In his recent interview with Tobias, Ted Seides from the Capital Allocators Podcast discussed Building A Process To Make Better Investment Decisions. Here’s an excerpt from the interview:
Tobias: Let’s just move on to decision-making. You’ve got this great quote at the beginning of your decision-making chapter from Drew Dickson, who studied under Fama at the GSB, now Booth, and he says something like, “If Eugene Fama who came up with this area of study still makes these behavioral errors and Drew Dickson is going to make them, too.” What’s the lesson from that? How do we handle it? How do we make better decisions? What are we doing wrong? How do we get to that point?
Ted: Yeah. I think everyone listening to your show is probably familiar. I’ve had Annie Duke on the show a couple times, and Michael Mauboussin. Gary Klein a little bit different. He’s a cognitive psychologist who created the premortem analysis. We don’t need to go through the behavioral parts of it. Our brains are hardwired to make bad decisions, to use system one brain thinking, and so the question is, you can’t change it, even if you’re aware of it, what you can do is build processes and systems to try to mitigate it somewhat. Some of those, you could think about how you structure a decision-making unit– there’s one thing if it’s, by the way, an individual, and then you can do the same things. A lot of what the investment offices that I talked to their teams, so I structure this around teams. So, there’s a little bit of the structure of the team, how they conduct themselves, and then their own thought process both as individuals and team members.
There’s a structure, Michael says, “The optimal structure for decision-making team is four to six people. It can be effective in as few as three.” But it’s not 10, it’s not a committee. It’s harder with one, you need to get a sounding board. It’s very simple. Then, of course, within that, you’d like cognitive diversity. I always point out that cognitive diversity and social diversity are not the same. Social diversity often creates cognitive diversity, but what you’re looking for is people that think differently, not people that look different, but think the same. Then you can move on to conduct and how do people conduct themselves within that group.
The key thoughts are you want to engender cognitive safety, and you want people to be able to think independently, and a lot of that starts with the leader of the group. So, there’s this behavioral notion that it’s very easy to infect other people with our beliefs. Because of the way the brain works, if I say something, you first believe that it’s true, and then you might assess it. If you’re the leader of a group, what that means is, you don’t really want to express your opinion till the end of the meeting. You hear good decision-makers, people saying, “No, we start with the youngest member of the team, the most inexperienced member team and work their way up.” We start with the introverts first that aren’t known to be the most influential and work towards the extroverts, because you want everyone to be able to express their opinion. Then, it’s really up to the leader to allow different opinions to be both heard and not punished if they differ from the leader’s opinion.
Tobias: I thought Simon Sinek says something similar to that. Very similar process, start with the person who’s lowest on the totem pole or the most introverted, and then don’t express an opinion. That accords with what I’ve heard in the past.
Ted: Yeah, look, this is part of what I did in this book is these are– I don’t want to say fundamental truths. In certain disciplines, when you read how people think about it enough, you sort of say like this is how it works best. No different than if you read Graham and Dodd, and you understand this is how value investing generally, that people think about it works, it doesn’t mean it’s easier to do. Then that last piece, when you’ve got that team speaking the right way, how they think and process information. Annie uses this great phrase from her first book, Wanna Bet? If somebody speaks about something in absolutes, and you say, “Wanna bet?” they think about it for a second and they immediately shift the system to thinking and they say, “Do I really believe that with 100% certainty? Or do I want to put probabilities on it?” That whole notion of thinking about things with probabilities.
The next is thinking about the outside view and base rates, incredibly important. I love talking about that with hedge funds. The average allocator in the business does not believe that hedge funds as a group generate sufficient returns, but they all believe that their group of hedge funds will. It’s not to say they’re wrong, but it is to say that whatever their expected return is on their group of managers might want to be colored by the base rate, which they believe is lower than– or significantly lower in most instances than their own portfolio of hedge funds. By the way, that’s true of every single hedge fund investor. In aggregate, if they are getting the average.
Then, the last is this notion of how you conduct risk assessments once you’ve pretty much come to a decision. Whether you use a premortem analysis or red teams and blue teams, or if one person, even just a pro and a con list and running it by somebody else, there are just ways that you’re trying to create uncertainty, to remove your own overconfidence, and to unearth all the different things that you could imagine happen, that you may not. We started talking about the Buffett bet, did I think that if, in fact, the market crashed, which I thought was a possibility, that there’d be some type of intervention that would never actually let the market stay down for a long period of time? No, never came up. If it had, I still probably would have made the bet, but I wouldn’t have thought the odds of winning were as high.
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