Self awareness is increasingly essential to the ethos of many investment managers. That is because active management requires judgment, and judgment is best exercised when all the facts and influences are known. The less you know, the more judgment becomes subject to behavioral tendencies. Selling, which is typically less disciplined than buying, is far more susceptible to such behavioral influences. Achieving and maintaining self awareness, then, has enormous potential for helping managers make better sell decisions.
Shooting in the Dark
Self awareness begins with accurate observation. Without adequate information about the decisions they make, investment managers are severely limited when it comes to assessing the effectiveness of their selling. Consider golfing. What if a golfer never knew the accuracy of individual shots? Instead she received only the final score. How would she know her strengths or weaknesses? What part of her game would she choose to improve?
his is exactly the dilemma that equity managers face regarding selling. The only feedback most investment managers receive about their sell decisions comes from total return. That's both aggregated and compiled well after the actions, and thereby all but useless for learning about effective selling. Lacking measures of sell effectiveness, managers must rely on hindsight, intuition and overly simplistic measures of success to help foster greater self awareness. These undisciplined approaches, however, often lead to errors in judgment. Childre and Cryer, authors of From Chaos to Coherence, explain the shortcomings of such an approach this way: "Remember, the mind likes to assume it 'knows what it knows' but often its perceptions are just not accurate."
Memory is Fiction
Reflection is essential to self awareness. But, memory alone is inadequate if your goal is to improve portfolio performance. Much of what our memory provides is a narrative that makes sense out of what we seem to remember about past events. And such recollections are heavily influenced by other factors, notably our emotions.
So when we look back over our sells for the past year, we tend to remember those that had the greatest emotional impact: big winners, big losers, or a string of small gains that kept us pumped up. The feelings that accompany these events are what make them memorable for us, and so it's no wonder, then, that hindsight often leads to learning the wrong lessons. False insights are then translated into undisciplined rules-of-thumb that weaken rather than improve sell effectiveness.
A Thesis on Memory
Thesis is the reason investors/clients buy or own a stock. The reason can, of course, change over the life of a position. This “thesis drift” might, for example, be based on a stock that was purchased based on growth at a reasonable price (GARP). As the price continues to fall, it is reclassified and held as a value stock. This change in thesis might be a case of nimble and responsive portfolio management or just an instance of Disposition Effect (selling winners over 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.
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, it commonly involves our sense of self efficacy. We are, after all, smart, trained and capable investors; yet we sometimes find ourselves owning a notorious loser. Our unconscious wants desperately for us to feel capable, yet it is no small matter that this unfortunate position is stinking up the portfolio. How we manage this dilemma can impact performance.
The self-aware professional confronts such situations by examining his process. The 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.
A Rule by Any Other Name
Now add a sense of urgency. The need to make q
uick decisions in a highly charged environment increases the challenge faced by equity managers. Fortunately, nature has endowed us with a powerful brain to help cope with such fast-paced challenges. One adaptive response we have learned is to use rules or heuristics to guide decision-making. Daniel Kahneman, the Nobel Prize winning psychologist, offers this insight in his book, Choices, Values and Frames: "When faced with a complex problem, people employ a variety of heuristic procedures in order to simplify the representation and the evaluation of prospects (choices)."
But without clear and quick feedback, we are just as likely to formulate the wrong heuristic as the correct one. So how does a manager get this feedback in order to get a better handle on what is behind some of her decisions?
It starts with learning to manage unconscious impulses.
Disciplined investing is not the absence of heuristics. Rather it is the mindful blending of rigor and rules-of-thumb reflecting substantial self awareness. Deep self knowledge provides managers the assurance they need to invoke intuition effectively, whether when probing for better sell signals or feeling their way through today's tumultuous market.
Buddha, The Ultimate Alpha Source
An extended stay in the Himalayas might be just the thing to help us develop greater self awareness. But this probably is not a practical option. Yet there are steps managers can take towards financial enlightenment that are simple and effective. Here are two ideas from practitioners.
Be the oracle. Just write down every sale that's made and why. Do it at the very time the investor/client actually decides. Add a little color, such as is the investor selling winners or losers (i.e., looking for The Disposition Effect); recent price movement (since volatility often affects sell decisions); and primary motivation for liquidating the position (i.e., stop loss, target price reached, thesis disproved). Fairly soon you will have data that can help you see patterns in selling that might prompt further investigation or improvements to this discipline. Having the map of investment decisions in front of you is the first step in understanding if these sells reflect intention or behavioral reactions.
Suspend judgment. Investment committee meetings often begin with an outpouring of opinions, judgments and aching convictions. Once this highly charged momentum is underway it is difficult to objectively listen to and examine facts. The self-aware investor guards against these group dynamics and works to capture maximum insight from diverse perspectives. Try starting the next meeting by suspending the judgments and focusing only on facts for the initial 15 minutes or so. This will enable all participants to engage in the conversation with a common perspective and to question facts before they become someone's opinion. A big part of developing greater self awareness is simply making room for it.
Self awareness is a best practice among leading investment managers. This softer aspect of investing can help you harden your active management processes. Self awareness is built on three essential elements:
1) the desire to improve,
2) a clear understanding of current circumstances and
3) unambiguous feedback about how any changes you make are either working or not.
As you strive for your own self awareness, ask yourself this: If selling is ineffective but never measured, is the portfolio's performance really impacted?
Formerly a successful portfolio manager and chief information officer with an investment firm, Michael Ervolini is now CEO of Cabot Research, LLC, which helps investment managers improve portfolio performance through the application of Behavioral Finance.
To learn more about Cabot Behavioral Analysis go to www.cabotresearch.com/ or send e-mail to [email protected]