Wednesday, December 10th, 2008
without a doubt

“What do you do when you’re not sure?”

So starts John Patrick Shanley’s Pulitzer Prize-winning play Doubt, the movie adaptation of which opens this Friday.The film features Meryl Streep, Philip Seymour Hoffman, and Amy Adams, about as fine a cast as you could have.  Streep has been nominated for fourteen Oscars and she’ll likely be honored again for this role, but she’ll need all of her skills to meet the standard set by Cherry Jones, who played the lead role on stage.  Hers was the finest performance I have ever seen. The setting for the play is a post-Vatican II Catholic school, but the issues are universal; all of us battle with ourselves and with each other about what we think we know.

Investment professionals are anything but shrinking violets and the well-worn phrase “often wrong but never in doubt” could be and has been applied to any number of them (including me, if memory serves).  The question of how to deal with uncertainty is of critical importance to leaders of investment organizations, and often is complicated by cultural norms that tilt to boldly-stated but relatively conventional opinions.

Somehow, firms (and the individual decision makers within them) must balance their advocacy of ideas and ideals with the knowledge that they might be proven wrong by the market.  The means to achieve that balance vary by the type of firm and the time horizon of the investment selections being made, so there are no easy answers, although some core principles do apply.

Essential to good decision making is a consideration of all possibilities in advance of making a decision.  It is critical to institutionalize the open exchange of ideas, to actively seek out those with points of view that differ from the consensus, and to celebrate and reward those that express doubt about the prevailing wisdom.  Most firms struggle to live up to those goals, and many instances of organizational failure can be traced directly to a discourse that was limited or unbalanced.  Particularly destructive is the behavioral tendency to anchor to a price, to a familiar market environment, or perhaps to the interests or beliefs of the boss.

Tactically, some firms try to limit the damage that can be caused by being wrong through the use of stop-loss orders, which have the virtue of acknowledging the uncertainty up front and clipping the losses of a miscalculation.  They have some drawbacks, however, including increased transaction costs and the possibility of missing normal price reversions.  In any case, a firm should have something — a stop-look or stop-adjust procedure of sorts — that is mandatory and real, not just for show.

Wherever possible, probability distributions (and not just of the “normal” variety) should be used to force expectations away from the single-point orientation that is common to most analytical tools.  For example, recently I saw a research report that was written about a firm that has been growing steadily, but which sells into an industry that is now under severe pressure.  The analyst had cut previous earnings estimates modestly (but which remained higher year-over-year) and used a multiple of earnings based on historical averages, yielding a target price that was more than twice that of where the stock was trading.  It was the very definition of a low-probability bet, likely to not pay off for the analyst or his firm, and one which gave no indication to the reader of the likely range of outcomes.

Shanley’s play explores the moral quandry of Sister Aloysius and how her judgment of the behavior of others is shaped by her inclination to see the world in black and white.  Decisions in all types of endeavors are subject to the same confusing and damaging tendency,Simoleon Sense | Two times recently, this site referenced interviews that were found on Neuronarrative with the authors of books on doubt and certainty.  This link re-links to an interview about the book Doubt, by Jennifer Michael Hecht, and the other posting was in regard to On Being Certain, by Robert Burton. and investors would do well to explore their processes for minimizing the harm that results.