In his latest 2021 Year-End Letter, Seth Klarman explained why the wiring we all have as humans can trip us up. Here’s an excerpt from the letter:
A sound investment process benefits from the scar tissue of past mistakes, a front-of-mind awareness of the very many things that can go wrong in any investment.
It is also well-served by clear, unbiased thinking and intellectual consistency. Nobel Prize–winning economist Daniel Kahneman’s latest book, Noise: A Flaw in Human Judgment (written with Olivier Sibony and Cass Sunstein), identifies two primary flaws in human judgment, two kinds of errors that people are prone to making. One involves bias, the other noise.
While many of us like to think of ourselves as completely rational actors, Kahneman and others have shown that we are susceptible to a wide variety of biases in our decision-making. It’s how people are wired. A good investor must be aware of this and actively struggle to overcome these innate tendencies.
In an investment context, bias refers to systematic errors, such as over-optimism. If one’s analysis consistently projects returns higher than what is actually achieved, then there is optimistic bias. Theoretically, such bias could be corrected by regularly substituting more conservative assumptions. Conversely, if a member of an investment team were perennially more cautious than warranted, some of their tepid recommendations could be sized up.
In Kahneman’s view, “noise” refers to the variability of decision-making. Ideally, with the same facts, you should follow a process that will reach the same conclusions every time. Many things can create noise in decision-making, Kahneman observes, from the inevitable swings in human emotion, such as greed and fear, to basic physical concerns, such as hunger and tiredness.
The wiring we all have as humans can trip us up. Exuberance after a positive result, for example, can lead to over-confidence in making other decisions, and dismay after a mistake can lead to an unfortunate re-calibration or hunkering down, causing one to miss out on subsequent opportunity.
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