SAM STOWERS

Experts and Statistical Formulas - Why We Should Choose Numbers Over Intuition

We've all heard that robots will take our jobs in the future. Not just manufacturing jobs either - even the best paid and most involved work is supposedly at risk. Should doctors, lawyers, stock investors, and hedge fund managers be afraid?

Pictured: Our terrifying future job replacements


Well, the financial workers should - they are statistically outperformed by simple mathematical formulas.

Daniel Kahneman talks about this in his book, Thinking Fast and Slow: we humans often fool ourselves and others into thinking our conclusions are valid when they aren't. Take job interviews for example; most studies have shown that interviewers are generally terrible at determining someone's success in a company or school. But despite being demonstrably ineffective, interviewers are certain of their conclusions.

This is thanks to the illusion of validity, which is just what it sounds like. Thanks to a large collection of biases and cognitive shortcuts, people construct narratives and causal relationships to back up their gut feelings about a person.

Unfortunately, the illusion isn't limited to job interviews. Another task where formulas routinely beat humans is hedge fund management and stock investment. That said, an onlooker wouldn't be able to guess this by looking around the industry's offerings. Most premium wealth management firms are still operated by humans making human decisions, even though they could get higher returns by removing themselves from the decision making process. If given this knowledge, would investors change their practices?

A study was done with a group of 25 anonymous wealth advisers at a high-dollar firm. Their yearly return was the main factor in their year-end bonuses, so the men with the most skill were paid the most. But when researchers measured the correlation of the investor’s skills with their market return, they found that the average correlation was 0.01. Essentially, their "skill" was meaningless, as the results looked more like a dice-rolling competition than a game of skill.

What did the investors do after seeing these results, and learning that their success was nearly based on blind luck?

Nothing. They absorbed the knowledge and went on their way, and continued doing their jobs as if nothing had changed. This is the power of the illusion of validity.

And while the investor's choice may be a bad thing for their customers, it presents an opportunity for those of us aware of the illusion. In decisions with many varied factors and moving parts, a simple statistical formula is likely to out-predict human judgement.

One university, Minerva Schools at KGI, is using such a formula as the core of its admissions process. A startup company, Fresh Prints, is using such thinking to hire better campuses managers (essentially franchisees). And while I'm not currently aware of any venture capital firms using such a process, a firm that did so would outperform its peers if managed competently. (if a fund like this doesn't exist in 6 months, I'm likely going to create one myself.)

Want to hire better employees and eliminate bias in HR? Want to admit better students to a university, or get higher returns for shareholders? Want to make consistently better decisions in an arena with lots of uncertainty?

Use a formula.

Thinking Fast and Slow, Daniel Kahneman