Friday, February 22, 2008

Behavioral Finance - Available Tool Bias

This is the eighth in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

Why study human behavior in relation to finances?
Recognizing and understanding why people do the things they do, what drives them, and what are innately human tendencies is the first step in overcoming your own self and making sound decisions! We want to make rational, logical decisions, but emotions and irrational tendencies get in the way.

These behaviors are not all bad, many are good in some way - that is why they survived. In fact, these behaviors served some purpose that helped extend life at some time in the evolutionary process.

8. Available Tool Bias
This is a very common human tendency. We have all probably heard about the man with a hammer and how every problem he encounters tends to look pretty much like a nail.

Munger gives the example of how economists love the efficient market theory because the math is so elegant. It’s a neat tool and they want to use it. The efficient market theory is based on the premise that prices on traded assets, like stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. Because everything that can be known is priced into assets, the theory projects that there can be no undervalued assets. Of course, investors like Munger defy this logic. Charlie Munger and Warren Buffet have made a fortune investing in undervalued securities.

Available tool bias reminds me of the way corporations have jumped onto the metrics bandwagon. It has become the new mantra - everything must be quantified, tracked and reported.

Yes, metrics allow you to measure many factors, but sometimes there are other factors that are also important, yet there is not a precise numbering system that can be applied to these important factors. You know they are important, but the numbers to quantify the factors do not exist. Consequently, people have a tendency to overweigh the factors that can be numbered. Using only the information (tool) that is available yields to the statistical approach and techniques that people have been taught and want to use.

At other times, by over emphasizing metrics, the big picture gets lost. For instance, at my place of employment, there is a mandate to hire X new employees to “feed the pipeline”. In years past, the company got stagnant, and did not hire enough new folks. So now they are overcorrecting. Never mind that the company does not have enough work for these new people. But that’s another story.

To manage this mandate, metrics have been set up. As a result, hiring managers will bring in an unknown, un-tested new hire to meet the metric before considering transferring a current employee that is genuinely interested in the work or is the best fit for the job.

Metrics rule. Trying to apply any logic to this situation gets you nowhere but in the doghouse. Management loves the numbers and wants to force this tool upon everyone and everything and they just keep hammering away.....

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