Hooked on a feeling
Malcolm Gladwell’s Blink — the power of thinking without thinking published in 2005 broadly explored issues of decision making and the information used to make judgements. The premise was that in a range of situations, quick decisions made on limited information were more likely to be correct than slower decisions based on more detailed analysis.
Gladwell focused on the unconscious thinking or intuition that enables people to ‘know’ even before they have fully analysed a situation in detail.
He gives the example of a fire chief who ordered his men out of a burning house because the fire was “acting wrong” minutes before the floor collapsed.
It was not until later that he analysed the features of the fire that made him think this — much hotter than expected, quieter than expected and so on. It turned out that it was a more serious fire that had been raging for some time in the basement below.
You know the feeling yourself when you leave the house and realise immediately you have forgotten something well before you know what it is — you then systematically go through the items to work out what it is: phone; wallet; sunglasses; and so on. It’s the ‘gut feel’ of knowing that something is wrong (or right) without even (at least at that point) knowing why.
While the book only touched briefly on investing — the implications of George Soros’ back pains for example — the concepts and conclusions are relevant to identifying good investments and selecting good investment managers.
Take stock-picking fund managers, for example.
The way they normally present their investment approach is to focus on the extended process of selecting companies for detailed due diligence, spending time going back through the company’s financial history, studying the industry, meeting the company management and then presenting a detailed case of the pros and cons of the investment to their internal investment committee before deciding how much to buy (or sell) and at what price.
I doubt whether this is the essence of good stock picking or investing generally.
I’m not suggesting good equity managers shouldn’t do this as part of their process, but of the hundreds and thousands of companies out there, what are the chances that by almost randomly selecting companies (albeit usually from some quantitative screen) one will find the one and finish an extensive and detailed review at exactly the time that the stock is available at an attractive price? In textbooks maybe, but not in the real world.
For the truly successful stock picker this is really only part of the process. The real investment decisions are often made on the run, on an ongoing basis using the information not just from such detailed analysis previously but from years of practical and market experience. They are then in a position to make changes when new information comes out, when a stock sells off on some negative news or when a line of stock becomes available, and so on.
I remember talking to one very successful equity manager a few years back who was comparing their investment approach with another (ultimately much less successful) larger group.
His view was that if you knew the company and industry well and something changed then one would very quickly know how to respond from an investment perspective. They didn’t need to do the detailed research that the less experienced analysts at the larger group were doing to justify positions. If they couldn’t sum up the investment case in a few bullet points then there probably wasn’t one.
Gladwell quotes one study of people who make decisions under pressure and one of his conclusions is that “when experts make decisions, they don’t logically and systematically compare all available options. That is the way people are taught to make decisions, but in the real world it is much too slow.” Rather, they would do it by “drawing on experience and intuition and a kind of rough mental simulation”.
Sometimes we simply take too much information into account in making decisions.
Gladwell refers to a study that showed that doctors judging the risk of heart attacks after going through a detailed list of client symptoms and circumstances were less accurate then a very simple decision tree system related to several key risks.
While more information usually increases the confidence of those making the judgement that they are right, it often does little to improve accuracy. It’s why the Internet and the explosion of information it allows hasn’t made it easier for day traders to make their fortunes.
What about selecting fund managers rather than stocks?
Well, if you accept the comments above, then the selection of good fund managers is more about trying to judge whether the key individuals have the sort of intuition we’ve discussed. Yes, the investment process and the business infrastructure are important, but these really are just to indicate whether they are able to play in the game.
Picking good investment managers is primarily about judging people — their wisdom, their experience and their good judgement. The problem is that making such judgements of fund managers can usually only be done well by those who have significant experience themselves and again these judgements are often heavily based on intuition.
It’s the experience of coming out of a meeting and having a strong opinion (positive or negative) without being able to put one’s finger on the reasons. Getting through the marketing overlay to even get this sense has become hard for many investors.
Perhaps unfortunately, I think much of the investment industry today has moved away from recognising that intuitive judgements (in the right hands) can be very valuable and the key to good investment decisions, whether picking stocks or picking managers.
I believe this is partly because, in a rapidly growing industry, many fund managers and fund researchers have not had the time or relevant experience to develop this intuition well, and partly because investors are becoming ever more demanding, such that a lot of time ends up being spent on those aspects of the whole investment process that add little value except in making investors feel more comfortable.
While I have long been a supporter of boutiques and hedge funds, even I am becoming somewhat concerned with the continued explosion of new managers and funds, especially those focused on Australian shares. Increasingly they seem to have only a few years of real investment market or funds management experience.
It begs the question — can these people possibly have any real investment intuition or edge at all in what are becoming increasingly crowded and competitive markets? Have they just been lucky and ridden the bull market?
Developing and using intuition is probably a bigger problem for those selecting fund managers because the average life of a fund researcher these days seems to be less than a couple of years before they move onto something else completely.
It is also much harder for fund researchers because most are required to produce highly visible research reports that often come under a lot of scrutiny. A comment such as “something made me uneasy, or I couldn’t see the guy’s edge” just doesn’t seem to cut it with clients when it’s written in print. The remuneration system for most research houses don’t encourage such comments either.
However, those outside research houses might think that all this means they can neglect detailed due diligence and simply run money or pick managers by the seat of their pants. Unless you are Warren Buffet this is probably not a wise move. Firstly, because the detailed due diligence over a long period is necessary to gain the sort of experience that helps develops one’s intuition. Secondly, in the current environment, compliance will ensure that clients will continue to demand detailed due diligence.
Of course, even if you are able to develop good investment intuition and use it, you will still make mistakes. Mistakes are inherent in the investment businesses.
As Gladwell puts it: “Truly successful decision making relies on a balance between deliberate and instinctive thinking.” It’s not a case of analytic versus intuitive as good or bad — it’s how you use them.
However, looked at this way it should highlight that good investing is not primarily about a defined and rigid process or a big brand name, but about people — their wisdom, their experience and their ability to make good judgements. Realising this and developing this experience makes finding good investment managers easier in many respects, but in other respects it also becomes harder.
It is easier because it becomes easier to exclude managers on a first cut.
However, it becomes harder partly because the reasons for decisions might not look as convincing when explained to others or clients.
Still it brings to mind one of my favourite Warren Buffet quotes (which I have used before): “It is better to be approximately right then precisely wrong.”
Dominic McCormick is chief investment officer of Select Asset Management .
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