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How to create the ideal decision-making environment – with Michael Mauboussin, Part 2

How can investors create the best environment for decision-making? We had the chance to put this question to market strategist and author Michael Mauboussin on the latest episode of The Value Perspective podcast

28/01/2020

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Given a blank sheet of paper, how would you set about creating the ideal environment in which to make decisions? This is an aspect of decision-making that even professional investors can overlook but, having just worked through Three ways to make better decisions with market strategist and author Michael Mauboussin in a new episode of The Value Perspective podcast, we had a great opportunity to address it.

In Mauboussin’s view, the importance of giving yourself the best chance of reaching the most appropriate decision in the probabilistic world of investing is underlined by research that suggests some 70% of the excess returns generated by an investment firm is a function of the business itself. “So, rough order of magnitude, the organisation is twice as important as any fund manager or other individual within it,” he adds.

Acknowledging there is no set answer to the question of the ideal decision-making environment, Mauboussin references the dictum of US architect Louis H Sullivan that “Form follows function” before observing: “What I would always suggest to any investment organisation is to step back and ask – how do we think we can generate excess returns?

“You can imagine there is a whole continuum here from, say, Jim Simons at Renaissance Technology – very high-frequency trading, very quantitative dealing, with unfathomable amounts of data – to Warren Buffett, who is very long-term oriented and makes relatively few decisions, but they are of a great order of magnitude. Both have been very successful but the processes they embrace are very different.”

Here Mauboussin introduces the concept of ‘congruence’, which he defines as “aligning your process with what you believe to be your source of edge”. Now clearly we were never going to pass up such a gilt-edged opportunity to highlight what we believe to be Our own four edges, here on The Value Perspective, but Mauboussin continues: “You can deconstruct this a bit further by asking, what is common in all processes?

“First, you are going to have access to data – and notice I don’t use the word ‘information’ just yet – and then that data needs to be translated into information, which I mean very much in the sense of ‘information theory’. From there, all investors will select securities – so figure out what stocks to buy or sell – and then, finally, they will think about portfolio construction.”

To make the very most of those basic ingredients, Mauboussin says, two further elements are key: “One is finding your edge and the second is betting properly – that is, portfolio construction – which can often also get short shrift in this whole process. To me, then, the key is to step back and say, how do we think we’re going to be able to do this effectively, align our processes and then try to stay as close to that as possible?”

A potential danger here, warns Mauboussin, is if an organisation says it does one thing but, in reality, does another. “Baupost founder Seth Klarman offered a wonderful visual when he suggested that if you took the roof off their office and saw everyone in the investment team was doing exactly what they had said they would do, then the firm was doing its job properly,” he says. “Again, it’s this complete sense of congruence.”

Mauboussin’s last point on this theme relates to stress and short-termism. “What we know is that different levels of stress in organisations will affect people’s decision-making quality in different ways,” he says. “There is some beautiful literature on this but the key takeaway for investment firms is, if you increase the amount of stress on people, it tends to shorten their time horizons.

“Look, too little stress can be bad also. An appropriate amount of stress is very helpful – but too much stress tends to make even long-term oriented organisations focus too much on the short term and we saw lots of evidence of that, for example, in the financial crisis. So leaders of organisations will want to have performance orientation and people working hard and obviously a culture of excellence.

“But they need to bear in mind that stress and focusing on short-term performance can lead to behaviours that are antithetical, ultimately, to long-term success. So, to me, the great investment organisations are those that are able to maintain an even keel. When things are going well they tend to bring things down a bit and, when things are going poorly, they tend to bump people up to try to keep them on the straight and narrow course.”

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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