THINK TWICE

Harnessing the Power

of Counterintuition
MICHAEL MAUBOUSSIN

MICHAEL MAUBOUSSIN is chief investment strategist at Legg Mason Capital Management. He has been
adjunct professor of finance at Columbia Business School since 1993. Mr. Mauboussin has served as
managing director of Credit Suisse and is the former president of the Consumer Analyst Group of New York.
Mr. Mauboussin is the author of More Than You Know and the coauthor of Expectations Investing. He is a
graduate of Georgetown University.
Mr. Mauboussin’s Web site is at www.MichaelMauboussin.com.

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 Think Twice - Page 1

MAIN IDEA
Why do smart people sometimes make appalling bad decisions, especially when the stakes are high? It really comes down to the
mental software hardwired into the human brain. We genuinely are not well equipped to deal with many of today’s most pressing
problems. We see the world we want to see rather than letting the facts speak for themselves. We also have no problems harboring
false beliefs, even if irrational. And most of us would rather do whatever comes to mind first rather than properly calibrating the
evidence which lies at hand and applying that to our decision making.
To reduce the number of mistakes you make, try and think twice about your choices. To do that, three steps are involved:

Learn about the mistakes Build and then use mental

others have made in the past so tools which will help you prevent
you can avoid them falling into any traps

ý Poor
Decisions Prepare Recognize Apply
þ Great
Decisions

Recognize the problem at

hand in its proper context and
allow for all the risks

The eight most common decision mistakes – and how to offset them . . . . . . . . . . . . . . . . . . . . . . Pages 2 - 7

Mistake Solution

Incorporate an outside view in every decision you

1 We all like to think our problems are unique rather than
make. Identify other people who have solved the
carefully considering the relevant experiences of others.
same problem and adapt what they did right.

Make a conscious decision to consider other

We all suffer from tunnel vision at times and fail to
2 alternatives and give voice to dissenters. And
adequately consider all the alternatives.
always know what incentives are involved.

Seek diversity and ensure you’re using the best

We want to rely on experts and like to believe they know
3 technology which is available. Remind yourself
more than they really do.
experts always have a very narrow focus.

Acknowledge decision making is an inherently

4 We don’t always act objectively but take our cues from
social exercise and therefore you need to manage
the behaviors of those around us.
the influences you feel. Watch out for group think.

Avoid focusing on just one part of the system and

We tend to look at complex systems and seek ways to
5 instead try to gain an appreciation of the overall
come up with a simplifying mental model.
system dynamics. If feasible, use simulations.

Acknowledge that circumstances can and do

We form inaccurate cause-and-effect relationships,
6 change constantly and there are no universal rules
especially for situations generated by circumstances.
which will apply at all times.

Be aware of the power and reach of coordinated

We’re not really familiar with tipping points where a small
7 behavior and be careful not to extrapolate the past
change can lead to major consequences.
into the future.

Evaluate the mix of skill and luck in the system

We overemphasize the effect our skill has on the result
8 you’re looking at and be careful about any
and minimize the impact of luck in our successes.
conclusions you draw which rely on luck.

How to improve your decision making immediately. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 8


The eight most common decision mistakes
– and how to offset them
Poor Decisions ý 1
þ Great Decisions
We all like to think our Incorporate an outside view in
problems are unique every decision you make.
rather than carefully Identify other people who have
considering the relevant solved the same problem and
experiences of others. adapt what they did right.
Corporate mergers and acquisitions are a multi-trillion-dollar
industry year after year. It’s not at all unusual for large
corporations to spend millions identifying potential targets,
carrying out acquisitions and then working to integrate those new
companies into their operations. All of these acquisitions are
made with the best of intentions but the reality is most
transactions do not create value for the shareholders of the
acquiring company.
Most executives acknowledge their chances of success in
creating value by making an acquisition are not good, but they
believe they can beat the odds. This is a prime example of
making decisions using an inside perspective alone. Executives
believe the synergies which will be created by combining the
companies will more than compensate for the premium the
acquiring company has to pay. There is the unstated belief the
acquiring company is getting more than it is paying for because
the executives know what they’re doing. Unfortunately for
investors, this usually turns out not to be the case at all.
To avoid falling into the trap of making decisions from an inside
perspective alone, the three-step process is:
Prepare Recognize Apply
n Prepare – look at how other companies have fared in making
acquisitions work for them rather than against them.
n Recognize – that you may be trying to move ahead on the
basis of unwarranted optimism.
n Apply – come up with a framework you can use to make better
decisions which incorporates all the available facts. Look for
comparable situations which can provide a statistical basis for
making a decision rather than viewing your problem as
unique. It rarely is.
So how do you incorporate an outside view into your decisions?
The specific steps involved are:
1. Select your reference data sample – a big enough group to
be significant but narrow enough to be useful. It’s helpful if
your reference group is stable over time and not in an
industry which is undergoing large-scale changes.
2. Analyze and assess outcomes – figure out under which
conditions success is more likely. For example, in the case of
acquisitions, you may find when an acquisition is made using
an all cash transaction and the premium paid is 5 percent or
less, then the deal is more likely than not to generate
synergies which add value. Look for patterns.
Think Twice - Page 2
3. Make a forecast – an estimate of your likelihood of success or
failure. More than likely, your forecast will be wildly optimistic
but that’s alright as long as you’re aware of that likely bias.
Figure out whether you can do something different which will
improve your chances of success. Determine whether
breaking from conventional wisdom will be helpful.
4. Keep on assessing the reliability of your prediction and
fine-tuning – as more data comes to hand. Keep trying to
identify cause-and-effect relationships you can integrate into
a better version of your forecast. More than likely, you will
need to end up adjusting your prediction towards the
long-term mean result.
“The main lesson from the inside-outside view is that while
decision makers tend to dwell on uniqueness, the best decisions
often derive from sameness. Don’t get me wrong. I’m not
advocating for bland, unimaginative, or risk-free decisions. I am
saying there is a wealth of useful information based on situations
that are similar to the ones we face every day. We ignore that
information to our own detriment. Paying attention to the wealth
of information will help you make more effective decisions.”
– Michael Mauboussin
ý þ
Poor Decisions 2 Great Decisions
We all suffer from tunnel Make a conscious decision
vision at times and fail to to consider other alternatives
adequately consider all and give voice to dissenters.
the alternatives. And always know the
incentives involved.
Most people start with a mental “anchor” when making a
decision. An anchor is a first approximation of what you expect
the end result to be. It will be based on the model you expect to
apply in this situation. When you have an anchor in place, then
you often end up with tunnel vision or a very narrow focus.
To illustrate:
n If someone were to ask you what the freezing point of vodka
is, you would probably start thinking about this by saying: “OK,
the freezing point of water is thirty-two degrees Fahrenheit.”
That’s your mental anchor and you would then try and
estimate whether you need to adjust upwards or downwards
from water’s freezing point to reach vodka’s freezing point.
When a large group was asked this question, the mean
estimate was a reasonable twelve degrees but the correct
answer is vodka freezes at minus twenty degrees.
n When a group of real estate agents were asked to appraise a
house, they were given all given identical background
materials except for one key point – the agents were given
different listing prices for the same house. When they all came
back with their appraisals, those who were given a higher
listing price had valued the house for substantially more than
those who had been provided with a low listing price. The
agents were influenced by that starting point anchor, even
though they believed they were making a completely
independent and unbiased assessment of market price.
n In negotiations, the initial offer which either party makes can
have a strong effect on how the negotiation as a whole turns
out. This is very pronounced in ambiguous situations.

Prepare Recognize Apply
Anchors and mental models which result in tunnel vision are
tricky because you’re not even aware you’re using them most of
the time. The incentives on offer can also generate tunnel vision
as can extrapolating what happened in the past to project into the
future.
To avoid the tunnel vision trap when making a decision:
1. Explicitly list all available alternatives – those which are likely
as well as those which are highly unlikely. The mere fact you
have a list of alternatives from which to choose will help you
move away from your preexisting anchor points.
2. Welcome dissent – even from people who are openly trying
to prove you wrong. Be willing to engage in robust debate
about the decision you’ve reached. Ask questions of those
who hold contrary opinions and listen carefully to what they’re
saying. If you appoint those with dissenting views to
prominent positions in your organization, you send the clear
signal clear thinking is required and welcomed.
3. Track your previous decisions – and see whether you
consistently err on one side of the equation or the other.
Humans have a strong “hindsight bias” where we believe we
knew more about the outcome beforehand than we actually
did. To offset that, write down your decisions in a journal
along with notes detailing the reasoning you applied. This will
encourage you to look at more alternatives.
4. Remember you won’t make good decisions while you are in
an emotional setting – so avoid making key decisions when
you’re stressed, angry, fearful, euphoric or greedy. Wait until
you feel calmer and your tunnel vision will melt away.
5. Always understand the influence of incentives on offer – and
consider what behaviors those incentives will motivate.
Incentives always distort decisions so be explicit about what
incentives are involved.
“For various psychological reasons, humans tend to consider too
few alternatives when making decisions. In many cases, the
obvious choice is the right choice. But in a world that presents
more alternatives than it used to, tunnel vision can lead to
substantial but entirely avoidable mistakes. You need not labor
over every decision. Rather, when the stakes are high, ask
whether you are susceptible to tunnel vision. If so, scrutinize your
decision-making process and take concrete steps to intelligently
consider hidden possibilities.”
– Michael Mauboussin
Poor Decisions ý 3
þ Great Decisions
We want to rely on Seek diversity and ensure
experts and like to you’re using the best
believe they know more technology which is available.
than they really do. Remind yourself experts
have a very narrow focus.
Experts most certainly have their uses. They are very good at
forecasting the outcome of hazy situations where there are a
wide range of possible outcomes, but once the principles and
processes involved become clear and well defined, then
Think Twice - Page 3
computers become more efficient at applying those principles
repetitively and thoroughly. Experts are important initially to
figure out the rules but then computers come to the fore. One of
the keys in making great decisions is to differentiate when you
should be involving experts and when you’d be better off taking a
fresh approach.
One area where this particularly applies is the ability of
computer-based systems to consolidate the best estimates of a
large pool of people to forecast a future event. Various
experiments have shown the collective wisdom of a crowd is
often more consistently accurate than using an expert.
Computers are good at making collective judgments available
and accessible and it’s smart to use this approach to inject
diversity into your own decision making.
Of course a reasonable balance has to be struck. Relying solely
on computers and the collective wisdom of crowds to make
decisions is just as bad as relying exclusively on experts. Neither
approach warrants blind faith. You have to look at each decision
you’re making on its own merits and figure out which approach
will enable you to make better decisions. There will be times and
circumstances where experts will provide invaluable advice. In
other settings, looking at the wisdom of the crowd will be helpful.
The trick is to know when to use either approach alone or a hybrid
combination of the two.
To make experts work for you rather than against you:
1. Match the problem you’re facing with the solution which is
most likely to work – have a range of options rather than
adopting a one-size-fits-all approach. Be prepared to mix
what you do to find something that will work for you.
2. Seek diversity – because experts generally look at the world
through a single lens. They try to explain the world using what
they know. Sometimes that’s helpful but other times it is not.
Inject loads of diversity into your decisions and they will be
more robust.
3. Use whatever technology is available – encode repetitive
functions (like screening) into algorithms which can then be
computer based. Over time, this will enable you to become
more effective at making good decisions. Technology is a
great tool to have working for you.
“You could fill your shelves with books celebrating the wisdom of
crowds, intuition, number crunching, or experts. But as a
thoughtful decision maker, your prime task is to identify the
nature of your problem and then consider how best to solve it.
Since all approaches have their pros and cons, there is no
unique solution. Technology is enabling decision makers to gain
invaluable insights, and some organizations are moving towards
new approaches to inform their decisions. But the biggest
obstacle is the fundamental discomfort most of us have in
handing over decisions previously made by experts to either
computers or collectives. While the evidence against experts is
in and clearly damning, human nature remains a high hurdle.”
– Michael Mauboussin
“Knowing when to look beyond experts requires a totally fresh
point of view, and one that does not come naturally. To be sure,
the future for experts is not all bleak. Experts retain an advantage
in some crucial areas. We openly defer to people in white lab
coats or pinstripe suits, believing they hold the answers, and we
harbor misgivings about computer-generated outcomes. The
challenge is to know when and how to use them.”
– Michael Mauboussin

Poor Decisions ý 4
þ Great Decisions
We don’t always act Acknowledge decision making
objectively but take our is an inherently social exercise
cues from the behaviors and therefore you need to
of those around us. manage the influences you
feel. Watch out for group think.
Sometimes, bad decisions are made because you feel social
pressure to go along with what everyone else on your team
wants to do. The people around you can influence your decisions
in all kinds of ways:
n You might feel someone else is better informed than you and
therefore has more data on which to base their decision.
n You might want to be part of the inner circle of influential
people in your group and therefore you participate actively in
shaping the decision.
n You might feel external circumstances are forcing your hand
to go one way or another.
n You may feel primed to go one way or another by recent
media articles or other external events.
n Just the way the question at hand is framed and how the
choices are set up can influence what you end up deciding.
n Your emotional mood and that of the people around you can
directly impact on the choices you make as well.
As if these influences are not enough, inertia can also play a key
role in the decisions you make. “We’ve always done it this way” or
having in place organizational regulations which must be obeyed
come hell or high water can be the genesis of exceptionally bad
decisions.
So how do you cope with the power of the situation and make
better decisions? As for all the other sources of bad decisions,
the three-step approach is:
Prepare Recognize Apply
Or in other words, to make better decisions:
1. Have a more keen awareness of your situation and
environment – the factors which may consciously or
subconsciously influence the decision you make. Analyze
your environment and control background influences. If at all
feasible, create a more positive environment which will be
conducive to better decision-making on your part. Keep
people focused on good processes, on keeping stress at an
acceptable level and so forth. Also have a willingness to
devote attention to addressing the consequences of poor
decisions.
2. Always consider the situation first and the individuals
involved second – which is contrary to the Western way of
thinking but aligns with Eastern preferences. Westerners
tend to focus more on an individual’s motives to explain their
actions whereas Easterners tend to be more attuned to their
environments and are therefore more open to change and
evolution. Whenever you’re making a new decision, start by
analyzing the situation first before you turn your attention to
the individuals involved.
Think Twice - Page 4
3. Watch out for what Warren Buffet termed “the institutional
imperative” – the tendency for many organizations to blindly
mimic what their peers are doing. This can be seen when one
company does a merger, its competitors scramble to
complete mergers of their own. This situation tends to arise
whenever executives derive their financial rewards from
outperforming their peers. Make decisions which are good
for your own organization and not because others are doing
something comparable.
4. Avoid inertia at all times and in all circumstances – make it
your habit to regularly revisit all your processes and analyze
whether or not they are serving a vital purpose. See whether
you’ve set in stone processes which have gone beyond their
use-by date. Chances are you’ll find plenty of processes in
place which you keep using by force of habit alone.
“We like to think of ourselves as good decision makers: we weigh
the facts, consider the alternatives, and select the best course of
action. We perceive ourselves as largely immune to the
influence of others as we decide and act. We convince ourselves
that the facts and our experience carry the day, not the
behavioral vagaries of those around us. Unfortunately, reality
flatly contradicts our perceptions. Decision making, whether in
the medical office, the boardroom, or the courtroom, is an
inherently social exercise. Primes, defaults, and the behaviors of
those around us weigh on how we decide and frequently in ways
that are beyond our consciousness. A thoughtful decision maker
recognizes these myriad influences and works to successfully
manage them.”
– Michael Mauboussin
Poor Decisions ý 5
þ Great Decisions
We tend to look at Avoid focusing on just one part
complex systems and of the system and instead try
seek ways to come up to gain an appreciation of the
with a simplifying overall system dynamics. If
mental model. feasible, use simulations.
Humans as a whole crave finding cause-and-effect
relationships. This sometimes leads to problems when we take
complex systems and reduce them to simplified models we can
understand. Or we might take the performance of an individual
and extrapolate that to come up with a forecast of how a group
will behave with disastrous consequences.
To illustrate, consider the question: What drives the stock price
of a company? Is it earnings per share or is it the overall cash flow
of the company?
n If you believe earnings per share underpins the stock price,
then you focus intensively on what people in the investment
community are saying. You read the Wall Street Journal
religiously and seize upon each nugget of new information
which might impact earnings as an indicator of the future
stock price. What people say day-to-day is important.
n By contrast if you believe cash flow generates market value,
then you’ll be focused on how the market as a whole is
behaving. If one industry’s cash flows are likely to rise in the
future due to some factor or another, then you will be
forecasting stock prices will rise in sync. You will study the
collective market rather than worrying about what individual
companies are doing right or wrong.

The same kind of thing plays out when companies hire superstar
CEOs or other top performers. Companies routinely pay a
premium to secure the services of top performers in anticipation
of superior results. Often, things don’t go as planned and the top
performers end up delivering only an average performance level.
It turns out superstars typically have a surrounding support
system which is optimized for their talents. When they are placed
in another setting without the support system they are
accustomed to, their productivity reverts back to average
performance. The mistake is we isolated their individual
performance rather than seeing them as one part of a large
interrelated system.
These mistakes arise whenever you focus on an isolated part of
a complex system without appreciating all of the system
dynamics involved. To make better decisions when dealing with
complex adaptive systems, the suggestions are:
1. Learn to look at systems at the right level – meaning if you’re
watching the performance of the market as a whole, study it
at market level. When doing that, you would pay no attention
to what’s happening to individual components because that
will just be background noise.
2. Be on the alert for tightly coupled systems – where processes
need to go from one stage to another. A commercial aircraft
is a good example of a tightly coupled system. All
components work together in a coordinated fashion. Most
complex or adaptive systems are much more loosely coupled
which means removing some elements will have no impact
on the larger system. In a stock market, for example,
removing a number of investors will have no impact at all.
However, when all investors lose their diversity and start
acting in a coordinated fashion, then you start getting a
market boom or a bust.
3. Try developing simulations – especially if you’re dealing with
a complex system where there are no clear linkages between
cause and effect. Simulations help the learning process to
take root. Military planners and pilots use simulations
extensively and more companies should pick up on this
learning and planning tool.
“Even though complex adaptive systems surround us more now,
our minds are no more adept at understanding them. Our innate
desire to cause and effect leads us to understand the system at
the wrong level, resulting in predictable mistakes. Unintended
consequences can lead to failure when well-meaning individuals
attempt to manage the system to achieve a particular goal. So if
you deal with a complex adaptive system, make sure you
carefully set your system-level goal and proceed with caution in
implementing agent-level changes for achieving your objective.”
– Michael Mauboussin
“Thinking twice is really a story of opportunity. The opportunity
comes in two flavors. You can reduce the number of mistakes
you make by thinking about problems more clearly. Also, you can
see and capitalize on the mistakes other people make. As
shrewd businesspeople know, one man’s mistakes is another’s
opportunity. Over time, the most rational thinker will win.
Thinking twice is about identifying those opportunities.”
– Michael Mauboussin
“Intelligent people perform better only when you tell them what to
do.”
– Keith Stanovich, psychologist, University of Toronto
Think Twice - Page 5
ý þ
Poor Decisions 6 Great Decisions
We form inaccurate Acknowledge that
cause-and-effect circumstances can and
relationships, especially do change constantly and
for situations generated there are no universal rules
by circumstances. which will apply at all times.
Whether you’re conscious of it or not, what you do in business is
grounded in the theories you hold to be true. When you do
something different, you’re doing so in anticipation of deriving
the benefits of a different theory. A sound theory will lead to
predictable and worthwhile results being delivered.
New theories generally get built in three stages:
Observation – we measure some kind of
1
phenomena and document the results
Classification – we try and simplify the results
2
and categorize things systematically
Definition – we start defining what the
3
underlying cause-and-effect relationships are
Theories then get fine-tuned and improved by testing predictions
against the real-world data which gets collected. Anomalies can
be highlighted and worked into the theory as things move
forward. Business is never as simple and clear-cut as taking a
single set of “keys to success” or “formula for winning” and
applying it.
A good example of this is Boeing’s experience with its
next-generation airliner, the 787 Dreamliner. Over the last few
decades, many people have talked about the benefits of
outsourcing to drive down costs within a supply chain. To gain
these benefits, Boeing decided to move from doing everything
in-house to using suppliers who would build complete airplane
sections according to the detailed blueprints Boeing provided.
Boeing hoped in this way, what was traditionally a capital
intensive and labor intensive final assembly process of thirty
days could be pared back to three days.
Unfortunately, what sounded reasonable in theory ended up
being a disaster in practice. Despite the fact suppliers had
detailed blueprints and specifications, Boeing found suppliers
interpreted those blueprints in subtly different ways. The end
result was components made by different suppliers would not
match up to other modules as planned. Boeing ended up having
to bring much design work back in house in order to get
everything to integrate properly. The 787 is two years behind
schedule and many billions over budget as a result of Boeing
embracing a management theory that sounds good but does not
work for complex products like a commercial airliner.
“Outsourcing does make sense for industries where
subcomponents are modules. In these cases, the performance
of the subcomponents is well defined, and the final assembly is
straightforward. Today, you can build a personal computer
yourself with standardized modules. Once an industry defines
the modules, then it makes more sense for suppliers to
specialize in one component instead of trying to make them all.
Assemblers like Dell can then focus on design, marketing and

distribution. Before the 787, Boeing had controlled the design
and engineering processes for its planes, ensuring the
compatibility of the components and a smooth final assembly.
Buy by ceding design and engineering to suppliers, Boeing’s 787
program became a case study in when to avoid outsourcing.
Boeing was drawn to outsourcing as an attribute, without fully
recognizing the circumstances under which it would work.”
– Michael Mauboussin
Not only do business theories have to be well put together and
applied in their right context to have any value but you’ve also got
to be careful to be aware of all kinds of strange correlations which
pop up all over the place. A simple example in stock markets is
the “Super Bowl Indicator” which states: “When the National
Football Conference team wins the Super Bowl, the stock market
will go up. When the American Football Conference team wins,
the stock market will go down.” The Super Bowl Indicator has
correctly forecast the stock market’s direction 80 percent of the
time from 1967 to 2008. In other words, there is a clear statistical
correlation but there is no causal relationship. Obviously what
happens on a sports field can’t and won’t have any material
impact on what the stock market as a whole does. When you’re
dealing with business theories, you’ve got to make sure you’re
actually looking at quantifiable causes rather than quirks of
statistical correlation.
To ensure you’re correctly considering circumstances
systematically when you make business decisions:
1. Look at whether the theory you’re using correctly allows for
circumstances – or are you merely extrapolating successful
choices from the past into new situations? This is what
happens when consultants study successful organizations
and come up with a universal set of “business laws” which
guarantee success. They don’t exist. Business is too
complex and the context is too varied for one single set of
principles to guarantee success in every industry and in
every market around the world.
2. Watch for correlation oddities – where people are trying to
see cause-and-effect relationships which don’t exist. We all
have a tendency to reach conclusions which are a stretch of
the facts so be on guard.
3. Balance your desire for simple rules with an awareness of the
impact of changing conditions – which in effect means to be
skeptical of anything which is “universal”. In evolution theory,
the strongest doesn’t always survive. It’s whichever species
adapts to changing circumstances the fastest. So too in
business. Being big is no guarantee of success but it’s the
entities which adapt the best to changing marketplace
conditions which do well.
4. Always be wary of “best practices” as well – because what
works just fine in one realm may be entirely wrong for a
different market niche. All players have strengths and
weaknesses and it’s what you to take advantage of your own
strengths that matters, not how good anyone else is.
“Most of us look forward to leveraging our favorable experiences
by applying the same approach to the next situation. We also
have a thirst for success formulas – key steps to enriching
ourselves. Sometimes our experience and nostrums work, but
more often they fail us. The reason usually boils down to the
simple reality that the theories guiding our decisions are based
on attributes, not circumstances.”
– Michael Mauboussin
Think Twice - Page 6
Poor Decisions ý 7
þ Great Decisions
We’re not really all that Be aware of the power
familiar with tipping and reach of coordinated
points where a small behavior and be careful
change can lead to not to extrapolate the
major consequences. past into the future.
When you freeze water, it stays a liquid until suddenly at freezing
point, it becomes ice. You can cool it by 5 degrees or more above
freezing point and nothing much happens – the water just gets a
little chillier. But at freezing point, just a one degree change in
temperature is enough for a major transition to occur. This same
phenomena crops up in all kinds of complex systems. There is a
trigger point where a small change in one factor causes a major
phase transition.
The financial crisis of 2007-2009 was a good example of this
phenomena in action. The genesis of the market meltdown was
the fact a statistician (named David Li) had come up with a
formula which purported to measure the likelihood of default
between different types of financial assets. This formula could
then be used to calculate how much financial risk you were
exposed to when investing in assets which were a collection of
financial investments. Thus, the financial derivatives market was
born and companies started investing in bundles of investments
which they believed were sufficiently diversified.
It turned out the formula had a fatal flaw. It was accurate when
financial assets acted independently, but underlying correlations
could still exist in a complex and dynamic world. Instead of acting
independently, all financial assets started acting in sync which
meant diversification went out the window. It turned out everyone
had taken on more risk than they imagined and this set off a chain
reaction that led to one default after another. Just a small change
in the condition of the stock markets ended up generating a
substantial and largely unpredicted loss of value across the
entire marketplace.
So what can you do to avoid falling foul of these kinds of phase
transitions? As usual, there are no absolute guarantees but
ideas worth pursuing would include:
1. Study the distribution of outcomes you’re dealing with – and
don’t explain away any extreme events as anomalies. Figure
out how you can prepare for everything the system can
generate, extreme event or not. Be aware you might not have
cause-and-effect figured out nearly as thoroughly as you
think you do and prepare accordingly.
2. Look for major phase transitions – where just a small change
can generate extreme reactions. When people start acting in
a coordinated fashion rather than in a random fashion,
incredible power can be generated. The dot-com boom of the
late 1990s and the financial market meltdown of 2007-2009
are worthwhile illustrations of this phenomena in action.
Don’t always assume randomness will reign supreme.
3. Beware of forecasters – who will tell you they know what’s
going on to a number of decimal points accuracy. Be
especially wary of anyone who makes a forecast which spans
multiple domains. Any one of them can have arbitrary
problems in hiding which the forecasters are not aware of.
Prepare for all contingencies at all times and in all
circumstances.

4. Do what you can to mitigate the downside while at the same
time still harnessing the upside – which essentially means
you should never bet more than you can afford to lose on any
particular outcome. The ideal is to get cost-effective
exposure to positive events at the same time as you insure
against the arrival of major negative events.
“Consequences are more important than probabilities.”
– Peter Bernstein, investor
“Increasingly, people must deal with systems that are marked by
abrupt, unforeseeable change and rare but possible outcomes.
We are all particularly mistake-prone with these systems
because we intuitively want to treat the system as being simpler
than it is and to extrapolate the past into the future. Flag those
systems w hen you see them, and slow down your
decision-making procedures.”
– Michael Mauboussin
Poor Decisions ý 8
þ Great Decisions
We overemphasize the Evaluate the mix of skill and
effect our skill has on the luck in the system you’re
result and minimize the looking at and be careful about
impact of luck in our any conclusions you draw
successes. which rely on luck.
How much of your past successes have been due to good luck
and how much has been the result of skill? Humans have a very
difficult time differentiating between the two. As a result, we fail to
acknowledge over the long run, results always revert to the
mean. Because of this, you can make three kinds of mistakes:
n You think the person you’re dealing with is “special” – and
therefore not bound by the law of averages. This is what
happens when corporate leaders think they’ve figured out a
better way to run their businesses and therefore they will
always turn in above average performance. Don’t fall for it.
Luck has more impact than they’re admitting to themselves.
This is why investors pour money into funds run by managers
which have beaten the market over the past couple of years
only to pull it out when that fund’s lucky streak ends and its
performance reverts back to average. These people are
buying high and selling low because they ignore reversion.
n You can easily misinterpret the data – and look for cases of
sustained outstanding performance when in reality what
you’re actually seeing would be a reversion towards the
long-term average. Put another way, all markets tend towards
mediocrity. Competitive advantage is never absolute and
inexhaustible. Eventually, everyone reverts to the mean.
Extreme results, based on either really good luck or really bad
luck, will be followed by other periods which will be less
extreme and which will even things out.
n You can get confused about what kind of feedback is most
productive – and base your actions on that part of the
outcome the person can’t control (the luck) rather than that
part they can control (their skill). Giving your people feedback
based only on outcomes is of no practical value whatsoever if
you fail to differentiate between skill and luck.
The existence of a “halo effect” is well documented in business.
In practical terms, this means we observe successful
organizations and attach attributes to their success – like they
Think Twice - Page 7
enjoy great leadership, a visionary strategy or superior financial
controls. We then recommend others embrace those same
attributes to also become successful. The halo effect completely
ignores the role of luck. If stellar performance subsequently
reverts back to average performance, observers then conclude
those features went wrong whereas in reality nothing has
changed. The people are doing all the same things but a run of
good luck has ended as it always does.
This halo effect is prominent in the business press. Frequently,
companies which are featured in glowing terms as cover stories
in Business Week, Forbes and Fortune magazines then end up
turning in an abysmal performance over the next two or so years.
Their run of success which attracted the attention of the
magazine’s editors ultimately reverts to the mean. Professional
sports teams observe this same phenomena – appropriately
termed the “Sports Illustrated Jinx” – where teams or athletes
which appear on the magazine’s cover will immediately go into a
prolonged slump.
So how do you avoid these reversion to the mean style mistakes
when making decisions? Some suggestions:
1. Become more realistic about evaluating the amount of luck
involved in the system you are analyzing – which is rarely
easy to do. When something good happens, it’s human
nature to assume that was because of skill. Similarly,
whenever something bad happens, you’re more likely to
consider it to be the result of bad luck. Be realistic and careful
about drawing conclusions around anything which involves
luck.
2. Consider the sample size you’re looking at – and see whether
enlarging your data sample will allow you to draw more robust
conclusions. The more data you’re using in your sample, the
better you understand everything involved and can draw the
correct conclusions.
3. Watch out for changes in the system – because not all
systems remain stable over an extended period. Whenever a
system changes, the mix of skill and luck changes as well.
Keep this in mind as you analyze the data.
4. Always remain on the lookout for the halo effect – where
someone wants to offer you a tidy solution to your problems
based on emulating what’s worked for someone else.
Business is much too complex for simple solutions which are
guaranteed to work under any conditions and circumstances
to exist. Anyone who offers you a proven formula, a set of
rules to live by or a set of attributes you need to have is trying
to sell you the Brooklyn Bridge. They’re trying to sell
something they don’t even have themselves. Be very wary.
“Here’s a simple test of whether an activity involves skill: ask if
you can lose it on purpose. Think about casino games like
roulette or slots. Winning or losing is purely a matter of luck. It
doesn’t matter what you do. But if you can lose on purpose, then
skill is involved. This simple test reveals the role of luck in
investing. When most people recognize that it is hard to
construct a portfolio that beats the S&P 500, most people don’t
know how hard it is to build a portfolio that will do a lot worse than
the benchmark.”
– Michael Mauboussin
“When outcomes are really good because of a dose of good luck,
prepare for the times when they will be closer to the average.
When outcomes are disappointing as the result of bad luck,
recognize things will get better.”
– Michael Mauboussin

Poor Decisions ý þ Great Decisions
How to improve your decision making immediately
1 Raise your awareness level – identify the mistakes you
commonly make in your normal business processes and
resolve to do something about them. Recognize when you’re
using sloppy thinking and start thinking clearly about the
problems you face. Remember, there’s always a hindsight
bias where we tend to think the solution was obvious after the
fact, but it seldom is at the time. Be more aware.
2 Use empathy – put yourself in the position of other people
who faced similar challenges and study how they responded.
If you learn from the mistakes of others rather than repeating
them over, that’s good. If others have to live with the
consequences of what you decide, get to understand their
perspective and point of view. You might still end up making
the same decision but you’ll do so with your eyes open.
3 Never forget to acknowledge the role of luck – or at the very
least the impact of a little skill combined with luck. Sorting out
skill from luck is a key step in making better decisions. If luck
determines the outcome, you know ultimately outcomes will
revert to the average. Outstanding one-off outcomes are
going to be followed by a succession of average outcomes in
the future. Also, if you’re evaluating the performance of
another person, make sure you differentiate between what
was generated by their skill and what was generated by luck.
Don’t confuse luck for skill, especially if you are providing
criticism of their performance.
4 Solicit as much feedback as possible – because feedback
which is timely and clear will over time help you improve your
decision making skills. Try keeping a journal cataloging the
decisions you make and the reasoning you used. Once an
outcome emerges, you can then go back and audit your
decision making process. You can look for clues as to how a
poor decision was reached. A journal will also enable you to
look for patterns and relationships. You may find you make
better decisions when you’re in a reflective mood than you do
when in a more agitated state. If that’s the case, you can then
develop a game plan for each day based on the mood you’re
in. Keeping a decision journal is a structured tool for all kinds
of analysis and introspection.
5 Develop a decision checklist – the items you should work
through when making a decision. Pilots use checklists before
take-off and before landing to ensure they can operate
safely. Admittedly, checklists are less useful in rapidly
changing environments but in many business domains, that
is simply not the case. You have to find a balance between a
checklist which is so general it is too vague and one which is
specific enough to guide action. Try creating a one- or
two-page checklist you run through each time you have to
make a decision and see how it goes. Find out what other
kinds of issues surface in practice. Analyze whether past
poor decisions have been a case of neglecting a step rather
than executing other steps poorly.
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Think Twice - Page 8
6 Try performing a decision “premortem” – the opposite of a
postmortem. Assume you are looking back from the future at
a decision which has failed. Try to anticipate what the cause
of failure was and do something to address it sooner rather
than later. Track your premortems in your decision journal so
you can become more attuned to picking up on early signs of
trouble.
7 Acknowledge there are things you cannot know in advance –
especially when you’re dealing with a complex system with a
large number of interacting components. Cause-and-effect
linkages are often obscured and it’s difficult to know what will
be the result of varying one component or another.
Acknowledge those complexities and feel good about stating
you simply don’t know how things will play out.
“There’s a funny paradox with decision making. Almost everyone
realizes how important it is, yet few people practice. Why don’t
we drill young students on decision making? How come so few
professionals – executives, doctors, lawyers, and government
officials – are versed in these big ideas?”
– Michael Mauboussin
“Three factors determine the outcomes of your decisions: how
you think about the problem, your actions, and luck. You can
familiarize yourself with common mistakes, recognize the
situation you’re in, and take what appears to be the correct
action. But luck, by definition, is beyond your control, even
though it may determine the outcome (especially over the short
term). That statistical reality begs a fundamental question:
should you evaluate the quality of your decisions based on the
process by which you make the decision or by its outcome? The
intuitive answer is to focus on outcomes. Outcomes are
objective and sort winners from losers. In many cases, those
evaluating a decision believe that a favorable outcome is
evidence of a good process. While pervasive, this mode of
thinking is a really bad habit. Kicking the habit opens up a world
of insight into decision making. Our most challenging decisions
include an element of uncertainty, and at best we can express
the possible outcomes as probabilities. In a probabilistic
environment, you are better served by focusing on the process
by which you make a decision than on the outcome. When
evaluating other people’s decisions, you are better served by
looking at their decision-making process rather than on the
outcome. There are plenty of people who succeed largely by
chance. More often than not, they are completely unaware of
how they did it. But they almost always get their comeuppance
when fortune stops smiling on them. Likewise, skillful people
who have suffered a period of poor outcomes are often a good
bet, since luck evens out over time.”
– Michael Mauboussin
“Smart people make poor decisions because they have the
same factory settings on their mental software as the rest of us,
and the software isn’t designed to deal with many of today’s
problems. So our minds frequently want to see the world one
way – the default – while a better way to see the world takes
some mental effort. Beyond the problem of mental software,
smart people also make bad decisions because they harbor
false beliefs. These beliefs prevent clear thinking. To make good
decisions, you frequently must think twice – and that’s something
our minds would rather not do.”
– Michael Mauboussin