Michael Mauboussin, director of research at BlueMountain Capital Management and chairman of the board of trustees of the Santa Fe Institute, talks with Global Finance about behavioral economics and how to improve corporate decision-making.
Global Finance: What guides most company’s decisions?
Michael Mauboussin: Decisions are guided as much by politics and personalities as by a judicious process. We like to think we conduct a thoughtful and detailed evaluation of our alternatives before choosing the best-suited option for our goals, but usually people decide, and then do the analysis as a justification.
Decisionmakers have different motivations, and there’s a traditionalist component whereby trying something new doesn’t have immediate buy-in regardless of any positive results. Investment managers, though, live and die by the results of their capital allocation decisions.
GF: Are rational decisions always best, or is intuition better?
Mauboussin: A majority of Fortune 500 executives say they use their gut to make decisions, but where does intuition work? Daniel Kahneman says there are two systems of the mind: System 1 is experiential, which is automatic, fast and difficult to train, and System 2 is analytical, which is slow, purposeful, deliberate and cumbersome. Intuition is when you’ve trained system one so that your answers are quick and mostly correct, but the system has to be stable (the rules don’t frequently change) and linear (cause and effect are in the same proportion every single time). As you migrate towards systems that are unstable and non-linear, all bets are off.
GF: Explain ‘inside view’ vs ‘outside view’? Why is it important?
Mauboussin: The classic way to think about any problem, the inside view, is to gather information and combine that with your knowledge, experience and perception, and derive a solution. The inside view tends to be very optimistic—like you think you’ll meet a deadline.
The outside view, by contrast, demands that you ask a more fundamental question: What happened when other people were in that situation? This is a very different and unnatural way of thinking about the world because you have to discount your beliefs. Also, you have to know what actually happened. Specific exercises can help someone potentially make better decisions by managing or mitigating biases, but you never can eradicate them.
Optimism is an important bias. Entrepreneurs are not big risk-takers; they’re ignorant about their imminent failure. Without optimists, people wouldn’t try to run through walls, but in the end we only see what was successful, and not the hundreds of failed attempts.
GF: What are the time horizons in behavioral economics in terms of capital?
Mauboussin: I think people wave their hands a lot about short-termism without marshalling much evidence for it. Certainly, the first litmus test is whether the markets get it or not. In looking at S&P forecasts, the market’s paying for cash flows many years into the future.
Still, there’s a very real perception among executives that investors want them to report short-term earnings. As such, they will forgo value-creating investments to deliver current earnings even though there’s little evidence that they’ll get penalized in the markets for it.
GF: Why would a company buy back stock rather than invest in its future?
Mauboussin: Buybacks are part of capital allocation. After the dot-com bubble and the Great Recession, many companies resumed their prior levels of growth but with fewer people and more technology. A byproduct is that returns on invvested capital (ROIC) have been going up. When ROIC is higher than your growth rate, you’ll generate cash. And if that cash isn’t paid out, it’ll build on your balance sheet. The golden rule of buybacks is that a company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
