Subtractive reasoning in finance
An interesting new paper out of UVA documents a human bias toward “additive” solutions to problems over potential “subtractive” solutions. As one article about the paper explains:
Picture a bridge made of Legos. One side has three support pieces, the other two. How would you stabilize the bridge?
Most people would add a piece so that there are three supports on each side, a new study suggests. But why not remove a piece so that each side has two supports instead? It turns out that getting people to subtract — whether a Lego block, ingredients in a recipe or words in an essay — requires reminders and rewards, researchers report April 7 in Nature.
This default to addition isn’t limited to assembling blocks, cooking and writing. Rather, thinking in pluses instead of minuses could well contribute to modern-day excesses such as cluttered homes, institutional red tape and even an overburdened planet, says behavioral scientist Benjamin Converse of the University of Virginia in Charlottesville. ‘We’re missing an entire class of solutions.’
One wonders how the bias toward addition might also shape investor behavior, or have shaped the basic functioning of the investment management industry as a whole. We’ve known for decades, for example, that a few simple factors that are relatively easy to calculate predict a great deal of variation in the cross-section of stock returns; yet the equities-focused piece of the investments industry continues to be replete with firms employing equity analysts who spend their time meticulously building and refining detailed valuation models and studying the minutiae of corporate disclosures and filings. Of course, someone has to pay for all of this infrastructure and effort (you, in the form of fees). But what if all or most of this “added” effort and cost is wasted (relative to the benefits in terms of investment performance) and can just be subtracted away? That is a key part of the premise for the quantitative/systematic approach to investing we’re doing here.
