Lewis: 'It's Never as Simple as Just an Algorithm'

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference.

In a wide-ranging keynote luncheon chat Thursday at the Morningstar Investment Conference, author Michael Lewis linked together the behavioral economics and decision-making psychology that drives everything from sports to financial market structure. Even his own book deals, he said, offer a lesson on the power of incentives to drive behavior.

From Moneyball to his newest work, The Undoing Project, there are lessons in decision-making relevant to investing.

"Acknowledge the power of data, good predictive analysis, worship it even, but not at the expense of total stupidity," said Lewis. "You've all got to become behavioral scientists, understand the way the mind leads you astray when anecdotal evidence is in the room."

In his discussion with Morningstar director of personal finance Christine Benz, Lewis explained the connection between Moneyball and The Undoing Project, which tells the tale of the friendship and collaboration of two influential psychologists, Daniel Kahneman and Amos Tversky, whose work explored the decision-making process and how the human mind can easily be led to make poor choices.

"Moneyball was a book about how markets didn't value people properly," said Lewis of the 2003 story of the Oakland A's baseball team and its evidence-based approach to building a team.

"The natural question should have been 'why?'" he said. "What's going on inside the human mind that leads perfectly intelligent people who know lots about their subject to make these kinds of mistakes."

The reality, says Lewis, is that "experts make mistakes." That kind of awareness is one of the forces driving investors toward passive investing, he said, noting that Burton Malkiel, in his seminal investing book that helped promote the idea of index investing, A Random Walk Down Wall Street, cited Kahneman and Tversky's work in part to explain why rule-based investing might outperform an individual that has biases.

Still, he said, "I would argue that the individual can come roaring back if he is more aware of his weaknesses."

And while Moneyball showed the power of algorithms to help make predictions, "You realize it can never be as simple as just an algorithm, the world is just too complicated," Lewis said. "Then you need to bring (anecdotal) information into the room but then the problem is you then bring in the cognitive biases."

Decision-making processes can be biased by memories, which are themselves generally biased.

"What is memorable is what you judge to be important," he said.

Benz asked Lewis about the aftermath of his 2014 book on high frequency trading, Flash Boys, and whether he has felt vindicated in his portrayal of the U.S. financial markets as rigged. Lewis said it's become clearer how HFT funds have been scalping investors, but that it's a "muddy, murky environment" where different players have differing views on whether it matters.

"It is true that in the grand scheme of thing it's not a huge problem because you're talking about pennies, and it's true that the general cost of investing has come down due to technology, but it's an offensive and unnecessary thing," Lewis said. "It's taking away from the pension funds of firemen and handing it to billionaire hedge funds. It shouldn't happen."

Underneath, Lewis said, are problematic incentives on Wall Street that lead firms and individuals to make decisions that can harm investors and the economy in general--such as with the financial crisis--in order to generate profits for themselves. Benz asked him about his decision to ask his publisher to do away with the usual industry practice and instead give him a share of the publishing profits, which he said was sparked by an examination of his own incentives.

If the book works, "I get paid," he said. "I'll be better at what I do if I have the risk. We forget how we respond to incentives."

Lewis said he’s not set on what his next project will be, although he's pondering turning his sights on Washington D.C.

"I hope I'm done writing about Wall Street," he said. "Basically, if I'm writing about it, really bad things are happening."