Inside-Out Investing

"It is the optimistic denial of uncontrollable uncertainty that accounts for managers' views of themselves as prudent risk takers, and for their rejection of gambling as a model of what they do." -Daniel Kahneman

Analysis is fundamental to equity investing. Deep dives require that you apply extensive energy and talent into understanding a company and its ability to deliver excess returns. Yet this activity can awaken behavioral tendencies that short-circuit your analytic processes. Consequently, rigorous analysis can heighten the potential for over optimism at exactly the moment when greater objectivity is needed. This essay examines the importance of calibrating judgments as a critical element of self-awareness and honing investment skill.

The Deep Dive

The greater the opportunity or risk associated with an outcome, the more analysis typically is applied to the decision. Investors commonly employ a process or framework to guide them through the steps of detailed company analysis. Such steps are analogous to what biologists, chemists, physicists and others refer to as the scientific method.

Presented with a challenging decision the problem is first reduced to its major components. These, in turn, are further deconstructed to smaller and smaller components facilitating clear understanding and confident resolution. After gathering and analyzing appropriate data for all subcomponents, the process is reversed and an understanding of the initial question is constructed by assembling your understanding of the components and their relationship to each other.

Done well, deep analysis can lead to rich proprietary insights about a company's likely performance or intrinsic value. This is the "information advantage" that skilled professionals bring to portfolio management. Intense rigor can also produce over optimistic conclusions — reflecting a run-away process.

Motivation Please

Thinking is more emotional than commonly believed. The cognitive process itself draws upon both the analytic and emotional parts of the brain. Reasoning is a blended outcome of the "best fit" for the data under consideration plus unconscious filtering and shaping of that data to support beliefs, biases or desires within the unconscious. This model of thinking, known as Motivated Reasoning, helps explain why even the most careful experts engage in over optimistic assessments when performing rigorous analyses.

Excessively optimistic forecasts of risky outcomes, according to Professor Kahneman, are linked to "... three main forms of a pervasive optimistic bias: (i) unrealistically positive self-evaluations, (ii) unrealistic optimism about future events and plans, and (iii) an illusion of control." Rigorous analysis often ignites these unconscious motivations resulting in both narrow framing of the possible outcomes (extreme possibilities are discounted) and higher certainty or success being assigned to each subcomponent evaluated — as if by thoroughly analyzing a risk it has been rendered less risky.

Judgment is further affected when issues are viewed as unique. "The natural way to think about a problem is to bring to bear all one knows about it, with special attention to its unique feature," says Professor Kahneman. This is precisely the dilemma of thesis management.

Inside-Out

The deep dive reflects what Professor Kahneman terms the "inside view." This is the view of a situation that is based on judgments applied to specific facts about that situation. Michael Mauboussin, author and Chief Investment Strategist for Legg Mason Capital Management offers a less flattering description: "Inside views are judgments about information gathered; they involve anecdotal evidence and fallacious perceptions." Yet, inside views are the very cornerstone of the process used by analysts and managers to shape investment decisions.

One technique recommended by both Kahneman and Mauboussin for managing the perils of inside views is to balance them with "outside views." Outside views are based entirely on facts. They ignore specific attributes of the situation under consideration. Instead, the outside view looks to typical outcomes for similar situations. It accomplishes this through the use of statistics compiled from a group of relevant comparable opportunities.

Consider a company analysis that requires forecasting the expected revenue stream from a drug currently in Phase 3 trials. Formulating such an outcome conventionally involves many steps including: estimating the chances that the trial will be successful, anticipating a likely efficacy for the new drug and then translating this information into estimates of market size, unit demand, cost and price. Each of these seemingly objective judgments will reflect selected experiences in your memory and the belief you have in management's ability to think strategically and execute effectively — a classic inside view. Approaching the same task using an outside view would begin by identifying like companies that have attempted similar endeavors. Once identified the results from this group of comparable situations would be analyzed to determine benchmarking information such as: percent success/fail, mean outcome when successful and the standard deviation across results.

Foregoing inside views is not realistic for most investors. Seeking assets that can generate excess returns is, by definition, hunting for uniqueness. Highly skilled investors, however, are experts at isolating truly unique characteristics for any opportunity. Then they rigorously analyze these characteristics as appropriate, drawing upon outside view facts to sharpen judgments and spotlight key risks.

Conclusion

Rigorous analysis is, in large part, what professional investors rely upon to make buy and sell decisions. This can lead to over optimistic assessments reflecting the shortcomings of inside views. Outside views can be incorporated into the evaluation process, helping calibrate interim steps of your analysis. The take-away for refining your investing is this: inside views may be essential for identifying opportunities that are well reasoned while outside views help keep your judgments reasonable.

References:
1. "Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking", Daniel Kahneman and Dan Lovallo, Management Science, Vol. 39, No. 1, January 1993.
2. "Think Twice: Harnessing the Power of Counterintuition", Michael J. Mauboussin, Harvard Business Press, Fall 2009.
3. "Motivated Reasoning", A Behavioral Matters essay, Issue No. 11, April 15, 2009, available at www.cabotresearch.com.