I read an interesting article last week from the September issue of the Harvard Business Review (ok, so I am way behind in my reading. You try keeping up with your magazine subscriptions while caring for a really cute rugrat). The article was by John Hammond, Ralph Keeney, and Howard Raiffa, and was called “The Hidden Traps in Decision Making”. I was already familiar with most of the concepts from my various academic pursuits (economics, decision theory, research methodology, etc.), but I had never seen them in one place before. As I was reading the article, which was intended for managers, I was constantly struck by how often HSX provided textbook examples of the types of traps they were discussing. So, I thought I would briefly describe the main concepts of the article, discuss how they apply to HSX, and go over ways you can avoid them.

The basic concept is that when people make decisions, they are not computers which systematically process all data. Instead, they make judgment calls and use heuristics, or rules of thumb, in order to get buy. But in certain circumstances, these rules fall apart, and bad decisions get made. For instance, based on past experience, drivers will leave a second or two space between them and the vehicle ahead of them. This works great, except when the road becomes slippery, visibility drops, and congestion rises during a blizzard. Even though the drivers *know* that conditions have changed, they do not alter their rule of thumb on following distance sufficiently, and accidents happen.

There are many different ways by which our judgment calls can go screwy. Familiarizing yourself with these possible judgment mistakes, and consistently asking yourself if you are making them, is the best way to avoid them.

The Anchoring Trap: Let me ask you two questions. “How much will She’s All That (SHEAL) do this weekend?” and “SHEAL is currently priced at $32, implying an $11 million opening. How much do you think SHEAL will do?” If you ask people questions like this, the “anchor” of 11 million skews their answers differently from what they would answer without the anchor. Other anchors on HSX are the box office for last year’s films, and box office for films of similar films. This is not to say that all of these pieces of information are not useful, but that they can occasionally trap your reference point away from the true market value if you do not collect enough other information. I see traders on HSX (including myself) making this mistake all the time. “Animated films from Disney always open in the mid twenties, so Price of Egypt will open in the mid-twenties as well”, is an example. Always be checking for more information.

The Status Quo Trap: The status quo is a powerful thing. People usually resist change, and when given a default, accept it more often than they would than if it were not the default. On HSX, this can make people more resistant to selling stocks that are already in their portfolio, or avoid buying stocks that are not. Certainly, you don’t want to churn your stocks for the sake of churning, as the time commitment and commissions would be costly, but you should constantly be evaluating. One of the things I constantly ask myself on HSX is “If I did not already own this stock, would I buy it?” If the answer is “no”, I should sell (although commissions near delist time occasionally change the answer). I suggest going through your portfolio right now and asking yourself that question about every single stock, to see if you are prone to falling in this trap. Always be questioning your past decisions, particularly as information changes.

The Sunk Cost Trap: A sunk cost is an investment which is unrecoverable. For instance, if you look for, and buy a house, the time spent looking is a sunk cost, even though the cost of the house can be covered by selling it. How many time have you heard bad news about a film you are holding, such as low screen counts, watched the price fall in response, and held tight hoping to recover your losses, only to take it in the shorts even worse later? Most of us have done this at some point, since it is hard to acknowledge a mistake, and sell a stock at a loss. However, by biting the bullet and selling, you are actually avoiding future losses. One of my HSX mantras is “never pay attention to the price you paid or the amount in the “gain/loss” column. Only look at current price and what you think the stock will do in the future”. As satisfying as it is to see gains, and as painful as it is to take losses, you really need to ignore them and focus on the present and the future.

The Confirming Evidence Trap: Ever find yourself asking someone whose opinion you respect “hey, should I hold Stock X?”, have him say “no”, and then say “I think I will hold it anyway”? You may have fallen victim to the confirming evidence trap, where evidence or opinion which supports your current leanings is listened to, but evidence or opinion contrary to your bias is ignored. We frequently seek out the confirmation of those who agree with us and avoid those who disagree, and end up neglecting key information. The best way to avoid this trap is find someone to play devil’s advocate, or play the role yourself. You will often find me in IRC making arguments contrary to what I truly believe in order to test the soundness of my reasoning. Also, if you find yourself in the situation at the beginninb of this paragraph, ask yourself “why the hell was I asking his opinion if I was going to ignore it if he disagreed with me?”. At the very least, ask probing questions about the whys and wherefores of the contrary opinion.

The Framing Trap: Decisions can be influence by how the question is framed, particularly in terms of wins or losses. Telling someone “if you buy this stock you have a good chance of making a million dollars” is essentially the same as “if you refuse to buy this stock, you have a good chance of losing the opportunity to make a million dollars”, but people will react to the statements differently, since the second statement emphasizes the missed opportunity as a “loss”, and people tend to be risk averse. Way to avoid: reframe the question yourself in a neutral manner, pay attention to the math, and pay attention to how decisions are being framed.

Estimating and Forecasting Traps: There are three traps related to forecasting. The first is the overconfidence trap, where people overestimate their faith in what is a wild-ass guess. Take a look at Ticker Talk on a Friday Night. You see lots of “VRSTY will rule!” or “VRSTY will bomb!” posts, and very little “I have no clue what VRSTY will do!” or “I think VRSTY has a slightly better-than-average chance of adjusting up!” posts. I am about as guilty as the next guy in this area. Checking my prediction record against the rule of thumb of “never hold anything” was a very humbling experience for me. I suggest you take a frank look at your track record in making predictions, and stare at it for five minutes before deciding whether to hold or fold on Friday nights. The second forecasting trap is the prudence trap, where people adjust their forecasts excessively “to be on the safe side”. HSX is about as risk-seeking a market as you will find outside of Vegas, so I don’t think this one is too important, unless you are very risk averse. The third forecasting trap is the recallibility trap, where significant events are remembered better than minor ones, skewing their views. Examples: people remember the very few plane crashes better than the incredibly common car crashes, and fear flying despite the fact that is much safer than driving. Also, people buy lottery tickets because the $200 million winner on the front page of the paper is publicized much better than the 1 billion lottery ticket holders who bet a dollar and all came up empty handed. On HSX, the big upward adjustments are hyped better than downward ones. “RUSHH woo hoo!” posts are more common than “PRNCE, you evil money sucking bastard!” posts. Triumph is hyped on center stage. Failure tries to quietly sneak out the rear entrance. For all of these traps, make conscious efforts to gauge probabilities, and risks. Challenge your estimates. Put them in public to be scrutinized, and evaluate your success after the fact to determine biases.

There you go. In general, the best way to avoid making decision traps is to constantly re-evaluate and question yourself, and deliberate seek out and consider contrary opinions. Part of me was afraid that this material might be too dry for HSX, so please let me know if you found it useful.

wonkishly yours,

Tom