A decent investment process is made up of three basic components:
- Generation. You need to come up with good investment ideas.
- Examination. You need to subject each idea to deep scrutiny.
- Implementation. You need to construct a portfolio from the best ideas.
Each of those parts of the process has its unique set of challenges. It’s difficult to do any one part better than your competitors, let alone all three. And there are places in between these hard components where it’s possible to either slip up or gain an edge. Those in-between spaces are where the soft issues of investment management play a subtle but significant role.
One such place is idea-aggregation, which sits between generation and examination. Many investment professionals are pretty good at coming up with investment ideas, but the teams in which they operate are often not great at ensuring that the best of these ideas are aired and shared. This means that an inferior set of ideas makes it into the examination phase, which means that even if you implement well, you’re doing so from a lesser pool and your portfolio will be of lesser quality.
Idea-aggregation is an area where many investment teams unnecessarily squander a lot of their innate horsepower. Why might this be so? Here are three variations on the theme of group-dynamics that might serve as explanation.
The best ideas are those that contain the most potential to add alpha. By definition, those ideas need to be different to consensus opinion. That consensus can exist in the context of entire markets, or your group of key competitors, or even your own team. It’s risky for a member of your team to bring an idea that might be outside the currently acceptable bounds of consensus.
The members of your team are subject to both normative and informational social influence. The translation of this psychospeak is that they want to be liked and they need to be right. Hardly surprising, but at least one of those desires is placed in jeopardy if they bring an unconventional idea. The more unconventional, the greater the alpha-opportunity, but also the greater the personal risk. This leads members of your team to air a subset of their ideas – the more conventional ideas that contain less alpha-opportunity and less personal risk.
If a conventional idea bombs, you have the safety of the herd. If an unconventional idea goes pear-shaped, you’ll look wrong (maybe very wrong) and you’ll lose some popularity points (maybe a lot). That’s not good for your career. JM Keynes said many smart things, one of them being that it’s safer to be conventionally wrong than unconventionally right.
This is loosely connected with the uncomfortable reality that wherever you have a gathering of more than two people, you will have politics. Many investment teams are highly political, despite protestations to the contrary. As I wrote in another article (Investment Debate), the political flavour will depend on the state of the team’s dominance hierarchy.
Where this hierarchy is unsettled, it can give rise to a high degree of manifest interpersonal noise, a fierce knife-fight amongst a few members to establish dominance over the rest of the team. In these battles, the main protagonists treat a degradation in the quality of investment debate as little more than collateral damage.
An unstable hierarchy also gives rise to a high level of latent noise, a type of noise that is self-obscuring, where the emerging top dog expends great effort to quash dissent and cement his position. This latter form of noise is paradoxically experienced as silence.
Some members of the team will find it intolerable to not be able to give voice to their opinions, and they will choose to take their expertise to the team’s competitors. Those members of the team who are prepared to tolerate the situation will survive by self-censoring, by neither offering their non-consensus view nor providing a reality check to the dominant voice.
Few teams actively seek to get better at idea-aggregation because of the general antipathy for group decision-making, which is equated with the phenomenon of groupthink. Groupthink is a behavioural form of latent noise that is responsible for a significant share of decision errors. But it is wrong to directly equate group decision-making with groupthink.
It is not groups per se that give rise to groupthink, but rather it is the suppression of dissenting opinions by the dominant voices that characterises groupthink. Groups that aggregate well are very seldom, if ever, subject to groupthink.
There is one organisation that has invested significant effort in the science of aggregation, and the results are evident in the firm’s investment performance. Ray Dalio founded Bridgewater Associates in 1975 as an investment advisory service, and it has since become the largest hedge fund in the world with $160 billion under management. During this time the firm generated cumulative dollar-returns of $50 billion for its investors, more than any other hedge fund in history.
The way in which the opinions of individuals are aggregated is key to the firm’s success. Dalio said in a TED Talk: “Collective decision-making is so much better than individual decision-making if it’s done well.” As an example, members of the investment team, as well as other employees, are required to use an in-house app, called the Dot Collector, to rate one another in real time on about 75 attributes so that opinions can be aggregated and weighted according to each individual’s “believability”.
Dalio says in his book, Principles, that the Dot Collector “…promotes open-minded, idea-meritocratic, collective decision making.” It is a grounded way of reaching better decisions, based on the collective input of team members. But, crucially, the aggregation more heavily weights the opinions of those who have greater credibility on the issue being discussed. This allows Bridgewater to make decisions that are not democratic or autocratic, but meritocratic. It’s not the boss’s idea that gets implemented, or the average idea, but the best idea.
Not every firm is able to emulate Bridgewater and not every investment professional would like to work at such a firm. But you can’t easily dismiss what they’ve achieved with their emphasis on idea-aggregation.
Few investment teams aggregate well because it’s difficult. However, the simple fact that so many teams are really not terribly good at aggregation means that the way that your team collaborates is a source of competitive advantage, possibly even the single greatest source.
- What’s getting in the way of better idea-generation in your team?
- What could you, personally, do differently to improve this situation?
- Who else do you need to enrol for this change to gather momentum?
- Justin Newdigate: Noise (2019)
- Ray Dalio: Principles (2017)
- Michael Mauboussin: Think Twice (2013)