Saturday, May 20, 2017

Managed futures - the intersection between Kahneman and Klein

Why is managed futures or more precisely trend-following an effective investment strategy? Many managed futures programs have been successful by keeping it simple and using heuristics like following the price trend and not always using all the information that is available about a market. Disciplined and systematic decision-making seems to be a robust means of dealing with a complex world. Managed futures programs do not work all of the time, but there has been consistently strong performance during times of stress, crisis, and uncertainty.

There has been an ongoing problem of explaining why systematic trend-following can be an effective strategy. Rules of thumb may be subject to biases and may be sub-optimal relative to more complex approaches to return generation. The foundation for the strong systematic managed futures performance is based on the ability of managers to quickly generate better decisions in the uncertain environment often faced by investors.  Trend-following can be thought of as a form of simplified decision-making first described by Herbert Simon as "satisficing" or bounded rationality. More recently, this bounded rationality has been called or described as "fast and frugal" decision-making as popularized by Gerd Gigerenzer.

Decision theory and empirical research has taken two different directions on how to describe the behavior of decision-makers. One school can be called the heuristics and biases approach to decisions which has been the field of study for Nobel Prize winner Daniel Kahneman. Gary Klein founded the other decision behavior school through his natural decision-making approach. Natural or adaptive decision-making celebrates rules of thumb gained through experience surrounding the environment.

Both offer different perspectives to the often “fast and frugal” approach used by trend-follower and provide insights on why trend-followers can make money when perhaps others have difficulty. Both approaches can help describe managed futures decision-making and why it can be effective especially during times of crisis. A more uncertain environment requires faster decision-making that is based on simple rules. When time is critical, information limited, and the environment uncertain, following price trends can be more effective than any full optimization of all data. We think that managed futures are the intersection of these two schools for explaining decision-maker behavior.

Daniel Kahneman has popularized the view that many decisions are based on heuristics or shorthand rules for fast decision-making; however, he has also been at the forefront of documenting all of the problems associated with biases from fast decision-making.  We switch between fast and slow decision-making or from thoughtful thorough analysis and quick decisions that have to use limited inputs to draw conclusions. The big decision problem is knowing when to switch between fast and slow decision-making and how to avoid using the wrong tools at the wrong time. If we use deep analysis for all our decisions, we will be paralyzed with inaction. If we use heuristics for making snap judgments we will surely fail when deeper thinking is necessary. For Kahneman, systematic managed futures managers have to balance between simple fast tools against deeper analysis.

Gary Klein has studied expert decision-makers for decades and has formulated the view that experts are able to make good quick decisions because they are able to properly contextualize the problems they face to find cues that will help with decision-making. Expertise comes in the form of recognizing patterns from repeated play. Intuition is a function of identifying cues based on the environment faced by the decision-maker. In a fast paced market where there may be limited new information, prices are primal. The best way to deal with decisions is to exploit the patterns or trends that are readily available. There could be biases from using a satisfying approach, but it may be the best approach in a complex world.

Some have view Kahneman and Klein are in conflict with one focusing on biases while the other focuses on expert judgment through cues and heuristics. In reality, managed futures managers implicitly take the best from each to form their strategy framework. From Kahneman, managed futures has a deep awareness for potential biases and uses rules to control risk and offset the natural tendency to sell winners and hold losers. From Klein, we see managed futures managers can be good natural decision-makers by using the patterns that are apparent in price activity. Trends happen and rules can be developed to exploit them.

In a complex world, managed futures have been able to develop rules for offsetting biases and rules for finding repeatable events. Increases in technology have allowed for more complexity and better decision-making but the game is still the same. Computers and models are used to look at more markets to find fast and frugal decision rules to effectively exploit opportunities and manage risk. This can be in the form of simple and adaptable rules in order to make quick judgments in fast changing markets.

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