After having spent significant time of my short career on the quantitative aspects; I was intrigued by behavioral science and so sometime
a year back I took course by Prof. Dan Ariely on this subject. I found course to be
quite insightful and practical. Since then I have been consciously trying to
recognize and overcome common behavioral mistake in my decision making process.
I must confess that my success ratio is pathetic but now I am at least aware of
my mistakes. As part of my experiential series, I would like to introduce few
concepts I learnt during the course with examples from non financial world and then
elaborate on my experience from the investment side.
‘Human mind likes to select
default option and therefore decision making tends to be more default. This
issue is exacerbated as complexity (option) increases. Default option is not
always bad or always good. It is just an option which is easy for our brain to
select ’. I have always enjoyed solving complex problems and therefore I took time
to accept this. But now I am able to appreciate the same over period of time.
Marketers exploit this behavior to make us buy stuff which they want us to buy.
For example cell phone manufacturer sells phones under different brand name
with almost similar specs at similar price that it is difficult for buyer to
make rational decision. In such cases, instead of buying based on ones need,
buyer tends to buy stuff that is sold to him. This is because mind selects
default option instead of choosing right one from the many available options.
On the investment side, this
problem is even more difficult to recognize. We spent so much time on selecting
right stock/investment so as to beat the market returns but once the investment
is made then our behavior moves to default option. Though every trader would
agree that once the position is marked to market on previous day, holding on to
the existing position is similar to taking fresh position but very few traders
put that to practice. We have tendency to continue with default option that is
to hold on to existing position. That's the reason of the industry practice
of having stop loss; to force the trader to think of his existing
position. So many times in past I have exhibited such default behavior while
trading and in fact still continue to do. For me, ability to exit an existing
position is still a challenge which I continue to face but now I am aware of it
and working on it.
This concept applies to the quant world also. Industry still continues to use archaic models that assume
normal distribution of returns irrespective of market behavior since it is more familiar to them and hence is their default behavior. VaR continues to dominate risk
management world rather than mix of complex stress scenarios which can quantify
tail risk also. Management still needs one simple risk metric even though it
may be inadequate under stress scenarios. Only change post crisis is recognition
that these models may fail. In era of negative interest rate, CAPM still
continues to be base model. Inspite of ballooning deficit, US still remains
standard for risk free rate. And the list is endless…
This concept also applies to every human being when s/he makes the important decisions of their life. If I look back today to see how the
most important decisions of my life were made then I feel lot of them have been
influenced by this default option especially when stakes were high. Just take few
minutes and ponder how you made your most important decisions of your life. Most of us must have been influenced by
this default option. I have currently no standard method or process which helps me avoid this pit fall except that I now recognize the issue. My way of
overcoming it is to reduce the available options and then consider default
option as unviable and then let my grey cells identify second best option. Then problem is reduced to evaluation between default and second best option just selected. Still it continues to be challenge
to ensure rational decision making. Any suggestions to
handle the issue better?
