The Attention Span- from The Knall/Cohen/Pence Group.
This week’s article is a little longer than last week’s, but I hope it’s worth your time because it discusses a hidden force that can influence almost every aspect of our lives.
“You Bet Your Life”
The Narrative Fallacy that Can Ruin Everything.
Occasionally, one stumbles on a behavioral trait that seems to explain a vast amount of the world around you.
The archetypal image of a slot machine addict probably isn’t a flattering one. The older person with an oxygen tank stubbornly frittering away their pension in the perpetual twilight of a casino floor. But despite their tawdry image, slot machines are a surprisingly huge business. According to Der Spiegel, slots make more money in the U.S. than baseball, movies, and theme parks combined. Moreover, people get “problematically involved” with slot machines three to four times faster than other forms of gambling.
While we would probably regard a slots addict with a mix of condescension and pity, many of us are unconsciously exhibiting similar behavior. Worse, we are wasting an even more precious resource than money: our attention.
Psychologist B.F Skinner conducted a series of famous experiments where rats were trained to pull a lever in order to receive a small food reward. If the rat got the same reward each time, it learned to pull the lever only when it was hungry. They then varied the outcomes; the rat didn’t know whether it was going to get one pellet, or none, or several when it pulled the lever. The rat then pulled the lever over and over again. It became psychologically hooked. This became known as a “Skinner box” and the principle of Intermittent Variable Rewards.
If there’s something mysterious in our environment, it is of existential evolutionary importance to explain it, in case it can hurt you. When faced with chaotic uncertainty, we are driven to retrospectively place an orderly narrative on it.
On December 26, 2004, members of the indigenous Moken tribe on the Andaman Islands in the Indian Ocean heard the cicadas fall silent as the ground shook. The elders of the Moken knew these signals from the myth of the Laboon- “the wave that eats people.” They immediately took refuge on higher ground, and the tribe survived the resulting catastrophic tsunami virtually unscathed. As a result, a story that had been passed down through the generations contained valuable information that saved lives. A mythological story, based on real experience, helped the tribe survive a disaster.
Problems arise when we fall victim to the narrative fallacy. This is when we impose stories on improbable or random events to make them seem predictable in hindsight. Slot machines also create the illusion of knowability by showing an unusually high number of ‘near misses’ on matches to keep players engaged for the next spin. An extreme reaction to this vulnerability is reflected in how arguably the world’s most successful hedge fund, Renaissance Technologies, approaches stocks. As Gregory Zuckerman, author of The Man Who Solved The Market, writes:
“The Renaissance team views the narratives that most investors latch onto to explain price moves as quaint, even dangerous, because they breed misplaced confidence that an investment can be adequately understood and its futures divined. A Renaissance employee once said if it was up to him, stocks would have numbers attached to them, not names, so investors would be less likely to succumb to a story.”
This is obviously an extreme case: understanding market narratives is going to be increasingly critical as more non-traditional investors join the landscape. But the danger is when you as an individual become prone to the fallacy.
In the years since Skinner, intermittent variable rewards have stealthily infiltrated multiple areas of our lives. The most money in today’s world comes from monopolizing our attention. It’s therefore of absolutely no surprise to learn that many of the principles used in slot machine development have since been used to make apps more addictive. Once you become aware of the phenomenon, you start to realize it’s virtually ubiquitous. There are the different varieties of notifications on Facebook; who liked what and when, messages, and friend requests. There’s Reddit gold, Instagram likes, incessant SnapChats, and push alerts. Facebook users consistently overestimate the length of time they spend on the platform, but considerably underestimate the number of times they check the app. It’s the variability of the notifications that keep users hooked, not so much the content.
In our personal lives, intermittent variable rewards marry the social pressure of community engagement with the psychological addiction of a Skinner box. It’s a combination so powerful it has helped birth the largest monopolies the world has ever seen. Whenever you see a new notification, understand that it has likely been tested billions of times to maximize for your engagement.
On Wall Street, quarterly earnings season strikes me as a classic Skinner box. You have a burst of data, followed by share price reactions. The obvious difference is that earnings season concerns company results that have a basis in the real world. Unlike slot machines, earnings season can theoretically be solved. However, the level of unpredictability is worth illustrating.
A legendary recent hack of the company filing system EDGAR gave criminals early access to 150,000 press releases. Even with advance-knowledge and the ability to cherry-pick only the most promising beats and misses, their success rate was just 77%. They “knew the future,” and they still couldn’t win all the time. Knowing the positioning and psychology of the other players was critical too. There was still a hefty dose of luck.
The point is not to conclude everything is futile, but more to better understand the odds at the table you’re playing on. There are a lot of very lucky investors that probably think they are geniuses.
The closer an activity is to pure luck, the more vulnerable it is to the narrative fallacy.
In the book The Success Equation, Michael Mauboussin outlined a luck-skill continuum for gambling, investing, and sports.
Slots and Roulette are pure luck. Chess is mostly skill. In sport, skill can be determined by the number of possessions that a team gets over the course of a game. Sports like basketball and tennis see the highest number of possession changes, therefore have the highest skill factor. In high-skill games, deliberate practice largely determines results, in high-luck games, a clear process is more important. Otherwise you can never really determine the role of luck vs skill.
As we discussed last week, people who can think probabilistically and finely calibrate their estimates over time are at a material advantage to those who think in more binary terms. Poker is a good analogy for modern markets as it combines pure quantitative skill with a generous psychological component. The “best hand” in poker only wins 12% of the time. This attitude is echoed by poker champion Annie Duke in her book Thinking In Bets. It’s a mix of probabilistic calibration and a decision-making process that can be assessed almost irrespective of outcome.
Mauboussin recommends using a simple decision journal: put advance probabilities on your expected outcomes, then consistently review your performance after the event. Indeed- he has found that just asking experts to put percentage probabilities on their forecasts resulted in considerably more thoughtful answers.
A key defense against the narrative fallacy is the importance of understanding “base rates.” Rather than looking at the specific inside-case narrative, consider the outside-case reality as well. This is illustrated by a famous question of Danny Kahneman’s:
“Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail. Is Steve more likely to be a farmer or librarian?”
The reflexive “inside-case” answer is librarian, because Steve has the clichéd individual characteristics we associate with that profession. However, it ignores the “outside-case” that there are twenty times as many farmers than librarians in the U.S.
Before starting a business or investing in one: ask what the base rate of success is for that industry. You help neutralize the narrative fallacy by looking at historical data over the specific story.
The global takeover of Intermittent Variable Rewards show how irresistibly we are drawn to narrative resolution of uncertainty. In order to not fool ourselves, we need to implement robust determinations of the role of luck vs skill. Long timeframes, robust processes, dynamic updating of our priors, and an understanding of the base rate is a potent combination for life and business alike.
2 interesting things:
1. Read: Power to The Person (Packy McCormick, Not Boring, 18min read).
- Why Read: The first iteration of the internet was all about massive centralization of power. The reaction against that has emphasized decentralization, with crypto the most obvious example. Jaron Lanier correctly identified that the information economy had no middle class in his absolutely seminal interview The Local-Global Flip in 2011. [It’s a foundational concept for me in terms of thinking about the world, and I hope to explain why in a future piece]. Part of Lanier’s proposed solution is a decentralization of creative and labor output. I confess I’m still really skeptical that this ever works on a scale big enough to support a meaningful percentage of the population, and that it doesn’t just end up as another power-law distribution favoring the best content producers. As I’ve flagged before Packy McCormick’s “Not Boring” Substack is really interesting, and I believe he makes a living from it. So he is more qualified to know, even if I’m still skeptical. His latest piece on Non-Fungible Tokens (NFTs) and the creator economy is a fun, short-ish intro to a trend that’s going to probably get a lot more visible, if not more viable. If I understand them correctly (never guaranteed), NFTs make data uniquely identifiable to an individual owner. It makes a digital asset (theoretically) scarce. For example: NBA Topshot means you can buy an individual highlight (a Lebron dunk sold for $208,000). The bigger lateral, per Packy, is that it allows artists to sell their work off in a decentralized way, without platforms controlling the economics and distribution.
- McCormick: “The Creator Economy and NFTs are massive human potential unlocks. Even if certain assets are in a short-term bubble, we are on an inexorable march towards individuals mattering more than institutions. We’re on the precipice of a creative explosion, fueled by putting power, and the ability to generate wealth, in the hands of the people. Armed with powerful technical and financial tools, individuals will be able to launch and scale increasingly complex projects and businesses. Within two decades, we will have multiple trillion-plus dollar publicly traded entities with just one full-time employee, the founder.”
2. Read/Listen: Oaktree’s Howard Marks’ Something of Value memo (60min read/also available as a 1 hour podcast).
- Why Read: Yes, it’s long, but it’s Howard Marks. This one is particularly worthwhile as it examines the mental flexibility investors will need to demonstrate over the next few years. As a long-term value investor, Marks is openly and honestly grappling with a changing world (thanks SK for the flag!). Some insights that resonated:
- · Marks: “As I said before, the natural state for the value investor is one of skepticism. Our default reaction is to be deeply dubious when we hear “this time it’s different,” and we point to a history of speculative manias and financial innovations that left behind significant carnage. It’s this skepticism that reduces the value investor’s probability of losing money.
- · However, in a world where so much innovation is happening at such a rapid pace, this mindset should be paired with a deep curiosity, openness to new ideas, and willingness to learn before forming a view. The nature of innovation generally is such that, in the beginning, only a few believe in something that seems absurd when compared to the deeply entrenched status quo. When innovations work, it’s only later that what first seemed crazy becomes consensus. Without attaining real knowledge of what’s going on and attempting to fully understand the positive case, it’s impossible to have a sufficiently informed view to warrant the dismissiveness that many of us exhibit in the face of innovation.
- · Since quantitative information regarding the present is so readily available, success in the highly competitive field of investing is more likely to be the result of superior judgments about qualitative factors and future events.”
Quote of the week: "All of the common valuation metrics for traditional markets, like P/E, are the memes of traditional finance." - Qiao Wang
Have a fantastic weekend!
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The Knall/Cohen/Pence Group
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