Think Twice: Harnessing the Power of Counterintuition Read online

  As Thaler tossed me my prize, he grumbled, “You don’t deserve this because you knew what was going on.”

  Yes, I did know what was going on. That was the point. And that is the point of this book.

  The Magic Square: Making Hard Problems Easy

  Preparation and recognition give you new points of view that can make tough problems simpler. One example is a game called Sum-to-Fifteen, conceived by the celebrated economist, Herbert Simon. You lay nine cards, numbered one through nine, face up on a table. Two players alternate selecting cards with the goal of collecting three cards that add up to fifteen. If you’ve never played the game before, try it. Or offer to try it on some friends or colleagues and watch carefully as they go back and forth.

  The game is moderately hard, because you must keep in your head a running total of your numbers as well as those of your opponent. You must think offensively, getting three cards that add up to fifteen, as well as defensively, preventing your opponent from doing the same. It is common for one person to win as his opponent gets tangled in the numbers.

  Now I’ll introduce a magic square that makes the game much easier:

  Note the numbers sum to fifteen if you look at them vertically, horizontally, or diagonally. All of a sudden, the game becomes very easy: it’s the childhood favorite, tic-tac-toe (also known as naughts and crosses). Once you perceive the game as tic-tac-toe, the winning path is much clearer. A tie should be a worst-case scenario, and losing is, well, inexcusable.9

  Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25 percent of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. If you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence.10

  Process or Outcome: Which Should You Focus On?

  Three factors determine the outcomes of your decisions: how you think about the problem, your actions, and luck. You can familiarize yourself with common mistakes, recognize the situation you’re in, and take what appears to be the correct action. But luck, by definition, is beyond your control, even though it may determine the outcome (especially over the short term). That statistical reality begs a fundamental question: should you evaluate the quality of your decisions based on the process by which you make the decision or by its outcome?

  The intuitive answer is to focus on outcomes. Outcomes are objective and sort winners from losers. In many cases, those evaluating the decision believe that a favorable outcome is evidence of a good process. While pervasive, this mode of thinking is a really bad habit. Kicking the habit opens up a world of insight into decision making.

  Our most challenging decisions include an element of uncertainty, and at best we can express the possible outcomes as probabilities. Further, we must make decisions even when the information is incomplete. When a decision involves probability, good decisions can lead to bad outcomes, and bad decisions can lead to good outcomes (at least for awhile). Say, for example, that you are playing blackjack in a casino and are dealt cards that add up to eighteen. Going against standard blackjack strategy, you ask for a hit and the dealer flips a three, making your hand. That’s a poor process and a favorable outcome. Play that same hand a hundred times, and you will lose on average, as standard strategy acknowledges.

  In a probabilistic environment, you are better served by focusing on the process by which you make a decision than on the outcome. Blackjack is a game of chance. That means you will do best by following a rule that reflects the real probability of being dealt the right cards: don’t hit when you’ve been dealt a seventeen or more. But it’s crucial to bear in mind that because of the substantial role that luck plays in this process, good decisions don’t ensure attractive outcomes. If you make a good decision and suffer a poor outcome, pick yourself up, dust yourself off, and get ready to do it again.

  When evaluating other people’s decisions, you are again better served by looking at their decision-making process rather than on the outcome. There are plenty of people who succeed largely by chance. More often than not, they are completely unaware of how they did it. But they almost always get their comeuppance when fortune stops smiling on them. Likewise, skillful people who have suffered a period of poor outcomes are often a good bet, since luck evens out over time.11

  Picking the Main Mistakes We Professionals Make

  The primary audience for this book is investors and businesspeople, although the concepts are relevant for other professionals as well. This book is neither a survey of common mistakes nor an exposition of one big theme. For instance, most books focus either on the components of prospect theory (loss aversion, overconfidence, framing effects, anchoring, and the confirmation bias) or they dwell on one important idea.12 Rather, I have tried to select the concepts that I have found most useful, based on my experience in the investment industry and through my study of psychology and science.

  Each of the following chapters discusses a common decision mistake, illustrates why that mistake is consequential, and offers some thoughts on how to manage the problem. Specifically:

  • Chapter 1, “The Outside View: Why Big Brown Was a Bad Bet,” describes our tendency to consider each problem as unique rather than considering carefully the experience of others. This mistake helps explain why executives express near-universal optimism when acquiring other companies, despite the poor record of acquisition success.

  • Chapter 2, “Open to Options: How Your Telephone Number Can Influence Your Decisions,” deals with tunnel vision, the failure to consider alternatives under certain conditions. Our minds want to reduce the options at times when we should keep our alternatives open. Also, incentives may encourage certain choices that are good for one person but not another.

  • Chapter 3, “The Expert Squeeze: Why Netflix Knows More Than Clerks Do About Your Favorite Films,” highlights our uncritical reliance on experts. Experts tend to know about very narrow fields, justifying a skeptical view of the claims and predictions they make. Increasingly, people can more effectively solve problems by making models of decisions using computers or by accessing the wisdom of crowds than by relying on experts.

  • Chapter 4, “Situational Awareness: How Accordion Music Boosts Sales of Burgundy,” underscores the crucial role of context in decision making. As much as we like to think of ourselves as objective, the behavior of those around us exerts extraordinary influence on our decisions. It also shows why we should not be too quick to judge the behavior of others without fully appreciating the context of their decisions.

  • Chapter 5, “More Is Different: How Bees Find the Best Hive Without a Real Estate Agent,” explores the pitfalls of understanding complex systems on the wrong level. Attempting to understand macro behavior by aggregating micro behavior fails because the total is greater than the sum of the parts. You can’t understand an ant colony by watching what one ant does. The chapter also shows that it is nearly impossible to manage a complex system, a lesson the U.S. government learned as it coped with the financial crisis of 2007–2009.

  • Chapter 6, “Evidence of Circumstance: How Outsourcing the Dreamliner Became Boeing’s Nightmare,” cautions against predicting cause and effect for a system based on attributes rather than circumstances. The answer to most questions in life is, “It depends.” This chapter explores how to think about what it depends on.

  • Chapter 7, “Grand Ah-Whooms: How Ten Brits Made the Millennium Bridge Wobble,” covers phase transitions, in which small perturbations to a system can lead to large changes. Since cause and effect are difficult to identify when phase transitions occur, it’s almost impossible to predict
the outcome. That’s why no one knows where the next hit movie or song will come from.

  • Chapter 8, “Sorting Luck from Skill: Why Investors Excel at Buying High and Selling Low,” deals with the role of skill and luck in outcomes and emphasizes the concept of reversion to the mean, which is often misunderstood. For example, sports reporters and business commentators are generally oblivious to roles of skill and luck as they report on successes and failures.

  • The conclusion, “Time to Think Twice,” summarizes advice on how to think about the mistakes discussed throughout the book. It also recommends some specific techniques for gaining a decision-making edge, such as maintaining a decision journal, to put these ideas into practice.

  Daniel Kahneman, a psychologist at Princeton University who won the 2002 Nobel Prize in economics, once noted his surprise at how ambivalent people are about the process of decision making.13 While they talk about improving, very few are willing to spend the time and money necessary to learn and, ultimately, to change. In the following chapters, I will introduce concepts that can help you make better decisions. I hope you will also have some fun along the way.

  I chose the themes for each chapter with three criteria in mind. The issues had to be common. Once you internalize a few of these concepts, you will see them everywhere—in the decisions you face as well as in the decisions of others. The concepts had to be identifiable. The themes here are not meant to be subtle or nuanced, and you will see them pop up in places where you may have overlooked them before. Finally, the mistakes associated with the themes had to be preventable. While I can’t guarantee you success, I can help you improve how you make decisions.

  CHAPTER ONE

  The Outside View

  Why Big Brown Was a Bad Bet

  “IT’S A FOREGONE CONCLUSION.” So proclaimed Rick Dutrow on the likelihood that his race horse, Big Brown, would capture the coveted Triple Crown in 2008. Winning the Triple Crown is a tremendous feat. A horse must win the Kentucky Derby, the Preakness Stakes, and the Belmont Stakes on three tracks of different lengths over just five weeks. Before Big Brown’s attempt, only eleven horses had succeeded in the preceding century, and none had done so in the previous thirty years. Here was Big Brown, only one race away from horse-racing “immortality.”1

  Dutrow, the horse’s trainer, had reason to be optimistic. Not only was his three-year-old colt undefeated in his first five starts, he was dominant. Although the odds makers placed only a 25 percent probability on his winning the Kentucky Derby, Big Brown won by four-and-three-quarters lengths. He was stronger still in the Preakness, crossing the finish line five-and-one-quarter lengths ahead of the field, even though his jockey eased him coming down the home stretch. In his last race, the Belmont, Big Brown faced mediocre competition, and his biggest challenger, Casino Drive, dropped out of the race at the last minute.

  Not surprisingly, enthusiasm for Big Brown built. Sensing opportunity, UPS, the company after which Big Brown was named, signed a marketing deal that included a corporate logo on the jacket of Big Brown’s outrider. A majority of racetrack pros picked him to win the race. And then there was Big Brown himself. He was portrayed as strong, confident, and ready. Dutrow gushed, “He looks as good as he can possibly look. I can’t find any flaws whatsoever in Big Brown. I see the prettiest picture. I’m so confident, it’s unbelievable.”2 The fans agreed: attendance for the pivotal race was double what it had been in the previous year despite the sweltering heat, as the crowd yearned to see history made.

  Big Brown made history, all right. It just wasn’t the kind of history everyone expected. He finished dead last, which no Triple Crown contender had ever done.3

  Veterinarians gave Big Brown a full physical exam following the race and he appeared to be fine. His capricious performance evoked what lab researchers call Harvard’s Law, “Under the most rigorously controlled conditions of pressure, temperature, volume, humidity, and other variables, the organism will do as it damn well pleases.”4

  However, there was another way of looking at Big Brown’s chances of winning the Triple Crown, one that was far less optimistic about his prospects of joining the pantheon of horse racing. This point of view asked a simple question: how successful were other horses when they were in Big Brown’s position?

  Steven Crist, a talented writer and renowned handicapper, provided some sobering statistics.5 Of the twenty-nine horses with a chance to capture the Triple Crown after winning the Kentucky Derby and the Preakness Stakes, only eleven triumphed, a success rate less than 40 percent. But a closer examination of those statistics yielded a stark difference before and after 1950. Before 1950, eight of the nine horses attempting to win the Triple Crown succeeded. After 1950, only three of twenty horses won. It’s hard to know why the achievement rate dropped from nearly 90 percent to just 15 percent, but logical factors include better breeding (leading to more quality foals) and bigger starting fields.

  While a 15 percent rate of success may raise some concern, it doesn’t take into consideration Big Brown’s innate ability and impressive track record. After all, not all of the horses in a position to win the Triple Crown had similar talent. One way to compare horses is the Beyer Speed Figure, which assigns a number to a horse’s performance based on the time of the race and the speed of the track, given the weather conditions. Higher speed figures are better.

  Table 1-1 shows the speed figures in the first two Triple Crown races for the last seven aspirants, including Big Brown. The sample is small because speed figures have been widely available only since 1991. While his jockey’s actions likely pared a few points from his Preakness figure, Big Brown looked downright lead-hoofed when compared to the other horses. Even considering the so-so Belmont field, it was obvious that Big Brown was not certain to win. Yet the bettors had Big Brown’s odds at a euphoric three-to-ten, implying he had more than a 75 percent probability of winning the final leg. Crist and other sharp handicappers had the horse sense to recognize the tote board substantially overstated Big Brown’s chance of winning.

  These contrasting points of view reveal our first mistake, a tendency to favor the inside view over the outside view.6 An inside view considers a problem by focusing on the specific task and by using information that is close at hand, and makes predictions based on that narrow and unique set of inputs. These inputs may include anecdotal evidence and fallacious perceptions. This is the approach that most people use in building models of the future and is indeed common for all forms of planning. Rick Dutrow and the other fans of Big Brown dwelled largely on the inside view, including the horse’s wins and imposing physical appearance. This comes naturally but almost always paints too optimistic a picture.

  TABLE 1-1

  Beyer Speed Figures for Triple Crown contenders

  Horse

  Kentucky Derby

  Preakness

  Total

  Silver Charm

  115

  118

  233

  Smarty Jones

  107

  118

  225

  Funny Cide

  109

  114

  223

  War Emblem

  114

  109

  223

  Real Quiet

  107

  111

  218

  Charismatic

  108

  107

  215

  Big Brown

  109

  100

  209

  Source: Steven Crist.

  The outside view asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered. Handicappers using the outside view judged Big Brown to be a very poor bet, as the experience of other horses in the
same spot suggested a probability of winning that was much lower than what was on the tote board. The outside view can often create a very valuable reality check for decision makers.

  Why do people tend to embrace the inside view? Most of us are unduly optimistic a good deal of the time. Social psychologists distinguish three illusions that lead people to the inside view.7

  To introduce the first illusion, take a moment to answer (honestly!) the following questions either yes or no:

  • I am an above-average driver.

  • I have an above-average ability to judge humor.

  • My professional performance places me in the top half of my organization.

  If you are like most people, you said yes to all three questions. This shows the illusion of superiority, which suggests people have an unrealistically positive view of themselves. Of course, not everyone can be above average. In a classic 1976 survey, the College Board asked high school test takers to rate themselves on a host of criteria. Eighty-five percent considered themselves above the median in getting along with others, 70 percent above the median in ability to lead others, and 60 percent above the median in sports. One survey showed that more than 80 percent of people believed that they were more skillful than half of all drivers.8