A Variation ofthe Previous Problem

A third flaw, in many ways parallel to the second, also indicates mans shortcomings as an intuitive statistician. In making decisions, we become overly immersed in the details of a particular situation and neglect the outcome of similar situations in our experience. These past outcomes are called prior probabilities, and logically should help to guide similar choices in the present."*

But they tend not to. This shows up clearly in an experiment made with a group of advanced psychology students." The group was given a

they are not sure what it is they are acting on. Remember here the advice of a world champion chess player when asked how to avoid making a bad move. His answer: "Sit on your hands."

But professional investors dont sit on their hands; they dance on tiptoe, ready to flit after the least particle of information as if it were a strongly documented trend. The law of small numbers, in such cases, results in decisions sometimes bordering on the inane.

Tversky and Kahnemans findings, which have been repeatedly confirmed, are particularly important to our understanding of some stock market errors and lead to another rule that investors should follow:

RULE 23

Dont be influenced by the short-term record of a money manager, broker, analyst, or advisor, no matter how impressive; dont accept cursory economic or investment news without significant substantiation.

The law of averages indicates that many experts will have excellent records-usually playing popular trends-often for months and sometimes for several years, only to stumble disastrously later. If you buy the record just after a period of spectacular performance, chances are the letter writer or manager will not sustain it.

This is the sad lesson to be learned from the records of the market-letter writers above and from the turbo-charged, aggressive growth managers of mutual funds in the mid-eighties, many of whom forlornly traded their hot hands in for a bartenders apron or UPS uniforms after decimating their clients portfolios. It is the same lesson that investors over the centuries have had to releam with each new supposedly unbeatable market opportunity.

Given the lack of substantive content, the graduate students should have ignored the analysis entirely, and made choices by the percentage of graduate students in each field-information that had been provided for them. It was assumed they would act upon the real data. At least, according to the laws of normative probability, this was what was expected of them. According to these laws, the more unreliable the available information in a specific situation (called the case rate-in this example the profile of Tom W.), the more one should rely on established percentages (called the base rate-in this instance the percentage of students enrolled in each field).

Did the group look at the base rate percentages? No. This experiment and others like it demonstrated that the students relied entirely upon the

brief personality analysis of a graduate student, said to have been written by a psychologist who had conducted some tests several years earlier. The analysis was not only outdated but contained no indication of the subjects academic preference. Psychology students are taught that profiles of this sort can be enormously inaccurate. The study, which follows, was intended to provide them with nothing of practical value. Here it is:

Tom W, is of high intelligence, although lacking in true creativity. He has a need for order and clarity and for neat and tidy systems in which every detail finds its appropriate place. His writing is dull and rather mechanical, occasionally enhvened by somewhat comy puns and flashes of imagination of the sci-fi type. He has a strong drive for competence. He seems to have litde feeling and litde sympathy for other people, and does not enjoy interacting with others. Self-centered, he nevertheless has a deep moral sense.

Tom W. is currendy a graduate student. Please rank the following nine fields of graduate specialization in order of the likelihood diat Tom W. is now a student in that field. Let rank one be die most probable choice:

Business Administration

Computer Sciences

Engineering

Humanities and Education Law

Library Science Medicine

Physical and Life Sciences Social Science and Social Work

profile and decided that computer sciences and engineering were the two most probable fields for Tom W. to enter, even though each had relatively few people in them. In spite of their training to the contrary, the psychology students based their decisions on unreliable information, ignoring the more pertinent data. Nonetheless they were confident they were made on the facts.

A parallel example in the stock market is the emphasis people put on the outlook for each exciting initial public offering or concept stock (the case rate), even though the substantiating data is usually flimsy at best. Still, investors rarely examine the high probability of loss in such issues (the base rate). Instead, most buyers of hot IPOs in the 1980s and 1990s focused on the individual story and forgot that over 80% of these issues had dropped in price after the 1962 and 1968 market breaks. Here again, the prior probabilities, although essential, were ignored. Which brings us to another rule of decision-making:

RULE 24

Dont rely solely on the "case rate." Take into account the "base rate"-the prior probabilities of profit or loss.

The greater the complexity and uncertainty in the investment situation, the less emphasis you should place on your curtent appraisal, and the more you should look to the rate of success or failure of similar situations in the past for guidance.

Put another way, rather than attempting to obtain every fact and sliver of information about a difficult investment situation (much of which is contradictory, irrelevant, and difficult to evaluate correctiy), you should, if possible, gauge the long-term record of success or failure of a particular course of action.

The same rule could be applied to a broad number of investment situations. For example, if you like a concept stock, you might take a cross-section of favorites of other periods and see how they worked out; or if you decide to try your hand at market timing, examine how well the system you selected has worked over time.

In each instance, the information in the particular case being examined should, where possible, be supplemented by evidence of the long-term record of similar situations-the base rate-before making your decision.