Sunday, July 22, 2007

Diagnosis and investments







Reading work outside the usual investment topics can provide a different perspective on some of the age old problems of trading. I just finished How Doctors Think by Jerome Groopman which is a must read before you get sick. Understanding how doctors think will help you get the best medical care possible. Understanding how doctors think will also make you a better investor.

I was amazed at how closely the problems of diagnosis are associated with problems of investment decision-making. Doctors are not gods but human beings who have to make difficult decisions under tight time constraints and limited information. The stakes are life or death but not dissimilar to what any traders has to face. Traders and investment professionals have to take information from a wide set of sources and try to develop a story for a forecast. If you are wrong, the costs are high.

The issue for both doctors and investment professionals is determining what can be done to become a better decision-maker. The chance of developing good expert systems has been discredited in both fields. There are no set of rules that can be applied to each discipline when faced with a high level of uncertainty. Of course, there are general rules that will work in most cases, but when models are routinely employed, problems will arise. There is the growing view that being a good diagnostician requires not following set rules but looking for the unusual in past facts and trying to fit a story for what may be out of the ordinary. A base model may be a starting point but not the solution.

Medical doctors are not dissimilar from traders. A patient comes in and describes some facts concerning their current circumstances. What hurts? They describe the context of their current situation through their medical history. The doctor has to assess the situation and make a decision on what is the best course of action. For most cases, this is relatively easy and follows the usual format. You follow the textbook symptoms and prescribe a solution. The problem arises when someone comes in who has symptoms that are out of the ordinary. What do you do now? These are the situations of maximum risk. This is when falling back on our usual behavior is dangerous. Doctors will fall into well-know decision traps as they try and fit the current situation into a box of what is consistent and wrong.

This sounds all too familiar with many trading decisions. You look at a trade. Where is the value? you may start with the usual analysis and then move to what may be out of the ordinary to find a solution. While behavior finance provides investors with a plethora of potential problems, there has been little work at describing what managers and traders go through to make a diagnosis of a trade. The how-to-do-it books focus on specific rules and prescriptions but do not discuss failure and how traders learn from mistakes. It is from our mistakes that we learn the most, but these are events we discuss least. Groopman does not have a broad array of prescriptive solutions to the diagnostic problems, but causes the reader to focus on thinking outside of the box. The best doctors are those who have the characteristics of Sherlock Holmes, the power of observation, questioning and deductions. The next time someone says that it is obvious that prices should go up be wary. Start asking questions why and think why this case may be special.

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