Monday, December 8th, 2014
dumb groups

The rise of behavioral finance has led to a widespread awareness of the human inclination to veer away from logical decision making,The Psy-Fi Blog | Here’s one compilation of those failings, “The Big List of Behavioral Biases. although most of us seem to get caught in the same traps over and over again anyway, even though we are aware of our tendencies.  I know I do.

On the other hand, the popular notion is that there is a “wisdom of crowds” (even though that’s likely to be true only under certain circumstances).  There are, of course, many times when the crowd goes astray, sometimes helped along these days by our electronic tools and their reinforcing algorithms.  (No market commentary intended, although some readers might take it that way.)

In between the individual and the crowd are small groups of people trying to make decisions together.  We live in a world of organizations.  Since this forum is devoted to those who roam the investment ecosystem, I’ll focus there, but the same issues plague group decisions everywhere.

To our detriment, those issues haven’t gotten the proper attention.  You see almost no focus on such problems within investment organizations — or by the outsiders that are charged with doing due diligence on them.  That doesn’t make sense:  we need an understanding of “organizational finance” in addition to behavioral finance.

A good place to start is an article in the Harvard Business ReviewHarvard Business Review | The title of the piece is “Making Dumb Groups Smarter.” by Cass Sunstein and Reid Hastie, which provides an outstanding summary of the hurdles we must jump (together).

When you read it, think about the organizations that you have seen from the inside.  Then contemplate how little you know about the workings of those you’ve only glimpsed from the outside.  Investment committees (all the various permutations thereof, at asset owners, advisory firms, asset managers, etc., different from each other, but also similar in so many ways) and formal investment teams, as well as looser collectives of decision makers, are all charged with making good decisions and are all at risk of doing so poorly because of interpersonal dynamics.

Why?  Quoting the article:

1) Groups do not merely fail to correct the errors of their members; they amplify them.

2) They fall victim to cascade effects, as group members follow the statements and actions of those who spoke or acted first.

3) They become polarized, taking up positions more extreme than those they held before deliberations.

4) They focus on what everybody knows already — and thus don’t take into account critical information that only one or a few people have.

The authors point out that these problems stem from two main factors:  garbled “informational signals” and “reputational pressures” that get in the way of open and honest debate.  One would expect rational allocators of capital to be aware of those potential failings and work to optimize their interactions to make the best decisions possible, but that’s just not the case in most organizations.  (In that, investment organizations are like other ones; the research work on group decision making “has yet to have a noticeable effect on actual practice.”)

Whatever kind of organization that you are in, the article can serve as a nice framework to judge how you’re doing — and it offers some suggestions that might help you consider how to improve your chances for working effectively together.

But you should look outward too.  If you have an element of due diligence in your work — “that’s all of us,” someone tweeted recently — reflect upon the degree to which you truly understand the decision making processes of those who serve as your agents (and their agents, and theirs; in fact, the whole daisy chain of them).  Their actual deliberations may not match up too well with the stories you have been told.the research puzzle | As always, your job is to “crack” the narrative.

In any case, doesn’t learning more about decision making make sense for those who toil together?  We run frantically toward whatever new frontier promises even a remote possibility of alpha, when it could be found around the very tables at which we meet.