Wednesday, October 25, 2006

Decision Making and Uncertainty

Investing and management are in many ways exercises in decision making.

Where to invest? Where to focus? What are the risks? What is upside, the downside, and what to do and, just as importantly, what not to do?

Thoughtful investors and managers work hard to analyze the pros and cons of a given decision, however, no matter how diligent the analysis the final decision will be a judgment call that involves a large degree of uncertainty.

If imperfect knowledge is a given and yet decisions must be make, what to do?

Bob Rubin is well known as a legendary arbitrage trader, co-CEO of Goldman Sachs, and Secretary of the Treasury. His wonderful autobiography In an Uncertain World provides important insight and lessons into how to best make decisions under uncertainty. The governing principle of his book is that nothing is provably certain.

He writes,

"In arbitrage - as in policy making - you also have to be able to pull the trigger, even when your information is imperfect and your questions cannot all be answered. You have to make a decision: Should I make this investment or not? You begin with probing questions and end having to accept that some them will be imperfectly answered - or not answered at all. And you have to have the stomach for risk."

Rubin does not believe that given the certainty of uncertainty that decision making should be from the gut or based on intuition. Rather he argues that decision making is fundamentally about calculated risks. He stresses a focus on defining a set of possible outcomes, quantifying the probabilities and payoffs associated with each outcome, and then quantifying the expected value payoffs for each outcome identified.

As an arb trader and policy maker, Rubin focused on identifying the potential upside and downside risk, the net of which is the expected value. For example, at GS he looked to take risks that would generate a return of no less than 20% on the firm's capital.

Similarly to Naseem Taleb's book Fooled by Randomness, Rubin stresses that good decisions that appropriately weighed the pros and cons can and will have bad outcomes. Also, it is clear that bad decisions can have good outcomes and that we can be fooled into believing that given the successful outcome that causality is clear - ie that we made a great decision.

Taleb's book centers on the "hidden role of chance in life and in the markets." As an investor, it is particularly apropos as one tries to identify systematic methods of creating value via investing. Investors and investees like to believe that the investment world is deterministic with clearly understood cause and effect. Understanding causal drivers of value helps to create repeatable models for investment that scale both across time and individuals in the firm. Nassim challenges us to be very careful in overascribing reason and logic to an outcome. Too often, investment outcomes are the result of randomness rather than science, ie being lucky rather than good.

He illustrates his point by comparing the world of investors to a large sample of coin-flippers. If you start with a large enough sample, someone will manage to flip heads for many months in a row. While others drop out, the surviving "flipper" will take on magical qualities and others will study his background, methods, and secrets for achieving such success. Then, of course, he will flip tails one day and "blow up."

Nassim's book instills a deep sense of humility in the reader and a recognition that time and chance are often at the root of success. I strongly recommend reading his book.

Both Rubin and Nassim provide valuable insights into how best to operate under uncertainty. There is much to learn from both books.

Successful people and firms focus on building frameworks that allow for systematic decision making and judge people ultimately on the quality of the analysis and the assumptions used to derive at a decision rather than simply on the outcome itself. We all live with uncertainty - how we make decisions day after day given that fact will separate the winners, the losers, and those simply who got lucky!

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