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« The Checklist: Evolution of an Effective Decision Process Part 1 | Main | The Consistency of Correlation: How Stable is my Beta? »

May 01, 2013

The Checklist: Evolution of an Effective Decision Process Part 2

As a continuation to The Checklist: Evolution of an Effective Decision Process Part 1 we now turn our attention to money managers and their checklists. 

Fund managers fall into similar traps of overconfidence about their ability to manage the complex system of investing. Dr. Gawande discusses investing (Chapter 8) by analyzing three public equity managers that employee an explicit checklist and a study by Geoff Smart, which analyzed 51 venture capital managers. The evidence, although not a large sample size, is compelling. The public managers attribute the checklist to being a primary component of their success and a distinct competitive advantage.

“The checklist doesn’t tell the manager what to do. It is not a formula. But the checklist helps him be as smart as possible every step of the way, ensuring that he’s got the critical information he needs when he needs it, that he’s systematic about decision making, that he’s talked to everyone he should. With a good checklist in hand, he was convinced he and his partners could make decisions as well as human beings are able. And as a result, he was also convinced they could reliably beat the market.” “They (Checklists) improve their outcomes with no increase in skill. That’s what we are doing when we use the checklist.” “When he first introduced the checklist, he assumed it would slow his team down, increasing the time and work required for their investment decisions. He was prepared to pay that price. The benefits of making fewer mistakes seemed obvious. And in fact, using the checklist did increase the up-front work time. But to his surprise, he found they were able to evaluate many more investments in far less time overall.” 1

And even though their competitors have noticed their success and asked them for their secret, when told that the key is a checklist, they turn up their nose.

“In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making even slightly more money— investing in Internet companies, buying tranches of sliced-up mortgages, whatever— gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists. I asked one of the equity managers how much interest others have had in what he has been doing these past two years. Zero, he said— or actually that’s not quite true. People have been intensely interested in what he’s been buying and how, but the minute the word checklist comes out of his mouth, they disappear. Even in his own firm, he’s found it a hard sell.” “I find it amazing other investors have not even bothered to try,” he said. “Some have asked. None have done it.” 1

The evidence from the VC community is even more compelling because the results are more statistically significant (51 managers) and are empirical. Mr. Gross categorized managers into five different categories by how they made decisions. One of the classifications was “Airline Captains” which meant they used checklists extensively to make decision.

“Smart next tracked the venture capitalists’ success over time. There was no question which style was most effective— and by now you should be able to guess which one. It was the Airline Captain, hands down. Those taking the checklist-driven approach had a 10 percent likelihood of later having to fire senior management for incompetence or concluding that their original evaluation was inaccurate. The others had at least a 50 percent likelihood. The results showed up in their bottom lines, too. The Airline Captains had a median 80 percent return on the investments studied, the others 35 percent or less.” 1

Smart’s study was performed over ten years ago and his findings are known by the VC community. You would think these fact-based results would change behavior, but as Gawande found when asking about Smart about behavior changes for VC managers:

“But when I asked him (Geoff Smart), now that the knowledge is out, whether the proportion of major investors taking the more orderly, checklist-driven approach has increased substantially, he could only report, “No. It’s the same.” We don’t like checklists. They can be painstaking. They’re not much fun. But I don’t think the issue here is mere laziness. There’s something deeper, more visceral going on when people walk away not only from saving lives but from making money. It somehow feels beneath us to use a checklist, an embarrassment. It runs counter to deeply held beliefs about how the truly great among us— those we aspire to be— handle situations of high stakes and complexity. The truly great are daring. They improvise. They do not have protocols and checklists.” 1

The Checklist Manifesto is well worth the day or so it takes to read. The real question, are you willing to adopt a Checklist mentality? Will you take the time to check the boxes? Are you disciplined enough to stop yourself from making decisions unless those boxes have been checked? I know that if I were back on the buyside, I would take out my mini-checklist and expand on it, formalize, and refine as we improve our process. I’ve seen firsthand the importance of making decisions explicit. But I think Dr. Gawande says it best:

“Instead they (pilots) chose to accept their fallibilities. They recognized the simplicity and power of using a checklist. And so can we. Indeed, against the complexity of the world, we must. There is no other choice. When we look closely, we recognize the same balls being dropped over and over, even by those of great ability and determination. We know the patterns. We see the costs. It’s time to try something else. TRY A CHECKLIST.” 1

 1Gawande, Atul (2009-12-15). The Checklist Manifesto: How to Get Things Right. Picador.

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