So you want to be a stock market investor? Take this test first!

Johnny HopkinsMichael Mauboussin, Research, Study1 Comment

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One of the great things about being a stock market investor in the year 2016, is that we have the internet. That means we have access to loads of free information to help us become better investors.

There’s lots of great research that tells us why we continue to underachieve in the stock market. One of my favorite bits of research is by a guy called, Michael Mauboussin.

Michael Mauboussin is the Managing Director and Head of Global Financial Strategies at Credit Suisse. He’s also written three books, he’s been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean’s Award for Teaching Excellence in 2009.

So, it’s fair to say, he’s an expert in the area of investing!

Michael Mauboussin wrote an excellent research paper together with Dan Callahan, CFA that shows that we have an over inflated opinion of how well we make decisions, including those related to stock market investing.

The paper, titled IQ versus RQ – Differentiating Smarts from Decision-Making Skills. Think of IQ as the horsepower of an engine and RQ as the output. The research demonstrates that we think we’re smarter than we actually are.

When asked about his success, Warren Buffett emphasized that it was RQ that made the big difference, not IQ.

How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output.

One way to assess our rationality is through a test of calibration. Think of a weather forecaster. If it actually rains 70 percent of the time on the days she predicts a 70 percent chance of rain, she is well calibrated. She is poorly calibrated, on the other hand, if it only rains on 30 percent of those days.

Mauboussin and Callahan conducted this classic calibration test, which you can take too, with 1,985 participants. The test requires that you answer a series of questions, then state how confident you are that your answer is correct. That is, if you are unsure whether your answer is correct you would select 50% confident. If you are certain that your answer is correct, you would select 100%, and anywhere in between. There are also a number of stock market research services in Australia you can use.

Here’s what they found:

The horizontal axis (the one at the bottom) shows how confident the participants were with their answers. The vertical axis (the one on the side) shows whether the participants answers were in fact correct.

When the subjects selected 50 percent, their probability of being correct was random. This means they were well calibrated. They didn’t know, knew they didn’t know, and answered as if they didn’t know.

However, as the assigned probability of correctness rose, the subjects became less calibrated. For instance, when the subjects selected 100 percent, they were only correct 77 percent of the time. At 90 percent, they were only correct 65 percent of the time. Overestimation of ability was greatest at the high levels of assigned probability of correctness.

So why is this important to us as investors?

The research provides the following answers:

“Overconfidence can be a problem for a couple of reasons. The first obvious one is if you are highly confident of an outcome and are wrong a relatively high percentage of the time, you will fail to consider alternatives and ultimately make poor decisions”.

And this:

“Another problem is that people who think that they know more than they do are less motivated to learn and improve than those who understand their limitations.”

Neither of these answers are going to make us successful stock market investors!

Another answer, as to why we have over inflated opinion of how well we make decisions, is provided by David Brooks in his book, The Social Animal:

“Worse yet, the most powerful among us have a tendency to bloviating [talk at length, especially in an inflated or empty way] certainty — swatting away doubt and choosing up sides precisely because not having answers feels so uncomfortable and potentially threatening.”

As an investor, its important to be humble and know that there’s a lot you don’t know, even if you think you do!

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One Comment on “So you want to be a stock market investor? Take this test first!”

  1. Very good! I believe that true intelligence is knowing the limits of your knowledge. If knowledge is finite, then our lack of knowledge must be infinite also. We get overly confident when our minds perception takes over the convective function of the brain / mind.

    This reminds me of Gregory Bateson’s Theory of Mind and also Steps To An Ecology of Mind;

    Criteria of Mind 10
    1) A mind is an aggregate of interacting parts or components.
    2) The interaction between parts of mind is triggered by difference, and difference
    is a nonsubstantial phenomenon not located in space or time; difference is related
    to negentropy and entropy rather than energy.
    3) Mental process requires collateral energy.
    4) Mental process requires circular (or more complex) chains of determination.
    5) In mental process, the effects of difference are to be regarded as transforms
    (i.e., coded versions) of events which proceeded them. The rules of such transformation
    must be comparatively stable (i.e., more stable than the content), but are in
    themselves subject to transformation.
    6) The description and classification of these processes of transformation disclose
    a hierarchy of logical types immanent in the phenomena.

    Bateson argues that using the above criteria the mind-body dilemma is soluble. He also
    asserts that, “the phenomena which we call thought, evolution, ecology, life, learning, and the like
    occur only in systems that satisfy these criteria.”11

    From the above discussion of the cybernetic paradigm, the degree to which the informational
    nature of cybernetic process has informed Bateson’s criteria is readily apparent. One might insist that
    he has reduced mental process to the operations of cybernetic systems. However, he consistently
    maintained that the criteria are intended to be employed as an analogous and metaphoric model of
    mind. Above all, the criteria are intended for use as a tool of abduction, e.g., comparing that which is
    shared among apparently unrelated phenomena.

    In part, the aim in this essay is to consider how the model of mind, or mental process that
    emerges from Bateson’s criteria of mind relate to the phenomena of learning. After all, it is “mind”
    that learns. Therefore, we should examine each of the criteria before moving on to discuss the
    practical applications of Bateson’s theory of learning

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