Saturday, October 24, 2015

Captain Kirk - forecasting and decision-making in balance

Many are familiar with the first Star Trek television series. The main characters represented a study in contrasts and can serve as a simple example of how decisions and forecasts need to balance different behaviors.

Mr. Spock was the pure analytical thinker without emotions. He never let emotions enter his decision process nor did he willingly accept emotions as a driver in the decisions of others. Dr. McCoy, despite his good skills, bordered more on the emotion side. He was often frustrated by the situations around him and let his emotions influence his decisions. Finally, you has the lead character, Captain Kirk, who often showed balance between the extremes of his two close friends. He was a combination of disciplined analytic thinking and emotions associated with judgments made under uncertainty. He needed the different points of view of Spock and McCoy to help balance his decision-making.

If we applied Daniel Kahneman thinking to the characters, Mr Spock represents System 2 analytical thinking while Dr. McCoy is a system 1 thinker who often follows simple rules of thumb or heuristics to make quick decisions. These characters can be used as the basis for extremes in decision-making. The captain balances these extremes in order to help his decision-making and forecasting. This nice analogy was developed in the new book Superforcasting by Philip Tetlock and Dan Gardner.

The quant is the Mr Spock of forecasting and money management. The numbers do not lie. The focus is only on what is rational and really does not accept the fact that irrationality can be a driver of markets. The pure quant approach will have limitations because non-rational behavior does not enter into market explanations. 

The Dr McCoy approach represents the decision-maker and money manager who will get emotional We have to accept the fact that the world is not always rational and there will be decision-makers who will be driven by emotions. Being emotional is not going to help with analytical reasoning, but accepting that emotion can drive decisions and markets is important. The world is a combination of rational logic with periods of emotions that will sway rational opinions. 

Captain Kirk needs to balance the thinking of his two friends. He has to employ strong analytical reasoning but also accept that emotions will affect the behavior of others and will skew forecasts from just pure rational behavior.

Kirk, if a market analyst, would balance the rational and emotional behavior embedded in prices in order to to make better decisions. He would accept that market prices are a combination of System 1 (heursitics and quick decisions) and System 2 (deep logical analysis) thinking. Market prices may deviation from fundamentals because it is a weighted average of these two types of thinking. The hard part for forecasting is that the weights will change with conditions; nevertheless, appreciating that market behavior is a balance of rational and emotional actions is critical.

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