The Case for Systematic Decision-Making
“If you do fundamental trading one morning you feel like a genius, the next day you feel like an idiot….by 1998 I decided we would go 100% models…we slavishly follow the model. You do whatever it [the model] says no matter how smart or dumb you think it is. And that turned out to be a wonderful business.”
This quote, from Jim Simons, founder of the world’s most successful hedge fund, Renaissance Technologies, demonstrated the utility of systematic decision-making in an MIT video.
In this article
- Econs and Humans
- Perception Is Not Reality
- The Evidence Speaks: Models Beat Experts
- But Discretionary Investors Beat Simple Models, Right?
- Further Evidence That Systematic Beats Discretionary
- Why Systematic Decision-Making Outperforms
- Experts are Worthless?
The urge to use our judgment throughout the investing process is strong. I argue that, while investors need human experts to design models, they should let computers be in charge of applying those models and fight the urge to use their judgment in the implementation process. “Gut-based,” or discretionary, stock pickers certainly have a compelling story: Invest countless hours in research, identify investment opportunities and profit from the hard work. Stock pickers, however, rely on the false premise that “countless hours of being busy” adds value in the context of investment management. The empirical evidence on the subject of systematic versus discretionary decision-making is abundantly clear: Models beat experts. In fact, the late Paul Meehl, one of the great minds in the field of psychology, describes the body of evidence on the “models versus experts” debate as the only controversy in social science with “such a large body of qualitatively diverse studies coming out so uniformly in the same direction.”
Econs and Humans
University of Chicago professors Dick Thaler and Cass Sunstein in their bestseller book “Nudge: Improving Decisions About Health, Wealth, and Happiness” (Yale University Press, 2008) describe two types of people that can be found in the world: econs and humans. Econs are fully rational, continuously calculating and have both unlimited attention and mental resources. Humans are a decidedly less rational and more emotionally driven bunch. This view is based on an understanding of two ways of thinking that are innate to humans. As described in Daniel Kahneman’s great work “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011), humans are driven by two modes of thinking: System 1 and System 2. System 1 decisions are instinctual and automated by the brain; System 2 processes are rational and analytical.
Welcome to the American Association of Individual Investors.
AAII is a nonprofit association dedicated to investment education. For full access to our award-winning content, classrooms, model portfolios and stock screens, please take a moment to join AAII today for only $29 -- a 40% savings off our regular rate.
Join AAII Today!
System 1, while imperfect, is highly efficient. For example, if Joe is facing the threat of a large tiger charging him at full speed, System 1 will trigger Joe to turn around and sprint for the nearest tree, and ask questions later. As an alternative, Joe’s System 2 will calculate the speed of the tiger’s approach and assess his situation. Joe will examine his options and realize that he has a loaded revolver that can take the tiger down in an instant.
On average, if Joe immediately sprints to the tree he may get lucky and outrun the tiger. If, on the other hand, Joe pauses and calculates his best option, which is shooting at the tiger with his revolver, his tactical pause may end with Joe trying to remove a 500-pound meat-eating monster from his jugular vein.
Joe’s tiger situation highlights why evolution has created System 1: On average, running for the tree is a life-saving decision when faced with a high-stress situation where survival is on the line. The issue with System 1 is that heuristic-based mechanisms often lead to systematic bias: Joe will almost always run, even when sometimes he should shoot. System 1 certainly served its purpose when humans were faced with life and death situations in the jungles, but in modern day life, where decisions in chaos have limited consequence,
the benefits of immediate decisions rarely outweigh the costs of flawed decision-making. The necessity of avoiding System 1 and relying on System 2 in the context of financial markets is of utmost importance.
Perception Is Not Reality
Ted Adelson, a vision scientist at MIT, has developed an illusion that highlights the fallibility of the human brain. This illusion is shown as Figure 1.
Stare at cells A and B in Figure 1. Do the colors of the squares look different? How confident are you that A is a different color than B? What odds would you accept in a bet? 5-1? 20-1? If you are a human, you should be confident that A and B are different. However, if you are an econ, your computer-like brain will identify a pixel in cell A and B, compare the red-green-blue values and identify that each is 120-120-120, a perfect match. Stare a little longer, but this time cut pieces of paper to create a small box around cells A and B. Now it should be clear: A and B are the same. The lesson here, and its applicability to decision making, is best described by Mark Twain, “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that simply ain’t so.” As investors, we need to be most wary of situations where “we know” something is bound to happen.
The Evidence Speaks: Models Beat Experts
The illusion in Figure 1 is simply meant to highlight that we can become overconfident based on first impressions. But how does a simple trick map into a broader claim that humans are irrational and thus poor discretionary decision-makers? For this endeavor, I stand on the shoulders of academic researchers who have spent their lives addressing this question.
The automatic accounts earned a total return of 84.1%, besting the S&P 500 index’s 62.7% mark by over 20 percentage points. The self-managed accounts, in which clients were given the model’s outputs, but were allowed to pick and choose stocks at their discretion, earned a respectable 59.4%. However, the 59.4% figure was worse than the passive benchmark, and much worse than the account performance for those that simply “followed the model.” This evidence is similar to the study on brain impairment accuracy: models represent a ceiling on performance, not a floor.
Further Evidence That Systematic Beats Discretionary
Thus far, I’ve presented a formal study published in 1984 and a somewhat ad hoc study of investor behavior. In order to make a more convincing case that models beat experts, we require more analysis. Luckily, one doesn’t have to look that far. There is a sophisticated body of academic literature that has studied the performance of systematic and discretionary decision-making for over 50 years. The breadth and depth of studies are overwhelming, but fortunately, professors William Grove, David Zald, Boyd Lebow, Beth Snitz, and Chad Nelson have performed a meta-analysis (a study of studies) on 136 studies that analyze the accuracy of “actuarial” (i.e., computers/models) vs. “clinical” (i.e., human experts) judgment.
Take a peek
at all the member benefits AAII has to offer.
AAII is a nonprofit association dedicated to investment education.
The studies examined by Grove et al in their 2000 Psychological Assessment article included forecast accuracy estimates for just about every category one can imagine. A few examples include college academic performance, magazine advertising sales, success in military training, diagnosis of appendicitis, business failure, suicide attempts, and so forth. Figure 4 summarizes the compiled results of Grove et al’s meta-analysis.