You have five public companies on your list, and you want to choose one of them to invest in. First, you find a local broker-dealer to pick the company for you to invest in. And then, you find a monkey in the zoo and put five bananas with each company's name on them. See which corresponding company the monkey chooses for you. You have two recommendations, one from the broker-dealer and one from the monkey. Which recommendation will be more trustworthy?
On the one hand, you have an experienced finance professional who trades stock for her life. On the other hand, you have a monkey who knows nothing about the financial market. The answer is that there is no correlation between the profitability of the pick and the subject that make the pick. In other words, it doesn't matter. Each pick has the same possibility of being profitable or losing money.
You probably disagree with me. How could an experienced professional make no better decision than a monkey? The trick is I chose an environment that provides zero-validity: the financial market. Research shows that the financial market acts as a random walk. This means that stocks take a random and unpredictable path that makes all predicting stock prices futile in the long run.
Random Walk of Stock Market (Source: lewuathe.com)
Intuition's trustworthiness is highly related to the predictability of the event. But, as I mentioned in my previous blogs, the world is highly volatile and unpredictable. Based on Heisenberg's Uncertainty Principle, we need to simultaneously measure the position and speed of a particle to predict the future. However, in practice, the more accurately you try to measure the particle's position, the less accurately you can know the speed, and vice versa. In other words, our ability to predict the future is severely limited by the complexity of the equations, which often have a property called chaos.
So, why do we have the feeling that our intuition is correct? Is there a "sixth sense" that exists? The human mind is highly affected by cognitive ease and coherence. We feel mentally relieved when things "make sense". Cognitive bias pushes us to look for linkages in a chaotic world.
Daniel Kahneman and Klein (2011) suggest that we can trust an expert’s intuition occasionally, but it has to follow two strict rules:
An environment that is sufficiently regular to be predictable
An opportunity to learn these regularities through prolonged practice
They named this skilled intuition. Like other skills, skilled intuition needs to be acquired through experience and practice. But to trigger skilled intuition, it has to be in an environment that provides regularity. Chess is an extreme example of a regular environment. An expert player can understand a complex position at a glance, but it takes years to develop that level of ability. Physicians, nurses, athletes, and firefighters also face complex but fundamentally orderly situations. By contrast, stock pickers and political scientists who make long-term forecasts operate in a zero-validity environment.
They also mentioned that there are also “wicked” environments where professionals are likely to learn the wrong lessons from experience. For example, in the early twentieth century, a physician often had intuitions about patients who were about to develop typhoid. Unfortunately, he tested his hunch by palpating the patient’s tongue without washing his hands between patients. When patient after patient becomes ill, the physician develops a sense of clinical infallibility. His predictions were accurate – but not because he was exercising professional intuition.
Back to the big question: Is an expert’s intuition trustworthy? In most cases, NO. In the business world, a BIG NO. I am surprised by so many people acting so confidently with their intuition. Even more surprisingly, other people admire this type of confidence. To make intelligent decisions, we have to be more analytic and rational.
What’s the number indicating?
What’s the base rate?
What’s your company’s value?
What’s your customers’ value?
Ask questions, gather the data, and then analyse it.
Do not trust your intuition.