Nobel Laureate Daniel Kahneman is a co-author in a recent book – “Noise – A Flaw in Human Judgement” . In chapter after chapter of the book, deeply disturbing facts are presented about significant noise in professional human judgement. Bail applications, asylum decisions, child custody decisions, medicine, forecasting, hiring and staffing, forensic sciences, insurance underwriting, granting patents – the list is long - of what the authors say are “real-world decisions” where noise is “scandalously high”. The authors decompose error in human judgement into two components– bias and noise. Bias is systematic deviation while noise is random scatter. While human bias has been well documented in thousands of scholarly papers and was even the primary subject matter of Dr. Kahneman’s nobel prize, noise in human judgement is seldom recognized. In-fact the book states that system noise is a greater component of total error than bias. Through some deft arguments the authors make the case that by first reducing noise, system bias becomes even more evident and ripe for corrective action.

Improving judgements:
The book goes on to discuss how judgements can be improved. The first they say is to have good judges. This may be a simplistic point – nevertheless, the authors go on to elaborate on what are the elements that make a good judge. Good judges they say not only (a)“tend to be experienced and smart” but also are (b) “actively open minded and willing to learn from new information”. Of the two, the later, ie being open minded to learn from new information is the more important.

The second aspect to improving judgements is to reduce bias. Bias is the average error while noise is the variation in error. Bias is more straightforward to capture and is intuitively appreciated by most of us. The authors recommend active de-biasing strategies for reducing bias. Detailed de-biasing strategies are provided in the book, discussion upon which will be difficult to fit into this blog.

The third point that the authors talk is something that does not come intuitively to us. That is reducing noise. They reccomend something called “decision hygiene” for noise reduction. Decision hygiene is akin to hand washing in medicine. To para phrase the authors – “When you wash your hands, you may not know precisely which germ you are avoiding – you just know that handwashing is a good prevention for a variety of germs. Similarly following the principles of decision hygiene means that you adopt techniques that reduce noise without ever knowing which underlying errors you are helping avoid.”

Decision hygiene:
Elaborating on their concept of decision hygiene, the authors refer to their protocol called the “Mediating Assessments Protocol”. We feel that decision hygiene is particulalry relevant in investiment decision making. To llustrate the concept of the Mediating Assessments Protocol in the context of investing, let us for example, examine something like the Sovereign Gold Bond investment as an investment opportunity. The steps adopted are as follows:

    Step 1 : Break down a decision/judgement into smaller and independent assessments :
      Maximum Drawdown
      Tax adjusted return
      Clients’ Emotional Risk Tolerance
      Correlation with existing assets of the client

    Step 2 : Each assessment will be independent and will have a relative scale keeping base rates in mind. Document the reasons for each assessment :
      Maximum Drawdown:
      Scale - Low : Fixed deposit (0%), High : Micro Cap Stock (70%)
      Assessment : High
      Justification : Historically there has been a 70% drawdown in the price of Gold

      Scale - Low : Land (lowest liquidity), High : Overnight Funds (Highest liquidity -one day)
      Assessment : Moderate
      Justification : The trading volume per day is maximum 500g based on past data. For someone with less than 50g it is liquid enough. Otherwise it may take about a week to liquidate holdings of 1kg or more.

      Tax adjusted return:
      Scale - Low : Physical Gold, High : Sovereign Gold Bond
      Assessment : High
      Justification : The RBI Sovereign Gold bond has the highest tax adjusted return of all forms of gold due to two reasons : Reason 1 – 2.5% on principal, Reason 2 : No Capital Gains Tax on redemption

      Clients Emotional Risk Tolerance:
      Scale - Yes, No
      Assessment : Client specific
      Justification : Justified if within emotional tolerance for risk

      Correlation with existing assets of the client:
      Scale - Low (correlation < 0.5), High (correlation > 0.90)
      Assessment : Low
      Justification : Lower correlation is good. Negative correlation is even better. Gold has low correlation with equity.

    Step 3 : Delay intuition till all the smaller independent assessments are complete.
    For a client with a small allocation < 100g of gold, Sovereign Gold Bonds is a definite yes. For clients < 70 years with larger allocations to Gold, allocation to Sovereign Gold Bonds is a yes if there are no liquidity requirements for at-least 5 years – when tax free redemption is allowed. Under all circumstances it should be recognized that Gold is an investment not for return but for hedging against runaway inflation. Hence allocation must be kept < 10%.
The reader is advised that this sample illustration of how decision hygiene can be practised, is by no means exhaustive. We have only tried to indicate how decision hygiene can be applied to decision making in investing through one example - that too not exhaustively. We see how creating independent decision buckets, helps to break down an investment problem into more manageable pieces. Taking independent scaled assessments on each bucket allows for judgement to be nuanced helping to reduce noise and allowing focus on all aspects of an investment. The scaling of each judgement with respect to a base rate is a critical aspect. Finally investing is both art and science and intuition is bound to be used. The authors nudge us to delay intuition till the individual assesment buckets are independently assessed on a scaled judgement scale and then allow intuition to take over. “Noise – A Flaw in Human Judgement” is an admirable attempt at making better judgements under uncertainty. There are lessons for serious investors in this book.