Wanna Bet?


Decision Making, Investment Process, Luck, Probability, Psychology / Thursday, March 5th, 2020

Our intuition works like this: 

Decision → Outcome (feedback) → Better Decision

You burn your hand (outcome) after touching a hot stove (decision) or place your feet on the brake (decision) slows down the car (outcome), we use outcomes as feedback to change our actions and make better future decisions. But there’s a caveat. 

In Thinking, Fast and Slow, Daniel Kahneman wrote you can trust your intuition under two conditions:

  • An environment that is sufficiently regular to be predictable
  • An opportunity to learn these regularities through prolonged practice

The bad news is that stock picking is both unpredictable and has noisy feedback. The stock market is a wicked environment that looks more like this:

Decision → Skill + Luck → Outcome

In Thinking in Bets, Annie Duke, a former professional poker player, explains that we have the “tendency to equate the quality of a decision with the quality of its outcome.” What is your biggest investment mistake? Your mind intuitively searches for the one that suffers the biggest losses. But losses—a negative outcome—can happen even if you made a good decision because of bad luck. This intuition of linking bad outcomes directly to poor decisions not only slows down our ability to learn from experience but also leads to more bad decisions.

Annie Duke explains we should be careful when using the outcome as feedback in a wicked environment:

“Outcome don’t tell us what’s our fault and what isn’t, what we should take credit for and what we shouldn’t. A negative outcome could be a signal to go in and examine our decision-making. That outcome could also be due to bad luck, unrelated to our decision, in which case treating that outcome as a signal to change future decisions would be a mistake. A good outcome could signal that we made a good decision. It could also mean that we got lucky, in which case we would be making a mistake to use that outcome as a signal to repeat that decision in the future.

Any single outcome can happen for multiple reasons with a mix of skill and luck. If you run a traffic light and nothing happens, is that because of good skill or pure luck? Running the light requires skill. But it also takes a lot of luck to come out alive. 

A better way to improve decisions in a wicked environment is to focus on the process and ask “Wanna bet?”

“What makes a decision great is not that it has a great outcome. A great decision is the result of a good process, and that process must include an attempt to accurately represent our own state of knowledge.

What good poker players and good decision-makers have in common is their comfort with the world being an uncertain and unpredictable place. They understand that they can almost never know exactly how something will turn out. They embrace that uncertainty and, instead of focusing on being sure, they try to figure out how unsure they are, making their best guess at the chances that different outcomes will occur. The accuracy of those guesses will depend on how much information they have and how experienced they are at making such guesses. This is part of the basis of all bets.”

Thinking in bets is the basis of probabilistic thinking. When you make an intuitive prediction that an increase in oil price increases oil companies’ profitability; the market is going to rebound tomorrow; or a stock is going to grow 20% for the next 5 years etc, how much do you wanna bet that your prediction is correct? 

When we place a bet on our belief, “we consider a greater number of alternative causes more seriously than we otherwise would have. That is truth-seeking.” Betting on your belief is also an antidote to confirmation bias. 

“Thinking in bets triggers a more open-minded exploration of alternative hypotheses, of reasons supporting conclusions opposite to the routine of self-serving bias. We are more likely to explore the opposite side of an argument more often and more seriously-and that will move us closer to the truth of the matter.”

So the process to learn from decisions is open-mindedness, humility that I can be wrong, seek out opposite arguments, consider alternative hypotheses, and putting outcomes into the right bucket

“The prospect of a bet makes us examine and refine our beliefs, in this case the belief about whether luck or skill was the main influence in the way things turned out.”

“When we think probabilistically, we are less likely to use adverse results alone as proof that we made a decision error, because we recognise the possibility that the decision might have been good but luck and/or incomplete information intervened.”

The reason that making bets makes us a better learner is that it reduces fundamental attribution error. We like to think positive outcomes are the direct result of our skill and negative outcomes as being unlucky. Ironically, we think others are lucky when the outcome is positive and a negative outcome means they’re just bad at whatever they’re doing. By fielding outcome as bets, we learn to appreciate the role of luck, welcome uncertainty, and become more open to learn correctly from our experience as well as others. 

Making better decisions stops being about wrong or right but about calibrating among all the shades of grey.”

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