Seeking Wisdom — an Investor’s View: Understanding and avoiding biases and judgment errors
Venture investors deal daily with imperfect, asymmetric information. Seeing the present is sometimes harder than it might seem.
Our world is pell-mell gripped by a pandemic, political unrest, and a global trade war — all of which have created more economic uncertainty than at any time since the Great Depression. Divergent views convulse our communities. In response to the pandemic, South Korea implemented draconian lockdowns while Brazil permitted unfettered movement. Global responses among other countries spread across this continuum. Though COVID-19 has disrupted the US more than Europe, key indices are up 15% in the US and down 18% in Europe in 2020. As civil unrest clogs American cities, Trump inspires both unswerving loyalty and vitriolic antipathy among US citizens.
How does one make sense of such divergent responses to these shared challenges? If responses vary so widely for current matters, what does this portend for the future? Thomas Carlyle, a 19th century historian and philosopher, tells us “the task of man is not to see what lies dimly in the distance, but to do what lies clearly at hand.” Iconiq Capital takes a similar approach: “We seek to understand the present clearly rather than anticipate the future.”
Seeing the present is harder than it might seem. Amy Herman, author of the Art of Perception, shows us that our vision is fraught with illusion even when we are all looking at the same picture. In one classic example, one half of the audience saw the central figure in a painting as blue, the other half saw it as yellow. Even when she highlighted the difference, we could not shift our frame of reference. The painting remained blue or yellow to observers and there was no easy way to mediate our different views.
If different perspectives are intractable in a painting, how much more challenging is it when we guard vested interests with the panoply of varying facts, images, and anecdotes at our disposal? Mayhem may manifest itself even without the helping hand of “fake media.”
Forty years ago, economics assumed Perfect Rationality — rational actors allocating time and assets with equal access to ubiquitous information. This seemed a utopian worldview even to an idealistic college student. Now we see Rational Economics as a simplistic, outdated model.
As venture investors, we deal daily with imperfect, asymmetric information. Behavioral economics has also debunked the rationality of actors. Daniel Kahneman and Amos Tversky won Nobel Prizes in Economics in 2002 for their Prospect Theory, which explained the consistent anomalies and contradictions in human behavior, based on thirty years of research on biases. They introduced the financial world to anchoring, loss aversion, focusing illusion, and other cognitive biases that account for systemic anomalies in judgment and decision making.
Psychologists have significantly advanced the study of biases in the past 25 years. The Cognitive Bias Codex now identifies 191 biases. In Risky Business: Unlocking Unconscious Biases in Decisions, Mark and Anna Withers bundle 117 biases into a manageable framework featuring eight personality traits. Paul Bevelin focuses on 28 biases relevant to investors in Seeking Wisdom: from Darwin to Munger. See my overview of the book here.
Improving Investors Performance by Adjusting for Inherent Biases
The study of biases may seem mundane for investors focused on cutting-edge technology. Yet, if they are relevant to mainstream financial investors, biases are more salient in venture capital where information asymmetry and arbitrage opportunities may persist for months or years.
Charlie Munger at Berkshire Hathaway described his own reluctance to grapple with biases: “I came to the psychology of human misjudgment almost against my will; I rejected it until I realized that my attitude was costing me a lot of money.” Having studied biases for decades, Munger has made it central to his investment process: “If you want to avoid irrationality, it helps to understand the quirks in your own mental wiring and then you can take appropriate precautions.”
Former Goldman Sachs partner Robert Rubin tells us in his book, In an Uncertain World: Tough Choices from Wall Street to Washington, that the role of a prudent investor is to make consistently good decisions regardless of the outcome, as good results can come from bad decisions and bad results from good decisions. Our investment process at NGP Capital is designed to yield good decisions, yet this relies on rigorous due diligence, faithful disclosure of diligence findings, and sound partner judgment. No investment process, however well designed, can assure the consistent application of these standards. Each of us must unstintingly apply our process diligently.
Jeff Bezos invoked the Narrative Fallacy as a central challenge when describing the rise of Amazon in Brad Stone’s book, The Everything Store: Jeff Bezos and the Age of Amazon. “When a company comes up with an idea, it’s a messy process. There’s no aha moment,” Bezos said. Reducing Amazon’s story to a simple narrative, he worried, could give the illusion of clarity rather than the real thing. Since Amazon requires six-page written memos for major business decisions, Bezos has much experience discerning narrative fallacies.
If it’s true for Amazon, an established public company with troves of publicly available data, how much more salient is the problem of Narrative Fallacy in venture investments? For example, in reviewing our two most recent investments, we found that an equally valid alternate narrative could be constructed that would present a strikingly different view than the investment case presented.
We can now better appreciate the primacy Iconiq Capital has placed on “understanding the present clearly.” As Seeking Wisdom and Risky Business both illustrate, this is a task fraught with illusions and mental traps even with perfect information.
Charlie Munger believes investing is a war of mental models. Delivering superior investment results requires models that approximate reality well and investment decisions that neutralize the many biases that impair judgment.
Philip Tetlock’s thirty-year study of forecasting supports Munger’s view. In Superforecasting: The Art and Science of Prediction, he found that hedgehogs outperform foxes. Those who meticulously build and adjust data-driven models outperform acknowledged experts whose forecasts rely mainly on domain expertise.
Conviction is a prerequisite for any investment sponsor. Yet conviction should not distort the investment narrative. As British philosopher and Nobel laureate Bertrand Russell said, “What is wanted is not the will to believe, but the will to find out, which is the exact opposite.”
Warren Buffett said, “Having a certain temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline.” According to Roger Lowenstein in Buffett: The Making of an American Capitalist, Buffett epitomizes patience and discipline: “Buffet’s genius is largely a genius of character — of patience, discipline and rationality … His talent sprang from his unrivaled independence of mind and ability to focus on his work and shut out the world.”
In the next two weeks, I will talk further about how Buffett and Munger have built their world-class investment temperaments using investment filters, mental models and checklists. There is a lot here and two weeks of vacation have produced much to ponder. I hope to distill my journey of the last couple weeks in a few (hopefully) bite-sized, digestible chunks.
In the meantime, make a difference and be the best you this week!
Originally published at https://www.linkedin.com.