FrameworkLessonPsychology and behaviourDecision-makingInvesting
Anchoring and base rate neglect are the two biases that cost money
Daniel Kahneman · Thinking, Fast and Slow
The idea
Kahneman catalogues dozens of biases. Two of them do most of the damage in finance. Anchoring is the pull of the first number you saw, whether it was the last price, the headline valuation or the opening bid, on every estimate you make afterwards. Base rate neglect is judging a case on its details while ignoring how often cases like it succeed. A founder's story is vivid; the fact that most companies in that category fail is not. Being able to explain each with an example of your own is what the behavioural questions are testing.
Before estimating, ask what number is anchoring you and what the base rate is for cases like this.
When it works
Valuation, deal pricing, forecasting, and the behavioural finance questions in hedge fund and asset management interviews.
When it may fail
Knowing a bias does not remove it, and the research on debiasing is less encouraging than the research on biases. The practical defence is a process that forces the base rate in, not awareness.
How to use it
For a valuation, do the base-rate step first: what do companies like this usually grow at and trade for? Only then open the model, so the model's assumptions are checked against the class rather than against the story.
Where it came from
Book Thinking, Fast and Slow · Daniel Kahneman
What the source says. The research behind every behavioural question you will be asked, with anchoring and base rate neglect as the two to explain with an example of your own.
Connected ideas
Takes it further
A good decision and a good outcome are separate thingsJudge a decision by what was knowable when it was made, and keep the outcome in a separate column.
Puts it to work
One person's record is a story about survivorship until proven otherwiseAsk how many people ran the same method and are not in the sample before treating a record as evidence of skill.
Says something similar
A cheap measurable signal beats an expensive intuitive one at scaleThe market misprices what is hard to measure, so a consistent cheap signal can beat an expensive expert.
Puts it to work
Every forecast row is a sentence about the businessA forecast is a story written in numbers; if a row cannot be said as a sentence about the business, it should not be in the model.
Concepts
Put it to work on L3VLUP
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