Trust models over instincts

(MoneyWatch) When it comes to making decisions, we like to trust our instincts. This is true even when it's in our best interest to heed statistical models when making decisions. It's why so many investors still subscribe to active management despite clear evidence that adopting a passive strategy gives them a better chance of achieving their financial goals.

Trust in instincts causes us to make all sorts of behavioral mistakes when it comes to investing. I profiled 77 of them in "Investment Mistakes Even Smart Investors Make and How to Avoid Them." By relying on purely passive, quantitative methods to determine our investment strategies, we are able to avoid the biases that lead us to make mistakes. I was reminded of this when I read Wesley Gray and Tobias Carlisle's excellent new book, "Quantitative Value." They explain it this way: "It's best understood as the antidote to behavioral error. Our apparatus for reasoning under conditions of uncertainty are faulty, so much so that we are often entirely unaware of how imperfect it is because it blinds us to our failure. We are confidently incompetent. We need some means to protect us from our own cognitive biases."

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Gray and Carlisle relate this story to demonstrate their point. A professor of psychology analyzed the Minnesota Multiphasic Personality Inventory (MMPI) test responses of more than 1,000 neurotic or psychotic patients. He used the data to build a model allowing him to predict final diagnoses. His model was accurate in 70 percent of the out-of-sample results, a figure greater than that of even the most experienced psychologists. He then ran the test again, this time providing psychologists with the model's prediction. To his great surprise, the psychologists continued to underperform the model. The psychologists thought, wrongly, that they could add something to the model. Unfortunately, they subtracted from it.

Grey and Carlisle provided the following case as further evidence. A statistical algorithm was developed to predict the outcomes of Supreme Court decisions. Even though this doesn't appear to be an area ripe for statistical analysis, the data showed that six variables explained the decisions. The model was tested against the forecasts of a group of 83 legal experts. The model's prediction was 75 percent accurate, whereas the experts were only 59 percent accurate.

Grey and Carlisle noted that studies have shown that models outperform experts in fields as diverse as "the detection of brain damage, the interview process to admit students to university, the likelihood of a criminal to reoffend, the selection of good and bad vintages of Bordeaux wines, and the buying of purchasing managers." Thus they concluded that investors are best served by tricking themselves into doing the right thing. And the way to do that is to rely on passive, quantitative methods to pick stocks, not qualitative methods, which are subject to human error. "The power of the quantitative approach is both in the protection it affords us against our own gambling instinct and in its relentless exploitation of the small edges provided by others' errors."

James Montier, in his book "Behavioral Investing," says: "Even once we are aware of our biases, we must recognize that knowledge doesn't equal behavior. The solution lies in designing and adopting an investment process that is at least partially robust to behavioral decision-making errors."

The behavioral errors investors persistently make result in the anomalies that academics have uncovered including:

• Small-cap growth stocks, which have provided lower returns despite producing much higher volatility than the market
• IPOs, which have underperformed stocks with similar market capitalizations and book-to-market ratios
• Very low priced (penny) stocks and stocks in bankruptcy, which have also underperformed the market
• Momentum, or the phenomenon that stocks that have outperformed (underperformed) over the past year continue to do so for several more months
• Given similar valuations (P/E ratios), stocks with high profitability have outperformed stocks with low profitability

The bottom line is that whether you believe that markets are efficient or that they make persistent pricing errors, the evidence strongly suggests that the strategy most likely to help you achieve your financial goal is a passive one. That means having a well-developed plan, including an asset allocation table, and a plan of rebalancing your portfolio as required.

Image courtesy of Flickr user Tax Credits.