MartinKronicle: Hi everybody. It’s Michael Martin from MartinKronicle.com. I’ve got a great show today. I think you’re going to enjoy quite a bit.

In the world of finance there are myriad investment themes today: crude oil, China and India, Greece, and all sovereign debt for that matter. We’ve got a bumper crop in US dollars. We’ve got the confluence of clean energy, efficient energy versus traditional energy sources. We’ve got oil spills, for that matter. We have OTC derivatives regulation, as well as the advent of the commodity investor.

How does an individual or an investment community make sense of the confluence of all these themes? Well, my guest today is an expert in decision-making within the investment process and he has a game plan to help you figure it out.

He’s the author of “Think Twice: Harnessing the Power of Counterintuition, ” and he’s also the chief investment strategist of Legg Mason Capital Management. Welcome Michael Mauboussin. How are you doing Michael?

Michael Mauboussin: Michael, I am great. How are you doing?

MartinKronicle: I am Rock n Roll All Night, And Party Every Day [laughter] …If you want to know what my life is like.

Mauboussin: That’s good.

MartinKronicle: Now, I’ve read all your work, going back to the “Consilient Observer,” so I am a big fan. And, I appreciate you taking the time today. Now in the back of the book – this is a very important question, it has to be addressed right way – it says you live in Darien, Connecticut with your wife and five kids, the heart of New England. So the first thing I need to know is Yankees or Red Sox?

Mauboussin: See, I am not a big baseball fan…

MartinKronicle: Safe answer…!

Mauboussin: …so I stay in the fence pretty much. But I got to say that I am a fan of…I am sort of a money ball fan so I think that both…I think both of those guys have a lot of money. But I think I like what the Red Sox have done with Epstein over the last few years. But, I am on the fence.

MartinKronicle: Theo Epstein is a rock star for sure. I think this might be influenced by the fact that John Henry probably has money with you, but then, again, what do I know.

Mauboussin: [laughs] Not at all, yeah.

MartinKronicle: Yeah. So good. A mentor of mine Ed Seykota used to say – coming back to the title of your book – that: “Make sure that your intuition doesn’t become ‘into-wishing’.” Do you see that a lot in your field, in your experiences, both as a teacher, as a head strategist and as a money guy?

Mauboussin: Absolutely. The first thing I would say about intuition is that it does have a role in decision-making. But I think it’s been vastly over glorified, in particular in its role in markets and in business.

And the way I like to think about this is, well, using what psychologists call the two systems of the minds: system one and system two. System one is your experiential system. It’s fast. It’s quick. It’s automatic and really difficult to control. System two is your analytical system: slow, purposeful, deliberate, but malleable. I think intuition works when you start off in an activity, say playing chess as a little kid. Every activity that you start, you’re in system two. So it’s the analytic side. You think of how each of the pieces move. But if you do it enough times, over time, it slides into system one and things become very intuitive. So there is intuition in certain sectors, but the key is that it has to have two conditions: One is you need to be dealing with the system that’s stable, or if you want to use a fancier term, stationary statistically. And second it has to be a system that’s linear – so ‘a’ causes ‘b’ the way every single time. It can’t non-linear. So the question I pose back is, when we’re dealing with chessboards, is it stable and linear? Yeah, pretty much. But when we’re dealing with things like markets or business, is it stationary and non-linear? I think the answer to that is yes. So there you have to be very, very careful about using your intuition.

What’s I think crucial about this, and to your quote, is that I think people often confuse experience with expertise. The difference is: an expert has a model that is actually predictive. Can actually anticipate what’s going to happen in the future. People that have experience often think that they’re experts and they can predict, but that’s not always the case because you’re experience may or may not be any indicator about what’s going to happen in the future.

And you think about people, for example, in the equity markets, my world. You started doing this 20 years ago, 25 years ago, there’s absolutely nothing in your experience that would have lead you to understand what happened over the last few years. So experience was not predictive in that case, and hence you have to be very careful about that. Yeah, I think that intuition works, but I think too many of us extend it at the boundaries and with some negative consequences.

MartinKronicle: I appreciate your feedback on that. I am always interested. I am a physically trained trader, having come from the hedge side very, very briefly, and then I moved to system development. So it’s all about Monte Carlo simulations and looking for expected outcomes in terms of trades, and we’re going to get to that for a minute. But also my foray into trading was learning how to be a tape reader. And I think that might be where intuition or a feel for the market could actually come into play. It’s a lost art on some level.

Do you have any experience with tape readers in terms of the old school way of trading?

Mauboussin: I don’t. I think that there is some value in being engaged. I mean especially when you’re trading, you have to be engaged. And, there probably is some sense in “feel the market,” and maybe the tape reading contributes to that.

That said, I think that…I don’t know if anybody has studied this systematically. Maybe somebody has.

MartinKronicle: Yeah.

Mauboussin: My sense is we tend hear the – like most things in life – we tend to hear the stories that come out to be favorable, and we don’t hear the stories that don’t come out to be favorable. So why I am absolutely convinced – and you know more than I do – that being a great trader involves being engaged, and there’s some element of that. I am open minded about it, but I just would be skeptical as to whether there is such a thing as a guy being a pure tape reader being able to generate like such returns.

MartinKronicle: OK.

Mauboussin: Just solely from that.

MartinKronicle: Fair enough. Paul Tudor Jones might disagree, but I don’t really know of everything that he uses. I know he was an Elliot Wave guy at one time, too.

Let’s get back to you. You and I are both in Michael Covel’s movie, “Broke: The New American Dream,” and I’ve watched it a few times, especially your stuff. Now in the movie and in the book you say – and I am kind of putting this together – that in a probabilistic environment you’re better served by focusing on the process not the outcome. And I say the outcome might be due to luck or skill. The public thinks: “If Mike Martin goes on TV and makes a call on Gold and and I get it right, it might be because I am expert. But I’d say in the short run, it’s probably much more random than that, and may it might be even more luck. Can you explain that for the listeners?

Mauboussin: Oh, yeah. I appreciate you bringing this up, and I think you’ve got a really important dose of honesty in all this. The way I think about this personally is that there’s a continuum in life of some activities that are pure skill and some activities that are pure luck.

So, you and I run a running race or something, you know the faster guy is going to win. And there are other things – roulette wheels or something – that are going to be pure luck. And almost everything else in life is some combination of these two.

I think what humans are really bad at is understanding where th