The human brain is an inefficient device for noticing, selecting, categorizing, recording, retaining, and manipulating information for inferential purpose.
- W.M. Grove and P.E. Meehl
If those are all the things that the human brain is inefficient with, what is left over? A lot, but there has to be focus on using the brain for the right problems and when to change the thinking process.
Investment decision-making needs to differentiate between the repetitive tasks for which brains are inefficient and the unique situations that happen infrequently and requires creative thinking. Often the highest returns and loses are for the infrequent events because they are unexpected or represent a structural change in markets. Identifying and exploiting these opportunities requires something different than categorizing data. If a manager does not have skill with identifying these unique situations, he should stick with developing strategies based on the repetitive tasks and diversify to minimum any infrequent event risk. If he has the rare skill of identifying unique situations, his investment process should focus in this area.
Predictive procedures for any decision-making can be either formal or informal. Money management investment choices are similar to diagnostic problems in medicine. Decision can be based on unique situational clinical information or statistical data.
A formal process is grounded in algorithms or rules to categorize market activity and the odds of success. An informal process just like clinical decision-making is subjective, holistic, and based on impressions from past cases. The informal approach is not bad. A subjective approach is just more appropriate for some types of problems.
For money management, we have classified this as the difference between a frequentist approach based on data counts and a case-based approach focused on finding past similar situations. It is important to understand whether a manager has skill in one approach or the other and when switches between formal and informal decision-making will be made. The successful manager is the one who can properly classify the types of decisions to be made and have a process or plan for when to switch from formal to informal decision-making. Identifying decision process switching is not easy and should be an area for focus when evaluating highly skilled managers.