 Horse Racing and the
CIA
John Mauldin
October 2, 2004
Your Pre-Game (Investment)
Routine
Your Most Embarrassing Investment Moment
Do You Really Need More Information?
Horse Racing and the CIA
Birthdays, Houston and Other Distractions
This week we explore in depth
an essay on how we think from that bastion of investment analysis,
the US Central Intelligence Agency. We look at the rookie mistakes
made even by pros. I describe one of my own more embarrassing
rookie moments and how it highlights an investment principle
that the best performing professionals always keep in mind. I
finish with a note on what you can give me (and your friends)
for my birthday. It should make for a lively letter.
Your Pre-Game (Investment)
Routine
One of the things I try to
get my kids to notice is how professional athletes all have a
routine when they perform. Watch a golf pro or a baseball player.
Before they get ready to hit, they have a routine, which is always
the same. They have narrowed their thoughts down to a few simple
steps.
What happens to a golfer if
he is thinking about his next meeting when he is in the middle
of his backswing? It's hard enough to hit that small ball straight
when you are totally focused. Getting distracted when a 98 mile
per hour baseball is coming at you won't help your batting average.
Thinking about something stressful when you need to be focused
is a prescription for problems.
The pre-swing (or pre-race
or pre-whatever) routine is crucial to solid performance. And
this week, that fact was brought out to me in spades.
I have probably done at least
100 interviews on radio and TV this year, as well as lots of
speeches. Not really realizing it, I have developed a routine
over the years that serves me well. While not really all that
glib in person (I think I do much better in print where I can
edit my thoughts), I do seem to be able to not embarrass myself.
Except last Wednesday.
The producer for the early
morning CNBC Squawk Box called me on Monday and asked me to be
on their show Wednesday morning. The topic was to be what the
bond market may be telling us about the economy and Fed policy.
Pretty standard stuff, and long time readers know that I have
a few opinions. This is a topic with which I am pretty familiar.
Normally, I would sit down about 30 minutes before the interview,
review my thoughts and research and then step up and swing away.(Assuming,
of course, that I have a more than reasonable familiarity with
the subject, although that has not always kept me from having
an opinion.)
However, I varied my pre-interview
routine. I must confess that I have watched Mark Haines ask a
tough question or two from time to time, so I decided to spend
a little extra time the day before re-reading a lot of papers
and looking at data. A little time turned into four hours. As
we will see in a few pages, the CIA paper offers an opinion on
what happens when we get too much information. That is the paper
I should have been reading! I will save that insight for later,
but for now let's go on to how I compounded that problem with
a second (and what turned out to be far more serious) break in
my pre-interview routine.
I enjoy coffee every morning,
but rarely drink coffee with any caffeine in it. Over a period
of a week or so, my body reacts quite negatively to too much
caffeine. Half a cup here or there is no problem, but I normally
stick to de-caf.
Having been out of town all
last week, I worked quite late Tuesday night and had to get up
quite early to drive across town to the studio. You guessed it,
I decided to have a little caffeine: two mugs worth, thank you.
By 8 am my time, I was feeling quite awake.
We went to the studio room,
which is a small, dark place. No monitors, just bright lights
glaring at you. The closest analogy is to the rooms you se on
TV where they interview suspects. You look into a dark place
between the lights (you can't even see the camera) and talk into
it like the other party is sitting there. You have an earpiece
with a dis-embodied voice and away you go.
I was ready. I had my opening
down and then we would go to questions, which is probably what
I do best. Then it hit. About two minutes before the show, I
got the mother of all caffeine rushes. Literally, my hand started
shaking. My jaws started to feel funny. I was thinking that someone
had put a controlled substance into my coffee. I started having
multiple swing thoughts. I took my eye off the ball.
At that moment, Mark came into
my ear and asked me the first question. I forgot all but my first
planned sentence. After that, rather than having a few main points
at the top of my head which I could confidently tick off, every
bit of research from the previous day all rushed to the front
of my mind, competing to get out. Could I sort through them quickly
and recover. Heck, no. I was worried they could see my hand shake.
Did I want to look like some nervous rookie? I stuttered, paused
and dropped a point or two. I in fact did get nervous. After
a minute or two, Mark finally helped me with a softball question
and I was kind of able to get back on track. Not my finest interview,
although I have been assured it was not "all" that
bad. However, no one used the word good, either. Oh, well. (I
had a 30 minute radio interview two hours later and I could not
sit still, walking around the whole interview.)
Your Most Embarrassing
Investment Moment
Successful investors have a
pre-investment routine before they "hit" an investment.
Thorough research, in-depth due diligence and thoughtful analysis
about how an investment fits into their overall portfolio is
all part of it. In my experience, there is a strong correlation
between the amount of work and research done before an investment
is made and the success of the investor. Good research does not
guarantee the performance of any particular investment, but it
does help you avoid more of the bad ones. This goes for whether
the time horizon for the investment is 30 minutes or 30 years.
Successful investors even develop
contingency plans for what to do when the special investment
or situation comes along that requires a little quicker action.
The goal is to not let your emotions rule your investment routine.
It is at precisely such moments
when the excitement of the opportunity, the thrill of the big
score, comes our way and our emotions are running ahead of our
thought process that we need to fall back on our pre-investment
routine.
Maybe that emotional lunge
will result in a ball straight down the middle. Maybe. However,
my most embarrassing investment moments, the ones talked about
late at night by my fellow professionals, and I bet yours,
too, are when we make that knee-jerk emotional snap judgment.
We look back and say, "If I had stuck to my pre-investment
routine, I would have found the flaw before I lost my money."
You don't want to end up in
a small room with Mark Haines talking into your ear. Develop
your routine and stick to it.
Do You Really Need
More Information?
Jim Williams, the founder of
the Williams Inference Center (www.williamsinference.com) recently sent
me a pile of fascinating research which I am wading through.
One of the first articles I read was an essay by Richards J.
Heuer, Jr. entitled "Do You Really Need More Information?"
It was published in a book called "Inside CIA's Private
World: Declassified Articles from the Agency's Internal Journal
1955-1992."
Buried among articles on how
(and how not to!) to spy is this rather straightforward piece
on what to do with the information you get and the problems with
objective and accurate analysis that are caused by our human
thought process. The essay is quite timely, even though it was
written in the spring of 1979. While reading the critique, one
could not help but wish that it would be required reading at
the CIA today. Perhaps we could have avoided a few problems.
But that is a topic for someone else. Our beat today is thinking
about money.
(All quotes are from the article.
If you are interested in the complete article, you can go to
http://www.cia.gov/csi/books/19104/
and click on chapter 5.)
I am guilty. Mea Culpa. I am
constantly researching, looking at (sometimes obscure) data,
trying to discern patters and trends. But what to do with all
of it? How do we filter it into useful and investable ideas?
"This article challenges
the often implicit assumption that lack of information is the
principal obstacle to accurate intelligence estimates....Once
an experienced analyst has the minimum information necessary
to make an informed judgment, obtaining additional information
generally does not improve the accuracy of his estimates. Additional
information does, however, lead the analyst to become more confident
in his judgment, to the point of overconfidence."
Horse Racing and the
CIA
Heuer describes a study done
about betting on horse races. They took 8 professional handicappers
(someone who sets the betting odds based on calculations of the
outcome of a contest, especially a horse race) and asked them
to rank 80 different pieces of data about a horse race as to
what they thought was most important. Do you factor in the jockey's
record as well as the recent record of the horse? The weather?
The competition? How much weight is the horse carrying? What
is the length of the race? There are scores of variables.
Then the handicappers were
given what they felt was the five most important pieces of data
and asked to project the winners for a race (actual names and
races were not given, so as to not bias the projections). They
were also asked to rank their confidence about their predictions.
Now it gets interesting. They
were then given 10, 20 and 40 pieces of what they individually
considered to be the most important information. Three of the
handicappers actually showed less accuracy as the amount of information
increased, two improved their accuracy, and three were unchanged.
But as a group, their accuracy did not improve and in fact was
slightly down.
But with each increase in information,
their confidence went up. In fact, by the end, their confidence
has in fact doubled. If they had actually been at the track and
betting, would they have doubled their bets as they became more
confident? Human nature says "yes, they would." But
that confidence would not have made them any better predictors.
They just doubled their bets which magnified their gains or losses.
Think of it like adding leverage to your stock portfolio.
"A series of experiments
to examine the mental processes of medical doctors diagnosing
illness found little relationship between thoroughness of data
collection and accuracy of diagnosis." Another study was
done with psychologists and patient information and diagnosis.
Again, increasing knowledge yielded no better results but significantly
increased confidence.
The inference is clear and
quite important: "Experienced analysts have an imperfect
understanding of what information they actually use in making
judgments. They are unaware of the extent to which their judgments
are determined by a few dominant factors, rather than by the
systematic integration of all available information. Analysts
use much less available information than they think they do."
How can this be? Heuer notes
that individuals tend to: "...overestimates the importance
he attributes to factors that have only a minor impact on his
judgment, and underestimates the extent to which his decisions
are based on a very few major variables... Possibly our feeling
that we can take into account a host of different factors comes
about because although we remember that at some time or other
we have attended to each of the different factors, we fail to
notice that it is seldom more than one or two that we consider
at any one time."
As I wrote in Bull's Eye Investing,
"The two most common biases are overoptimism and
overconfidence. For instance, when teachers ask a class
who will finish in the top half, on average around 80 percent
of the class think they will! Not only are people overly optimistic,
but they are overconfident as well. People are surprised more
often than they expect to be. For instance, when you ask people
to make a forecast of an event or a situation, and to establish
at what point they are 98 percent confident about their predictions,
we find that the correctness of their predictions ranges between
60 and 70 percent! What happens when we are only 75 percent sure
or are playing that 50-50 hunch?"
Let's take one quick example
where we think "knowledge" makes for a better investment.
Again from my book:
"First, a researcher takes
a deck of 52 cards and holds one card up. Watchers pay a dollar
for the chance to win $100 if that card is picked out of the
deck. Keep in mind the expected payout is 1/52 - 100 = 1.92.
Las Vegas would quickly go broke with such odds. Then they are
asked if they would like to sell their chances: roughly 80 percent
would sell if they could, asking for an average price of $1.86.
If you could get such a price, it would be a reasonable sell.
For someone who could buy all 52 chances, it would be a good
purchase or arbitrage. He would make a quick 3.18 percent.
"Now it gets interesting.
The next time, someone is allowed to pick a card out of the deck
and offered the same chance, but now he has a personal attachment
to the card because he touched it. Only about 60 percent of those
who picked cards were willing to sell their chances, and they
wanted an average price of just over $6. And when this same trick
was performed at MBA schools the average sale price has been
over $9.
"I know this card. I have
studied it. I have a personal involvement with the card; therefore
it is worth more," thinks the investor. Of course, it is
worth no more than in the first case, but the psychology of "owning"
the card makes investors value it more."
Is it just MBA students? Studies
show that institutional investors exhibit quite significant biases
about industries they know, as well as thinking that their own
home country stock market will outperform the stock market of
another country.
Knowledge makes us confident.
And the more knowledge we have, evidently the more confident
we become, even though our accuracy may not be enhanced.
"How" Heuer asks,
" Can this happen to smart people like us?"
There are four types of additional
information that an analysts might receive.
- Additional detail about variables
already in our analysis.
- Information on additional
variables. "Occasionally, in situations where there are
known gaps in our understanding, a single report concerning some
new and previously unconsidered factor will have a major impact
on our judgments. Such a report would fall into either of the
next two categories of new information:
- Information concerning the
level of value attributed to variables already included in the
analysis, and...
- Information concerning which
variables are most important and how they relate to each other.
And that brings us to the heart
of the matter: a discussion of the types of new information which
is the basis for distinguishing two types of analysis: data-driven
analysis and conceptually-driven analysis.
In data driven analysis, "...accuracy
depends primarily upon the accuracy and completeness of the available
data. If one makes the reasonable assumption that the analytical
model is correct and the further assumption that the analyst
properly applies this model to the data, then the accuracy of
the analytical judgment depends entirely upon the accuracy and
completeness of the data."
On the other hand, "Conceptually
driven analysis is at the opposite end of the spectrum from data-driven
analysis. The questions to be answered do not have neat boundaries,
and there are many unknowns. The number of potentially relevant
variables and the diverse and imperfectly understood relationships
among these variables involve the analyst in enormous complexity
and uncertainty. There is little tested theory to inform the
analyst concerning which of the myriad pieces of information
are most important and how they should be combined to arrive
at probabilistic judgments.
"In the absence of any
agreed-upon analytical schema, analysts are left to their own
devices. They interpret information with the aid of mental models
that are largely implicit rather than explicit. Assumptions concerning
political forces and processes in the subject country may not
be apparent even to the analyst. Such models are not representative
of an analytical consensus. Other analysts examining the same
data may well reach different conclusions, or reach the same
conclusions but for different reasons. This analysis is conceptually
driven, because the outcome depends at least as much upon the
conceptual framework employed to analyze the data as it does
upon the data itself."
There are some investment decisions
that are data driven. Having the right data, the right research
is key.
But more often than not, what
we think of as data "proofs" for a certain viewpoint
depend more upon our perceptions than the actual data. What happens
is that we develop mental models. We take in information and
process it according to our mental models, which are subject
to our personal biases. The accuracy of any particular judgment
depends almost exclusively upon the accuracy of your mental model,
because there is virtually no other basis for our judgment. If
the accuracy of our mental model is the key to accurate judgment,
it is necessary to consider how this mental model gets tested
against reality and how it can be changed so that we can improve
the accuracy of our judgment.
How can we deal with this bias?
"Information that is consistent
with our existing mindset is perceived and processed easily.
However, since our mind strives instinctively for consistency,
information that is inconsistent with our existing mental image
tends to be overlooked, perceived in a distorted manner, or rationalized
to fit existing assumptions and beliefs. Thus, new information
tends to be perceived and interpreted in a way that reinforces
existing beliefs.
"...If we are to penetrate
to the heart and soul of the problem of improving analysis, we
must somehow penetrate and affect the mental processes of the
individuals who do the analysis. This strategy is to focus on
improving the mental models employed by the analyst to interpret
his data.
"...All involve confronting
the analyst with alternative ways of thinking. The objective
is to identify the most fundamental analytical assumptions, then
to make these assumptions explicit so that they may be critiqued
and re-evaluated.
AND THIS IS KEY: "...The
analyst should then try to disprove, rather than prove, each
of the alternatives. He or she should try to rebut rather than
confirm hypotheses...It is especially important for the analyst
to seek information that, if found, would disprove rather than
bolster his own arguments. One key to identifying the kinds of
information that are potentially most valuable is for the analyst
to ask himself what it is that could make him change his mind.
Adoption of this simple tactic would do much to avoid intelligence
surprises."
Let's take a few real world
examples. I am, and I presume many of my readers are, bearish
on then dollar. We read Stephen Roach and Bill Gross and find
comforting confirmation for our views. "Look at the trade
deficit," we tell ourselves, "the over-indebtedness
of the US consumer and government and on and on." Two years
ago I wrote about the Fed study which shows that currencies drop
about 30% on average when trade deficits get to 5%. We are now
at 5.7% and the dollar is down a mere 12% or so on a trade weighted
basis. What happened? Why is the deficit up?
Because it is not cut and dried.
There are all sorts of factors at play. If there were not the
dollar would already be at 1.5 to the euro. What is running counter
to the theory? China and Japan, along with the rest of Asia,
are buying our debt. Andy Kessler's book Running Money suggests
it might be because the margin surplus we have in the states
is more important than old economy models of trade deficits has
a point. Many of you dismissed the idea because it is so clearly
contrary to Monetary and Austrian models. But he makes a point
in that global trade and markets are not like they were 50 years
ago. Does he persuade me to think the dollar is going up? No,
but it may partly explain why it is not in free fall.
Further, old economic models
all suggest that if the dollar drops then our trade deficit will
improve. In the long run, that is true. But it might not be in
the short run.
Let's say China does let the
Yuan float and the competitive currency devaluation practiced
throughout Asia begins to wane, as they all let their currencies
rise. Does that mean that our products will start to sell better?
Perhaps not.
Think about a foreign consumer.
China floats the Yuan. The dollar starts to drop. Wouldn't he
be better off to wait another 6 months for the dollar to drop
another 10% or 20% before he buys our products? You could actually
see the deficit rise as foreigners hold off their purchases.
In some ways, that is precisely
what we have already seen. Where is the rush from Europe to "buy
American" when the euro is up almost 50%? There are other
reasons put forth as to why the dollar might strengthen.
If we are going to make investment
decisions, we MUST test our assumptions. But right now, we are
talking about our personal thought models. We will cover the
dollar at some later point.
(This week's Outside the Box,
which you will get Monday evening, has a fascinating exchange
of mail between Gross and Roach about deficits and the dollar.)
Who do we share our opinions
and views with to "test" them? Most likely, it is people
who are close to our fundamental mindset. But these are the individuals
least likely to actually bring up a different viewpoint.
I force myself to read people
with which I know I will not agree, and I work hard to keep an
open mind. Perhaps that is why I am so "Muddle Through."
When I do get a conviction, it may be wrong, but I have hopefully
thought about it. And you should do the same.
Repeating a key point above,
"...The analyst should then try to disprove, rather than
prove, each of the alternatives. He or she should try to rebut
rather than confirm hypotheses...It is especially important for
the analyst to seek information that, if found, would disprove
rather than bolster his own arguments."
What happens is that we create
a mental picture of what the world looks like. You can call it
a world view. Heuer suggests it is like a mosaic. All the pieces
of data combine to make a picture or a mosaic which we can use
to get an insight. Except that:
"Such insights suggest
that the picture formed by the so-called mosaic is not a picture
of reality, but only our self-constructed mental image of a reality
we can never perceive directly. We form the picture first and
only then do we fit in the pieces. Accurate estimates depend
at least as much upon the mental model we use in forming that
picture as upon the accuracy and completeness of the information
itself."
If we believe there are weapons
of mass destruction, then the data points that way. If we believe
the dollar is going down, the markets up, gold up or down or
whatever, then that is what the data says.
Again, as we close, take this
point away and ponder how it applies not only to your investment
thinking, but to every part of your world view:
"Information that is consistent
with our existing mindset is perceived and processed easily.
However, since our mind strives instinctively for consistency,
information that is inconsistent with our existing mental image
tends to be overlooked, perceived in a distorted manner, or rationalized
to fit existing assumptions and beliefs. Thus, new information
tends to be perceived and interpreted in a way that reinforces
existing beliefs.
I can't tell you how many times
I have traveled overseas and someone says after getting to know
me, "You're not what I thought someone from Texas (white
male, conservative, Republican, etc.) would be like." But
in some places it takes some time. Those existing mindsets can
be very tough to change.
Birthdays, Houston
and Other Distractions
On Monday I hit the big Double
Nickel. For some reason, (probably connected to all the human
psychological biases, especially the over-optimism and denial
I write about) I have never felt like I was getting all that
old. Comfortably middle-aged, maybe.
But 55 is no longer in the
middle. It is on the other side of middle and this birthday is
giving me pause. But not for very long, I hope. There are so
many good things happening, life is too much fun (at least as
long as I don't think about - gasp - being 55) and all seven
of the kids are getting together in an hour. Heck, I might just
decide to do another 55 years. [Editor's note: Happy Birthday for Monday, John,
from an old, wise 60-yr old (yikes) Barb).
 My daughter Tiffani (who works with
me) decided that I should point out since this letter is free,
I should suggest an appropriate birthday present.
"Why don't you tell them
to get a copy of Bull's Eye Investing and give it to friend?"
(You have bought your own copy, haven't you?) "Or tell them
to click on http://www.2000wave.com/tellfriend.asp, with
a note to make sure they tell why they love it so much..."
Assuming of course, that you do.
You can read about what some
call "The Most Important Book of 2004" and why you
should get Bull's Eye Investing by going to www.absolutereturns.net or buy it a 32% discount
from Amazon.
I will be in Houston next Saturday
speaking at 11 AM to the Houston Investors Association at Melcher
Hall on the University of Houston Campus. You can click on http://houstoninvestors.com/Location.htm
to get directions.
On Friday night I will be doing
a book signing at 6:30 to around 8 at Murder by the Book (the
name of the bookstore) at 2432 Bissonnet Street (713-524-8597).
The store is one of the nation's oldest and largest mystery specialty
books stores. I have pondered the relationship between murder,
mystery, secular bear market and investments, and hope to have
a connection by next week. Drop by and help me solve the puzzle
if you are in the area. (www.murderbooks.com)
Sadly, the youthful Rangers
simply could not run the table. Anaheim over-powered us, and
we must now wait till next year. But two years ago we ended the
season 45 games out, and to be "in the hunt" in the
last week is a much better feeling.
Next year will be the year
for the Rangers. It will also be the year I get my weight down
to 185 while bench pressing 185. And I get control of my travel,
work and writing schedule. Hey, it could happen.
Your 'sometimes it's good to
be blindly optimistic' analyst,
John Mauldin
John@frontlinethoughts.com
Copyright ©2004 John Mauldin.
All Rights Reserved.
http://www.frontlinethoughts.com/printarticle.asp?id=mwo100104
John Mauldin
is president of Millennium Wave Advisors, LLC, a registered investment
advisor. All material presented herein is believed to be reliable
but we cannot attest to its accuracy. Investment recommendations
may change and readers are urged to check with their investment
counselors before making any investment decisions. Opinions expressed
in these reports may change without prior notice. John Mauldin
and/or the staff at Thoughts from the Frontline may or may not
have investments in any funds cited above. Mauldin can be reached
at 800-829-7273.
This information
is not to be construed as an offer to sell or the solicitation
of an offer to buy any securities.
_______________
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