Tuesday, September 29, 2009

Common Mistakes Even Smart Investors Make

Time Magazine Interviews Legg Mason Capital Management's chief investment strategist Michael Mauboussin.

You just wrote an entire book about how smart people make bad decisions. Maybe you could shed some light on the financial meltdown.

Increasingly, we as human beings create systems that are more complex than we can comprehend. If you're designing an airplane you create redundancies to try to mitigate bad outcomes, but as we saw earlier this year with Air France 447, when certain cascading events line up, they can lead to a disaster that you just can't anticipate. In the realm of the social, we create institutions like global, interconnected markets. By and large when investors are operating with some degree of diversity, when they're thinking about things differently — time horizons, trading strategies — the markets are basically efficient. But what we know is that people episodically coordinate their behavior. They all become optimistic or pessimistic, and that leads to extremes. Even with the best of intentions, you can't anticipate all the things that are going to happen.

Let's zoom in to the level of the individual. How do you approach investing differently, knowing what you do about the psychology of decision-making?
One theme is contemplating different outcomes and attaching probabilities to those. There is this notion called the inside-outside view. The inside view, which is how almost all of us plan, is that when you're thinking about the future, you gather all the information around you and do your analysis and go from there — whether you're launching a new product, putting an addition onto your house or forecasting the markets. The outside view asks the question, what happened when other people were in this situation? It looks at things from a larger statistical sample. Almost always the outside view gives you an answer that's more pessimistic than the inside view. An analyst sent us a report about Amazon.com that said I think they can grow 25% a year for the next 10 years. The analyst looked at the category, at international expansion — he had a story — but the question is, how many companies in history have ever done that? The psychology of this is that there are all these illusions that we have, like the illusion of superiority and the illusion of control.

Read the entire interview.