I’ve recently been reading the fourth edition of Jim O’Shaughnessy’s What Works on Wall Street. One of the topics covered early on by Jim is why statistically based models beat human forecasters. To summarize, it’s all about our human inability to make emotionless decisions. Models never vary. They display an utter lack of emotion that we’ll never be capable of.
I was out enjoying the beautiful weather today here in Monmouth County, NJ when I was given a real life example of human irrationality in forecasting. I was listening to Richard Neer take calls about The Masters on 660 WFAN.
After an incredible first three rounds, Jordan Spieth was ahead by four strokes going into the final round at Augusta today. His odds were set at 4:9 or, in percentage terms, a 69.23% chance of victory. His closest opponents, Justin Rose and Phil Mickelson, were given odds of 12-1 and 18-1 respectively or 7.7% and 5.2%.
Despite the odds clearly being stacked in Spieth’s favor, most of this morning’s callers were predicting that he would choke.
This reminded me of something Jim explains in What Works on Wall Street, recency bias. He describes recency bias as:
“The tendency to remember more recent events or observations more clearly, and to overweight recent information and underweight events from the more distant past.”
Last year at The Masters, Spieth was unable to hold a two stroke lead on Sunday. Several callers mentioned Spieth’s struggles at the 2014 Masters as their reason for believing he would ultimately lose this year.
Other callers simply had a hunch that Phil Mickelson would have a big day today. If you watch golf, you’ve likely seen Phil pull off some amazing victories before. This reminded me of what Jim O’Shaughnessy wrote about personal experience and its effect on the forecasting process:
“People always default to making predictions based upon their individual experience and intuition.”
Instead of objectively analyzing concrete numbers, like Phil’s 18-1 odds of victory, most people prefer to base their decisions off a feeling. You know that feeling, right? The one where you just know something is going to happen.
Intuitive, emotional heuristics cause so many errors when it comes to investing. Whether somebody “just has a feeling” about a company or “has a buddy who knows the CFO”, they’re interjecting dangerous emotion into their decision-making process. Feelings and relationships don’t change data. It’s been said that, “an ounce of emotion is equal to a ton of facts”, though and, unfortunately most people end up making poor, emotionally-driven decisions.
All of today’s callers and their cognitive biases made for an interesting radio discussion, but a pretty irrational forecasting method. Jordan Spieth ended up winning the 2015 Masters, affirming that statistically based models tend to outperform human forecasters.
Side note: Since Spieth won, I’m definitely feeding my own hindsight bias here, but we’re all only human, right?
Source: