something that would be vulnerable, and again the magnitude would not be the same as it was in the United States, but that would be quite costly. 

Another one is the U.K. property market; I think the U.K. has also had a very strong property market and it’s got some of the same characteristics, but I don’t really know if those things are legitimate concerns or bubbles that’ll deflate. I know it’s funny because a lot of people do want to talk about bubbles and that we should try to prevent them and so forth. And, you know, I think the classic line from Alan Greenspan to Ben Bernanke is it’s very difficult to know until after the fact and I can see both points of view on that, but it is hard to really anticipate these things with any sort of... in a systematic way.