Thesis, Narrative or Just Another Disappointing Story

"What is most important is not dispelling particular erroneous beliefs, but creating an understanding of how we form erroneous beliefs." -Thomas Gilovich

Stocks are often managed on the basis of a thesis. This has come to mean that the manager has a clear expectation of how a stock will add alpha to the portfolio and she can express it in a tight sentence or two. The mere existence of a thesis suggests purpose, conviction and discipline. On the other hand, the dictionary defines thesis as an unproved statement or argument put forward as a premise. Too often the tentative nature of a stock's thesis is lost, inviting behaviorally motivated decisions that undermine performance. In this essay we examine the nature of the investment thesis and how, lacking sufficient self-awareness, it can be just another disappointing story.

Mind Your Thesis

Our unconscious brain plays a dominant role in the decisions we make. Many scientists now believe that the role of our conscious brain, to a large extent, is to create a narrative so that we can understand what our unconscious brain has already decided.

A thesis can, therefore, as easily be the end result of intense research and process or the verbal expression of one or more instinctive judgments. Consequently, the thesis for stock A may be fact based and built entirely from your process while the thesis for stock B might feel comparably formulated but reflect much less discipline. Understanding the veracity of each thesis in your portfolio can help you strengthen your process and improve performance.

Selling Your Thesis

Buying stocks often is a highly disciplined and process driven activity. Not so with selling. Rigorous investigation points to selling as being underdeveloped with regards to research, analysts' recommendations, capital expenditure and overall industry investment. The short shrift being given to selling, suggested by these signs of inattention, is underscored by the uneasiness exhibited as most managers explain that they are not as confident in their sells as their buys.

Selling is, therefore, more judgmental and thus prone to behavioral influences. One way this can be observed is through thesis drift. For example, a stock might initially be purchased based upon growth at a reasonable price (GARP) but as the price continues to fall it is reclassified and held as a value stock. This change in thesis might in fact be a case of nimble and responsive portfolio management or just another instance of the Disposition Effect.

The Disposition Effect is perhaps the most studied behavior affecting professional equity managers. It states that when choosing positions in the portfolio to sell managers are behaviorally more inclined to sell winners over losers. This behavior can lead to a relatively high turnover of gains in the portfolio and a commensurate longer holding period for losers. Redefining the thesis for a stock, as in the example above, can reflect the unconscious desire to avoid realizing a loss and formulating a narrative to help make that happen.

Painful Avoidance

Thesis drift can also result from cognitive dissonance. A term coined by the social psychologist Leon Festinger in the 1950's, cognitive dissonance refers to the discomfort we feel when holding on to mutually inconsistent beliefs.

In finance, cognitive dissonance commonly involves our sense of self efficacy. We are, after all, smart, trained and capable investors yet we often find ourselves owning a notorious loser. Our unconscious wants desperately for us to feel capable yet there is the not so small matter of this unfortunate position stinking up the portfolio. How we manage this dilemma can impact performance both today and tomorrow.

The self-aware professional confronts such situations by examining his process. His goal is to learn, improve and reduce the chance that the same misadventure will occur again. Others might formulate a narrative for why riding this stock down to the bottom was a reasonable decision. In such instances the self protective mandate of our brain may be initiated before we have even had a moment to think about what happened consciously. Knowing that our unconscious can override introspection is knowledge that can help us learn from the decisions made in 2008 rather than put them behind us too quickly.

Conclusion

The thesis under which you hold a stock is only as good as the process under which it was developed. Self-aware investors with rigorous process can rely on thesis to guide as well as explain their buys. When it comes to selling, however, the lack of discipline and process make formulating a sound thesis more challenging. Learning to question the thesis of each position held as thoroughly as that of a new buy is how many managers are preparing for the rebound. The alternative may have you generating a narrative that your clients won't be happy with.

References:
1. How We Know What Isn't So: The Fallibility of Human Reason in Everyday Life, by Thomas Gilovich, 1993, Simon and Schuster.
2. "The Origins of Cognitive Dissonance: Evidence from Children and Monkeys", by Louisa C. Egan, Laurie R. Santos, and Paul Bloom, Psychological Science, November, 2007.