The overlap between psychology, behavioural finance and investing is an interesting space. For various reasons including the rise of passive investing, share price returns now frequently disconnect from underlying reality at many companies. Being a stock market investor can therefore be a humbling experience, as Jesse Livermore observed in the well-known book “Reminiscences of a Stock Operator”. In the market you are sometimes right despite faulty analysis, and sometimes wrong despite faultless logic. Its infuriating. And it makes it hard to attribute an outcome to a specific attribute or action. People of course exist somewhere on a continuum bounded at one end by the Dunning-Kruger effect (where you are too dumb to realize that you are not smart), and the Imposter Syndrome (where no matter how smart you are, you never feel good enough). Interestingly this juxtaposition was aptly captured by the American writer Charles Bukowski who observed that the problem with the World is that the foolish think they know for certain, while the intelligent are full of doubt.

In this environment of uncertainty, behavioural errors in fund management find a home. There are many behavioural errors and all of them will cost you money, if you do not have an embedded process to minimize them. After all, you cannot target specific fund returns, but you  target a process, and the returns will follow. At All Weather Capital we modelled our investment process on practices embedded in the aviation industry, which has a very good track record for safety. Commercial flying has roughly one accident for every eleven million flights. That number is the result of decades spent designing out human error (in the case of investing, human bias). Two pilots in the cockpit at all times. Three-person teams for the more complex decisions. Checklists for everything, even for pilots who have done the same take-off or landing ten thousand times. The reason for all of it is simple: consistency, and protection against error and bias that would otherwise occur.

Because the biases are real, and they are subconsciously working against you constantly. The best explanation of this I’ve come across is Daniel Kahneman’s “Thinking, Fast and Slow,” the work that eventually earned him a Nobel Prize in Economics, despite him being a psychologist. His central idea is that our brains run on two systems. System 1 is fast, intuitive, effortless, built around pattern recognition and storytelling. System 2 is slow, deliberate, analytical. We like to believe System 2, the analyst, is in charge. But System 2 is hard work. Humans are lazy and often we default to rubber stamping whatever System 1 has already decided. That handoff is where the biases creep in. “Anchoring bias”, where an early number (say, a stock down 10%) distorts every judgement that follows. “Recency bias”, where the last data point gets weighted far more than it deserves. “Loss aversion bias”, where the pain of losing outweighs the pleasure of an equivalent gain, so we hold on too long. The “availability heuristic bias”, where whatever comes to mind most easily feels like the best choice.  But the biggest risk of all, in my experience, is overconfidence.

Kahneman had a neat way of demonstrating this: “the 90% confidence interval calibration test”. Give a thousand people a set of trivia questions (how far is the moon from earth, how deep is the ocean and so on) and ask them to provide a high and low estimate wide enough that they are 90% confident the true answer falls between the two numbers. If people were well calibrated, roughly 900 of them should get it right. In practice, fewer than 1% of people get nine or more out of ten correct. We are, almost universally, far more certain about an outcome than we have any right to be.

Just for fun, ask yourself how many gold (in tons) has ever been mined? Once you have your answer, let’s say you melted every ounce of it and poured it into a single cube. What dimension would the cube be? Guess any upper and lower limit number for both questions, but you must be 90% certain that the answer lies within that range. Ready? Ok well about 220 000 tons of gold have been mined and if this amount was melted into a single cube the sides would measure about 22.5 metres each, small enough to fit on a tennis court. Most people guess wildly high or wildly low. Almost nobody’s range captures it. That’s unfortunately how the human brain works, without a process to guide it.

Fund management demands three things: analytics, temperament, and checks and balances. We try to build all three into the structure itself rather than relying on any one person’s discipline. We encourage debate. We use three-person teams so the loudest voice in the room can’t become the only voice. We run structured disagreement, a Red Team and Green Team, whose job is explicitly to argue the opposite side of any position we hold. The goal of all this isn’t to avoid mistakes. The goal is to keep mistakes small, understood, and survivable. The learning point is to be aware of your unconscious biases and develop a process to dial out the worst effects of these human weaknesses. And just to circle back to the Imposter Syndrome. Having met hundreds, if not thousands of very accomplished people over my career, it is my observation that many at the very top of their profession suffer from Imposter Syndrome. No matter how expert and accomplished, they never feel good enough. So despite being talented and smart, they keep pushing themselves relentlessly. Hence they end up being the best. But just not recognising this themselves. Next time you meet such a person, recognise what their success cost them.