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Better Decisions, Better Results

Seeds of Thought
Cognitive Science Meets Investment Management

Issue 15-11
March 20, 2015

Risk Seek vs Risk Bleed

I wrote about this in the previous edition of Seeds, but based on the phone calls and in-person meetings
that followed, I think it warrants additional attention. I have been arguing for quite some time that
investors should be long, overweight even, large cap US equities. The reasons are plentiful, but I wont
expound them again here. What I want to focus on now is how it is possible that I can be so bullish large
cap US equities without feeling the same way about equity markets in general, nor about other so called
risk assets, because that appears to be where the confusion arises.
Underpinning my view is the belief that we are experiencing one of the most risk averse moments in
nearly a century. The evidence is ubiquitous. You can feel it in the pit of your stomach. For those of you
who cant, witnessing how capital continues to flow to the most risk averse instruments, regardless of
how hard incentives are pushed to drive it elsewhere (think negative yields) should be evidence enough.
I elected to use the word pushed because it is representative of what is happening. No one wants to
take risk. Any risk being taken is done so reluctantly. Honestly, is anyone long equities who is not a
reluctant long? The point I am trying to make here is that investors desperately want to take as little risk
as possible. That is priority one.
However, the amount of capital available for investment is unprecedented and, thanks to a broken
transmission mechanism, getting larger every day. Normally, what the central banks have been doing for
the last 6 years would have resulted in capital shifting out of financial assets and into the real economy.
Instead, we continue to see the opposite. The combination of an ever increasing pool of investable
capital with a declining supply of "risk free" options means even if investors remain risk averse, capital
will have to continue to bleed out into the low lands of alternative destinations. Simply stated, I believe
large cap US equities represent the second best alternative to those risk free options. Thus, higher large
cap US equity prices should not be seen as representative of capital shifting into risk seeking mode, but
merely an extension of the longstanding preference for risk aversion.
This shouldn't be a very contentious call considering the fact that it has been playing out this way for
years now. I am merely providing an explanation for the phenomenon that continues to create
dissonance for many market participants.

One Simple Step to Improve Results

In 1999, the CIA declassified articles written for the agency between 1955 and 1992. One of them was a
piece written by Richards Heuer called Do You Really Need More Information? In it, Heuer describes
a study wherein they asked horse racing handicappers to rank the importance of 88 handicapping factors.
They then provided the handicappers with the top five and asked them to handicap races. Then they
were given the top 10, the top 20 and finally, the top 40 factors in order to handicap races.
Surprisingly, as they added more information, their accuracy actually began to recede. While that alone
is informative, the real value of this study and the many that followed was in discovering that the
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Seeds of Thought

confidence of the handicappers grew as more and more data was made available to them. In fact, by the
time they had all 40 top factors at their fingertips, their confidence was twice what it had been with just
the top 5. In other words, there is empirical evidence of a negative correlation between the accuracy of
predictions and the confidence predictors have in them.
If you think about it, this can have a big impact on your returns. Since we tend to size our positions
relative to the confidence we have in them, we are likely to overweight positions merely as a result of
the availability of unnecessary information.
In his book, The Psychology of Intelligence Analysis Heuer explains that experienced analysts have
an imperfect understanding of what information they actually use in making judgments. They are
unaware of the extent to which their judgments are determined by a few dominant factors, rather than by
the systematic integration of all available information. Analysts use much less available information than
they think they do. He found the same held true for doctors diagnosing illnesses, as well as experts in
other professions, too.
In the end, he concluded that individuals overestimate the importance we attribute to factors that have
only a minor impact on our judgment, and underestimate the extent to which our decisions are based on
a very few major variables.
So how do we use these findings to improve our results? Well, when you combine what Heuer
discovered with what Kahneman and Tversky found regarding the deleterious impact of even
nonsensical information (see Seeds issue 15-10), it is clear that we as decision makers must make a
concerted effort to first correctly identify what the key factors are and then work to actively avoid
overexposure to any additional factors. In fact, any time and effort we expend to suppress our natural
urge to gather more data and read more research, may actually contribute more to our bottom line than
giving in to it.

Stay Home, See the World

When I first started trading in emerging markets, it was firmly believed that locals had a distinct
competitive advantage over the rest of us. Those who worked at major institutions with a strong network
of local presence were feared. Guys like me didnt have a chance. It was, and for many it is still
believed, that you must visit the countries in which you invest. We did the road trips, meeting with
central bankers, government officials and local business leaders. I took notes on who we met, where we
went and what we learned. I also tracked my performance in the days, weeks and months that followed.
What I discovered was a distinct lack of correlation between the trips and my performance. On those
trips, I was actively seeking confirmation of the views I held before the trip. If I was bullish before, I
would be even more bullish when I returned, and vice-versa. In other words, I learned for myself exactly
what Heuer had discovered decades earlier.
Yes, I sounded important when I sent around my notes, showing all the high profile executives and
policymakers with whom I had met. My analysis gained credibility by association, but the reality was, it
didnt do a thing for my bottom line, and as a trader, only the bottom line matters to me. So for almost
two decades, I have had a strict rule not to visit those countries in which I am actively involved.
Although on the face of it it doesnt appear to affect my returns either way, the truth of the matter is, it is
a waste of time and energy. It was a distraction. As the research has proven, by seeking confirmation of
our views and inevitably finding it, confidence in our expectations increases and so too will its
proportional weight in our portfolio, and returns.

Can You See It?

Issue No. 15-11

March 20, 2015

Bija Advisors

Seeds of Thought

I know it is difficult to believe that traveling less, gathering less data and reading less research can
actually improve your returns. It goes against everything we believe. Our brains utilize heuristics, or
shortcuts, more commonly than wed like to think, and they are dependent upon the deeply engrained
beliefs we hold. When information is presented which challenges those beliefs, we experience cognitive
dissonance, which is best described as a feeling of great unease when we hold two conflicting views. In
order to rid ourselves of that uncomfortable feeling, we are driven to resolve it, typically by ignoring
evidence in favor of the new argument and seeking that which confirms the more deeply engrained
belief. Its how we maintain inner peace.
Now, look at the Rubiks cube on the left.
What colors do you see for the center
pieces? Does it match what you see when I
remove all the extraneous information?
Imagine this as your view of the markets.
Does the additional information of all those
colors surrounding the center pieces help or
hinder your ability to see them as they really
are?

About the Author

For more than two decades, Stephen Duneier has studied cognitive science, applying what we know
about how the brain works, how we deal with uncertainty and solve problems to develop a whole new
approach to business, investing, and life itself. The result has been top tier returns with near zero
correlation to any major index, the development of a billion dollar hedge fund, a burgeoning career as an
artist and a rapidly shrinking bucket list.
Duneier now teaches Decision Analysis at the University of California Santa Barbaras College of
Engineering while delivering his distinctive brand of actionable intelligence to top decision makers
across numerous industries via Bija Advisors publications.
As a speaker, Stephen has developed a series of informative and inspirational talks on topics ranging
from how global macro analysis can help us understand the world around us, how cognitive science can
improve performance, and the keys to living a more deliberate life. Through the years, he has earned a
reputation for delivering his unique insight via beautifully woven, highly entertaining stories that
inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option
Trading at Bank of America and Managing Director of Emerging
Markets at AIG International. His artwork is represented by the
world renowned gallery, Sullivan Goss. He received his master's
degree in finance and economics from New York University's
Stern School of Business.

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Issue No. 15-11

March 20, 2015