Nobel Laureate Daniel Kahneman posits that there are two broad neural systems that drive decision making: The analytical and the intuitive. Most often analytical judgment is deliberate and logic based as opposed to the intuitive system which is quick and feeling based. The process of arriving at investment decisions necessarily requires us to deal with risk under uncertain conditions with performance expectations and time pressure further adding to the inherent complexity. There is not an iota of doubt that the “gut” feelings of seasoned campaigners often result in huge positive pay-offs. The challenge is to integrate “messy” emotions and “soft” intuitions into a rational, linear format.
Conventional thinking suggests that investors slowly and deliberately judge potential outcomes, assigning probabilities that allow them to calculate potential gains or losses, to arrive at a well reasoned analytical conclusion. Yet, in a world where virtually all outcomes are uncertain and volatility arises from multiple interacting factors that are unexpected, the truth is that investment practice is considerably different from what theory suggests.
Many of the most successful investors start out by gathering information from diverse sources (senior management, suppliers, customers, employees and equity analysts) which they systematically sift by means of very disciplined and rational thinking. But prior to arriving at the final conclusion about whether to buy or sell, they choose to fall back on an intuitive approach that puts together much of the analysis that has been carried out and persuades them that the investment “feels right”. The first part of the journey is shaped by a robust and well-tested ‘investment philosophy’ that determines what goes through the sieve. But the truly smart and experienced professional goes beyond the signals provided by these objective measures of achievement. On occasion, the variability in cash flow or an off-balance sheet liability or a comment by the auditor will trigger a desire to dig deeper. Sometimes, they are more positively inclined to a company’s products given their personal experience or they sense that analysts are being too cautious.
Intuitive decision making is honed unconsciously, through experience, and accounts for the overwhelming majority of our daily decisions. Part of its grace and simplicity is that it operates below the surface, not accepting input from higher cognitive levels. Thinking about a decision brings the process into conscious awareness, and such deliberation drowns out important aspects of the fragile intuitive process. Tapping a hunch is not easy because on many occasions, strong emotions overwhelm intuition. Being part of an environment that emphasizes time, social or performance pressure can easily damage intuitive judgment. Fortunately, quiet reflection can help an individual to open up to the intuitive consideration of complex information. As investors, our most desperate appeal to intuition arises when we are grappling with uncertainty. Typically, three issues repeatedly come into play in most settings:
- The source of the uncertainty
- The range of options available to cope with the situation
- The decision maker’s personal tolerance for ambiguity
Inevitably, the nature of information available is the cause or source of uncertainty. The most common situation is the one where we are missing important details, either because of an inability to access the information or overload. Quite often, we do not trust the information that we have, leading to doubt that affects our rational thinking. On occasion, the information might be inconsistent with other data we have and trust. Frequently, we are bombarded with information that is irrelevant—noise—which creates serious doubt in our mind about the value of the information. Finally, in certain circumstances we have all the information we need, trust all of it, recognise that it is consistent as well as relevant, yet we remain uncertain because we cannot interpret it!
Given the many different sources of uncertainty, the more extensive your repertoire of tactics, the greater the likelihood that your decision making is flexible as well as efficient. The savvy investor has an excellent understanding of what is a real crisis. This skill allows him to safely delay doing anything in the hope that, as time passes, he will get a better handle on the evolving situation. This should not be confused with holding back because of the fear of getting it wrong in tricky circumstances.
Demanding more information is the classical response to uncertainty. The real test is to figure out when additional information is necessary and gauging whether the information is sufficiently valuable and likely to arrive in time to make a difference. Faced with a major decision that creates significant uncertainty in your mind, one smart tactic is to get more involved by increasing your attention and focus on the specific problem. This is quite different from seeking additional data. Rather, the emphasis on monitoring the situation helps you in timing your decision better. Instead of gathering more data, you can reduce uncertainty by making assumptions about what the missing information is likely to be. In effect, you rely on your intuition to strike down the assumptions that you believe to be tenuous.
Trying to make sense of what is going on around you goes beyond merely filling in the gaps with assumptions. The need to construct realistic explanations, categorise situations and recalibrate interpretations based on earlier data is essential to fine tune intuition for optimal decision making. In many instances, we need to recognise that we live in an imperfect world where it is imperative to decide based on incomplete information. Therefore, the best way to cope with uncertainty may be to make a number of small bets that can be reversed with minimal damage under conditions of adversity. In his book, The Art of the Long View, Peter Schwartz describes how managers can build decision scenarios to try and make sense of a situation, as well as communicate to others the dynamics of the problem and the underlying assumptions. The goal is not to predict; rather, the decision scenario helps you in building a richer mental model that creates awareness of the dilemmas as well as trade-offs.
Another method of coming to terms with uncertainty is to reduce the complexity of the plan you are formulating. An attempt at simplification by working towards a more modular plan facilitates greater flexibility and ensures that the failure of one element does not endanger other aspects of the plan. The capability to make mid-course corrections as we gain a better understanding of the situation in an environment of high uncertainty may sacrifice efficiency but provides far greater downside protection. Logical incrementalism (one small step at a time) is one of the most common tactics for handling uncertainty.
Rather than making a clear commitment, the idea is give yourself the opportunity to learn by accumulating feedback, leading to improvements.
In following such a strategy, it is important not to fall prey to “sunk cost” arguments. The idea of embracing uncertainty goes beyond simply accepting it—rather it is about valuing uncertainty for what it adds. This approach works only when you treat your plan for the future as a broad platform for change and have exceptional intellectual flexibility.
What direction does the synthesis between intuition and analysis point towards as we wait for the outcome of the Lok Sabha elections during the next few days? First, the recent surge in the indices suggests that a Modi victory is almost assured. Should the margin of victory turn out to be less than expected, resulting in a fidgety coalition, some of the recent gains are likely to evaporate rapidly. Second, there has been a meaningful rotation away from secular growth into cheap, or “value” shares during the last couple of months. It may well be that investors have once again realised the virtues of thrift. More likely though that the pendulum swings to the other extreme over the next few quarters. Should that be the case, interest rate sensitives (infrastructure, banks, construction/real estate), capital equipment manufacturers, early- and mid-stage domestic cyclicals such as cement and automobiles will perk up considerably from where they are now. The dark horse in such a scenario could well be stocks related to agriculture. Logical incrementalism and a simple uncomplicated plan that capitalises on Modi’s stated agenda should probably work best! (Sanjoy Bhattacharyya is a partner at Fortuna Capital
(This story appears in the 16 May, 2014 issue of Forbes India. To visit our Archives, click here.)