Notenstein Dialogue, October 2013
Professor Dr Gerd Gigerenzer,
Analysis or intuition? In an uncertain world, not everything is calculable. Intuition, statistics-based thinking and simple rules lead to better decisions – not least in the financial world.
fluences and factors play their part and not all risks are calculable. In this world probability theory and vast quantities of data are not enough – we need more: sound intuition.
Notenstein: Decisions get taken on the basis of information. The more important the decision, the more information is gathered. Shared experiences and internet forums can aid in figuring things out. Expert bodies consult the relevant professional literature, carry out evaluation processes and deliver opinions. In the case of (supposedly) quantifiable questions, analytic tools are stuffed with data, algorithms are run and highly complex models ultimately generate indisputable results. But now you say that gut feelings are often superior to the systematic approach. Gerd Gigerenzer, what should we rely on when we have to make decisions – intuition or analysis?
With roulette all the risks are known. No need for gut feelings here. Gerd Gigerenzer: Imagine for a minute that you go to the casino and try your luck at roulette. With roulette all the risks are known and you can work out how much you’ll lose. No need for gut feelings here. But when you leave the casino you return to a world in which an infinite number of in-
Few are prepared to admit publicly to making intuitive decisions. Fear prevails. What is intuition? Intuition is knowledge that is felt, that rises rapidly to our consciousness, though we are not aware of its more profound reasons, and then steers both private and professional decisions. Intuitive decisions are based on personal experience, but also on experience that we cannot put into words. We know more than we can say. Intuition is not arbitrary, nor is it a sixth sense, or divine revelation. Nor is it the prerogative of women – men also act intuitively. Intuition is a form of unconscious intelligence. How often do top managers make intuitive decisions? They are mostly buried under a mound of unreliable and contradictory information. In this situation, when a manager has a feeling for something and follows that feeling – that is an intuitive decision. I asked the top manages of a DAX-listed company how often important professional decisions ended up as intuitive decisions. The figure shows that gut feeling won the day in about half the cases. What is remarkable is that no-one claimed to make intuitive decisions either always or never – we obviously need both intuition and analysis.
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Notenstein Dialogue, October 2013
How often do top managers make intuitive decisions? No. of people 20
Board members Divisional heads Main department heads Department heads
16 12 8
ecause financial theory suggests that all the probabilities b and factors of influence are known – as in roulette or Black Jack – so that hitting the jackpot is only a question of employing the right strategy. However, this is obviously not how the financial markets function. Psychology and the herd instinct, terror strikes, natural disasters, or simply just politics, cause turmoil on the markets at regular intervals, thus making them impossible to forecast.
4 0 Never
Sometimes
50% of the time
Mostly
Always
Intuitive decisions
Note: Self-assessments by 32 managers in a DAX-listed company. Source: G. Gigerenzer, Risiko: Wie man die richtigen Entscheidungen trifft, Bertelsmann, 2013.
But only a few are prepared to admit publicly to making intuitive decisions. Fear prevails. For if something goes wrong, you look pretty silly if you cannot explain your decision. And intuitive decisions mean accepting personal responsibility. This can result in weeks spent gathering data, conducting statistical analyses, or engaging consultants, in order to present an intuitive decision as an objective, factbased decision. This is a waste of money, time and intelligence. Our society has a problem with intuition.
Intuition without prior information results in arbitrariness. Notenstein: So, good decision-making needs both analysis and intuition. If we don’t allow ourselves to be steered by our intuition when making difficult decisions, we make no use of this “felt knowledge”, yet are intellectually overwhelmed by the flood of information and lose ourselves in the details. But it’s also true that intuition without prior information can result in arbitrariness and that experience improves the quality of decisions arrived at intuitively. Consultants often serve for the ex-post rationalisation of intuitive decisions that have already been taken. The use of consultants can, though, also be understood in terms of gaining access to third-party experience in order to be able to make better intuitive decisions. Another thing about the casino, though: many people equate the financial markets with gambling, either because these no longer have any relationship with the real economy, rather resembling some glittering virtual reality, or
Psychology and the herd instinct, terror strikes, natural disasters, or simply just politics, cause turmoil on the markets at regular intervals. Gerd Gigerenzer: Bankers are sometimes criticised as gamblers in a casino. If only that were so! Then, all the risks would be calculable. This might have been the case in the good old days of the 3-6-3 business model: pay 3 percent interest, take 6 percent for credit and be on the golf course by 3 o’clock. However, since the 1980s developments such as complex derivatives, growing globalisation, short-termism and the decoupling of decision and responsibility have resulted in an increase in unpredictability. In this uncertain world, classic financial theory fails as a solution – rather it has become part of the problem.
Reliance on sound Swiss- banker intuition, rather than misleading risk models, would have meant that the crisis would not have occurred the way it did. Do you still remember when David Viniar, of Goldman Sachs, talked of mammoth losses caused by utterly unexpected 25-sigma events (events whose probability distribution is 25 standard deviations removed from the expected value), and indeed, several days in succession? According to conventional risk models, such an event is so improbable that it shouldn’t have occurred once in all the time since the Big Bang. Such models generate the illusion of certainty, and create the impression that risks can be expressed by a single figure without the need for much understanding of the real world of finance. The role of experience, conscious or intuitive, is thus pushed further into the background. Reliance on
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Notenstein Dialogue, October 2013 sound Swiss-banker intuition, rather than misleading risk models, would have meant that the crisis would not have occurred the way it did. We are always inclined to seek for complex solutions to complex problems. That may be the right approach when we are dealing with calculable risks, but not when much is incalculable. Let’s take an example: how to invest a sum of money in the N fund. Harry Markowitz won the Nobel Prize for Economics for his answer – portfolio theory. So we might suppose that when he came to make investments for his pension he used his own optimisation model. Not so. He relied on a simple intuitive rule: 1/N – that is, distribute the money equally across the N options. A study with seven investment problems has shown that in six out of seven cases, 1/N was actually better. In conditions of uncertainty, simple rules are often more successful, reliable and transparent than classic financial theory. This is particularly the case when predictability is difficult, there are many alternatives and little data.
Simple rules can, however, entice investors into rash adventures if no c onsideration is given to their overall financial situation – the size of their assets, their age and liquidity requirements. Notenstein: 1/N sounds good, but things are not really that simple! But perhaps it’s a way of combining intuition and analysis: the rule is intuitive, but the intellect is still at work. Such simple rules can, however, entice investors into rash adventures, if no consideration is given to their overall financial situation – the size of their assets, their age and liquidity requirements (in other words, their risk capacity). Those who need money to buy a house, or need a steady income stream in retirement, are ill-advised to follow 1/N blindly, and invest as much in risky investments as in lowrisk ones. If the risky ones go pear-shaped, things can quickly become uncomfortable. So, when investing, the intellect comes first: you need to define your risk capacity – or have it defined. No less important, though, is your personal risk appetite, and that depends on your gut feeling. There are those daredevils who invest according to the motto of the SAS – “Who dares wins”. They operate with high levels of debt and highly concentrated risks. Others avoid risk, and develop existential
anxiety if ever their asset status is preceded by a minus. The same, apparently simple, rule works for different investors in completely different ways – there’s no common denominator. This is why it’s necessary to see how matters stand with regard to risk capacity and risk appetite before any investing is done. The aim is to find a prudent balance between analysis and intuition – simple rules are not enough. And it’s also a matter of managing (one’s own) expectations, with the help of historical experience.
The aim is to find a prudent balance between analysis and intuition. Lastly – and indeed as the final step in the process – it is necessary to consider which N options are actually available for investing in, and might come into question. Are they tradable, transparent, comprehensible? Is there fraud involved? Is the gold I’m buying real gold or fool’s gold? And so on. For implementation, we need some reference points regarding the characteristics of the individual investments. Some simple observations can be extremely helpful here. The figure below shows the average returns and volatilities of some current investment categories. What stands out is the significant differences in fluctuations in value. The prices of emerging-market stocks and commodities move very sharply, while bonds rise and fall within very limited parameters. The figure also clearly shows bonds’ advantageous risk/return relationship. They have benefitted from a trend, over a decade, of continuously falling interest rates. This trend has now come to an end, however, so the figures are not entirely straightforward. Nevertheless, overall, it is clear that there is a positive long-term relationship between risk and return. On this basis, a portfolio can be assembled that fits an individual investor’s risk capacity and risk appetite. Other factors also play a role, of course: liquidity, corporate key indicators, valuations, trend indicators and macroeconomic data provide valuable information – even if only to trigger an informed intuitive decision. There is a point to simple rules, which often serve to provide investors with some discipline. In the case of 1/N, such a rule is clearly the diversification principle. Discipline prevents us from being unduly influenced by primeval instincts like fear and greed. But the rules alone are not enough: for their application, context and experience are enormously important.
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Notenstein Dialogue, October 2013
Less risk, lower returns Returns
15%
Emergingmarket stocks Real estate
10%
Developedmarket stocks
Corporate bonds 5%
Commodities
Government bonds Gold
0% 0%
5%
10%
15%
20%
25% Volatility
Note: The average values are based on data from 31.12.1987 to 30.08.2013. Source: Bloomberg, Notenstein analysis
Discipline prevents us from being unduly influenced by primeval instincts like fear and greed. Gerd Gigerenzer: Simple rules are often underestimated – and wrongly so! Our research shows that simple rules can be superior to complex calculations, precisely when instability and unpredictability are high, or it is necessary to estimate a large number of parameters from few samples. This is explained by a mathematical theory, the bias variance dilemma. Simple rules like 1/N have a “bias” – they make no attempt to estimate all the parameters. Complex models (such as the Markowitz portfolio) by contrast, suffer from a different failing, namely “variance” –they react too sensitively to the random characteristics of small samples. Accordingly, a good forecasting methodology must reach a compromise between simplicity and complexity. Einstein is said to have put it like this: everything should be as simple as it can be, but not simpler. Our research also shows that sound intuition is generally based on quick and simple rules, known as heuristics. Modern psychology assumes that top managers have an “adaptive toolbox” of heuristics for dealing with people and strategies that derives from their personal experience. An analysis with CEOs of the biggest American companies revealed such intuitive rules. Examples are: “Hire well and let them do their job” and “First listen, then speak”. These principles appear elementary, but they determine the corporate environment. “Hire well” generates quality, and “let them do their job” creates trust and enables innovation.
A good forecasting methodology must reach a compromise between simplicity and complexity. Notenstein: So, gut feelings and heuristics can serve as a valuable guide, an internal voice that warns when all are celebrating, or encourages when despair reigns. But herein lies the problem. What happens when a taxi-driver tells his passenger that he feels it is the right moment to buy stocks, but the passenger interprets a taxi-driver talking up the stock market as a warning sign? Whose gut feeling is right? Gerd Gigerenzer: Negative feelings are often more influential than positive ones. For example: the board of a bank is in late-night discussions over a merger. Finally, everyone is in favour, except one who warns that he has a bad feeling about it. How is this conflict to be resolved? There is no patent remedy, but research tells us what we shouldn’t do – ask the colleague the reasons for his bad feeling. For he won’t be able to say. It’s better to ask the others another question. Is he the one among us with the greatest experience of the issues under discussion? If so, no further questions; it’s time to look for another potential investment.
We are today in a period of instability and unpredictability. Notenstein: So, the motto is “keep it simple”, and when in doubt it’s worth paying attention to experienced gut feeling. The first of these means that statistics may certainly be used as a source of information, particularly when conclusions for the future can be drawn from the past – in “normal”, stable circumstances. In such an environment experience (i.e. large samples) is an important factor in determining expectations and making decisions. On the other hand, forecasting models are largely useless in times of radical discontinuity. Then, we do better to rely on intuition. We are today in a period of instability and unpredictability. The world was seriously shaken by the financial crisis in 2008, and has since experienced extremely expansive monetary policy and record low interest rates. What the impact of the unprecedented debt mountains will ultimately be remains highly uncertain. And the global balance of power has also changed: the USA has lost some of its previous strength and Europe languishes. By contrast, the emerging
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Notenstein Dialogue, October 2013 markets, and China in particular, present themselves with an entirely new self-confidence. How should investors respond to this uncertainty? One response is to accept uncertainty as a fact of life. That is not easy to do, and certainly not easy to recommend, not least as expectations of advisors tend to be very different. So it becomes a matter of defining scenarios for potential developmental trends in the global economy and the financial markets – scenarios that also embrace the unthinkable. It is then possible to conjecture how the various asset categories would behave under these scenarios. And in the end, it’s a gut-feeling decision. We refrain from equipping the individual scenarios with probabilities, or using the model to calculate an optimal portfolio. This multi-stage process is nothing other than applied heuristics. The effect is to channel one’s thinking, but ultimately the process results in a deliberate (informed) intuitive decision. So, could we define the main role of the investment advisor in uncertain times as creating a framework within which to provoke intuitive decisions?
Many clients expect of their advisors certainty that does not exist. Gerd Gigerenzer: Many clients expect of their advisors certainty that does not exist. Benjamin Franklin said that in this world nothing can be said to be certain, except death and taxes. But the frantic search for certainty is commonplace today. It also affects the doctor/patient relationship, for instance. If a doctor says, in all honesty, that the prognosis for the disease is extremely uncertain, he runs the risk that the patient turns to another doctor who offers the illusion of certainty. In the past, people put their trust in horoscopes, or tried to insure themselves against every eventuality; today, modern technologies have become the vehicles for the illusion of certainty. Today, we collect terabytes of information, to turn our computers into crystal balls. We talk of “optimal portfolios”, and forget that we live in an uncertain world, where not everything is calculable. How widespread is the illusion of certainty? The figure shows that only 4 percent of Germans regard a professional horoscope as absolutely certain, but where modern technology is concerned, the majority believe that test results are certain. But none of these results is certain. Of ten women whose mammography produces a positive result, only one (!) actually has breast cancer; nine have a false positive result. And this is unlikely
to be explained to the women affected, among other reasons because many gynaecologists don’t know this themselves. HIV and other tests are significantly better, but still not certain.
Which test is absolutely certain?
Percentage regarding the test as absolutely certain Professional horoscope Mammography
4% 44%
HIV test
63%
Fingerprinting
63%
DNA test
78%
Note: The data are based on a representative sample of 1,000 Germans. Source: G. Gigerenzer, Risiko: Wie man die richtigen Entscheidungen trifft, Bertelsmann, 2013.
We collect terabytes of information, to turn our computers into crystal balls. Doctors need experience and intuition every bit as much as investors do. Suppose someone arrives at A&E vomiting and feeling dizzy, with a suspected stroke. The classic quick HINTS method is a 60-second examination by an experienced doctor at the bedside. The alternative is a magnetic resonance tomography (MRT), which takes a good deal longer. A study with 101 patients showed that an experienced doctor identified all 76 strokes correctly, whereas the MRT missed eight of them. Experience cannot always be replaced by equipment. The MRT may bring the clinic more revenue, but it offers the patient less certainty. One of the problems of modern medicine is that trainee doctors are learning to rely more and more on tests, and receiving less and less training on observing the patient. Notenstein: The roles of doctors and investment advisors are indeed comparable. If we apply your ideas to the financial world, this would mean investment advisors relying more on their experience and intuition, rather than on mathematical models. This is particularly relevant with regard to the current situation. The papers are full of warnings that, given the all-time highs reached by various stock indexes, such as the German DAX or the American S&P 500,
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Notenstein Dialogue, October 2013 we are on the brink of a stock market collapse. At the same time, however, the current valuation levels by no means suggest that stocks are overvalued, as shown by figures from the European stock markets.
Stock market valuations 5,000
30
4,000
25
3,000
20
2,000
15
1,000
10
0 1975
5 1980
1985
1990
1995
2000
2005
2010
MSCI Europe (LS) Price/earnings ratio (RS) Average price/earnings ratio Source: Bloomberg, Notenstein analysis
We at Notenstein are thus less worried about the currently very high stock prices. On the other hand, both experience and intuition warn us of the possibility of upcoming turmoil on the bond market. The current environment is characterised by ultra-generous monetary policy and zero interest rates (at least in the short term). In dealing with the unprecedented burden of debt in the Western world, politicians have adopted a strategy of muddling through and hoping for the best. Instead of successively reducing the debt mountain and initiating economic reforms, the politicians (with strong support from the central banks) have contented themselves with pushing the problem ever further down the road. Our inner voice tells us that this cannot be a happy situation for fixed-interest investments. Interest rates must eventually rise, and the process has indeed already started. This applies particularly to long-term interest rates, which the central banks can only control to a limited extent. And when states try to get rid of their debt by unconventional means, this must be to the cost of their creditors – think inflation, default, haircuts and so on. For us, it seems clear enough that both rational analysis and gut feeling urge caution here.
Both experience and intuition warn us of the possibility of upcoming turmoil on the bond market.
But back to where we started our discussion. You said that people are afraid to admit to intuitive decisions. Instead, they present calculations, even if these are just a pretence. Why is that so? Gerd Gigerenzer: The key question is this: what can we do to have more experts and lay people capable of dealing with risk? The most sustainable measure would be a revolution in education. For school is where our children are still taught the mathematics of certainty, such as geometry and trigonometry (and then forget almost all of it all again). These are beautiful mathematical systems, but they are no help in understanding the risks in finance, health or the digital media. Why do we not teach young people statistics-based thinking and the skilful management of money and health? The problem is international. One-fifth of Americans believe that they belong to the most prosperous one percent of the population, and just as many believe that they will soon be joining them. The majority of Italian bank clients associate “risk” not with opportunity but with loss. So they invest their money in something that their advisor says is “safe”, and which they can get out of during its term. In the Swiss health system, financial incentives are so structured that the more unnecessary treatments are carried out, the better off the doctors and hospitals are: twice as many cardiac catheters in the canton of Vaud as in St Gallen – benefit unproved; twice as many tonsil operations in Basel as in Grisons. The problem is not just the man in the street, who doesn’t understand what is happening to him. Many experts have problems themselves in understanding risk. Our research shows that some 75 percent of German and American doctors are statistically illiterate, and do not understand the results of their tests. Of 87 American portfolio managers only three were able to calculate the volatility of a stock – it was mostly underestimated.
The majority of Italian bank clients associate “risk” not with opportunity but with loss. I think that all of us – politicians, investment advisors, doctors and clients – should invest more in risk literacy. For without such literacy, we are putting our money and our health at risk. To deal sensibly with risk and uncertainty, we need two abilities: statistics-based thinking and sound intuition – rationality and gut feeling.
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Notenstein Dialogue, October 2013 Notenstein: Professor Gigerenzer, many thanks for this most interesting discussion.
The Notenstein view Intuition, gut feeling, rules of thumb: these seem to have little place in the highly complex world of finance. But Professor Gigerenzer takes the (counterintuitive) view that this is precisely where gut feeling and simple rules can result in better decisions than rigorously rational methodologies. What are the consequences of this from an investor’s perspective? Let’s summarise:
The Notenstein Dialogue aims to stimulate discussion and the continuous re-examination of previously held views. What is the value of investment advisors? What is the benefit of a systematic approach to investing? A plea for more gut feeling renders neither advisors nor a systematic approach obsolete. Advisors, with their experience, can be a valuable support. Applying an investment methodology that defines the guidelines for investment decisions provides a disciplined framework and protection against the perils of arbitrariness.
• In decision-making situations in which all influences and probabilities are known (in gambling, for instance) the likelihood of the various alternatives can be calculated. However, the real world, and not least the financial markets, is characterised by uncertainty and unpredictability. Here, good decision-making requires intuition. • Intuition is not arbitrary, but a form of unconscious intelligence. Intuitive decisions are based on experience. But intuition has a hard time in our society. Much energy is expended in the ex-post justification of intuitive decisions, in order to evade responsibility if something goes wrong. • Classic financial theory, with its risk models, generates an illusion of certainty, and suppresses the role of intuition. At the same time clients expect of their advisors a certainty that does not exist. The views expressed by Professor Gigerenzer indicate the need to accept uncertainty as such, and to give more weight to one’s own gut feeling. • It always takes both analysis and intuition. When investing, as with other complex decisions, it is advisable to stick to a few simple rules. Today in particular, the financial markets are characterised by a high degree of uncertainty. Conventional optimisation models are not necessarily the most help when devising an investment strategy. Rules of thumb, such as thinking in scenarios, may well produce better results.
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Our dialogue partner Professor Dr Gerd Gigerenzer is Director at the Max Planck Institute for Human Development and Director of the Harding Center for Risk Literacy in Berlin. He is a former Director at the Max Planck Institute for Psychological Research, Professor of Psychology at the University of Chicago and John M. Olin Distinguished Visiting Professor, School of Law at the University of Virginia. He is a Fellow of the German Academy of Science (Leopoldina), Honorary Doctor of the University of Basle and of the Open University of the Netherlands and Batten Fellow at the Darden Business School, University of Virginia. He has been awarded numerous prizes and is the author of award-winning books. Professor Gigerenzer has trained US federal judges, German doctors and top managers in decision-making and understanding risks and uncertainties.
Archive The previous issues of the Notenstein Dialogue are available at www.notenstein.ch/notensteingespraech. «Obviously history doesn’t ever repeat itself exactly – except for people having nightmares.» Prof. Harold James, Notenstein Dialogue, August 2013 “‘One size fits all’ applies as little to pension policy as it does to clothes or shoes.” Dr Gerhard Schwarz, Notenstein Dialogue, June 2013 “The concept of private property is being undermined throughout the overindebted West.” Dr h.c. Beat Kappeler, Notenstein Dialogue, April 2013
Speaking for Notenstein The Notenstein Dialogue was led by Dr Michael Zurkinden, Wealth Management and Advisory Services, together with Dr Ivan Adamovich, Head of Private Banking International and Member of the Executive Board, Daniel Hubler, Wealth Management and Advisory Services, Dr Pascal Gisclon, Macro Research, and Lotti Gerber, Communications.
“The USA is broke. Not in 30 or 15 or 5 years’ time. It’s broke now.” Prof. Dr Laurence J. Kotlikoff, Notenstein Dialogue, February 2013
The Notenstein Dialogue The Notenstein Dialogue aims to encourage discussion and thinking around the key social and economic trends, and to identify potential consequences for investors. On a bi-monthly basis, Notenstein’s experts conduct a dialogue with a leading figure from business or academia. The aim is to challenge our partner in the dialogue with our own views and theories, and thus to generate insights that can ultimately be put into practice. We are open to controversial opinions that encourage a lively dialogue. The Notenstein Dialogue takes place over several days, in written form. This form of interaction enables the calm and considered analysis of arguments – in an era often characterised by a breathless flood of information.
“The franc has married the euro without a pre-nuptial agreement.” Prof. Dr Thomas Straubhaar, Notenstein Dialogue, December 2012 “There are enormous opportunities. The global population will continue to grow, and on average people will get older.” Dr Severin Schwan, CEO Roche, Notenstein Dialogue, October 2012 “I trust advisors who forecast market developments just as far as I do those who claim to be reincarnated.” Prof. Dr Reiner Eichenberger, Notenstein Dialogue, June 2012
Imprint Issue Notenstein Dialogue no. 9, October 2013 Published by Notenstein Private Bank Ltd, Bohl 17, PO Box, CH-9004 St. Gallen,
[email protected], www.notenstein.ch Customer service We welcome responses and orders for all our publications, either on www.notenstein.ch/contact or by mail. Our bank also publishes Notenstein Brunch, a daily market commentary (available in German), and Fokus Asien, which offers in-depth background information on developments in Asia several times a year (available in German, French and Italian). Photographer Dietmar Gust ISSN 2235-8293
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“Given the flood of liquidity created by these conventional and unconventional monetary-policy measures, there is a serious danger that bubbles will occur.” Prof. Dr Aymo Brunetti, Notenstein Dialogue, April 2012
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