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June 1, 2010

Assumptions on Assumptions – A good guess is not enough

I was working with a smart firm the other day and one of the partners was reticent to implement Alpha Theory. He believed  that it was flawed by forcing assumptions on top of assumptions. While I can understand this visceral response, the logic doesn't hold true in complicated decisions like asset selection and portfolio management. At the end of the day you are making an economic decision about an asset, whether to pay a certain amount of dollars. This means that your "assumptions" must be expressed in economic terms to balance the decision equation.

Assigning probability is the task that creates the most angst, but look at why it is important in three ways. One, if you can look at your portfolio and say that you have more confidence in one idea versus another idea, then you have expressed probability and you can simply classify positions as either High, Medium, or Low Conviction Level and those automatically translate into probabilities. Two, let's run through an example and say I offer you a bet to win $1 if Obama wins the 2012 election. Would you pay $.30 for that bet?, $.40?, $.50?, $.60?, $.70?. The highest amount you would be willing to pay is an expression of your subjective probability of Obama winning the 2012 election. Certainly this is subjective, but an effective expression of your assumptions is required to make effective decisions. Third, and lastly, psychologists have consistently proven that a weak model is better than strong heuristics. This blog references an article by Robyn Dawes that shows why we build some basic processes around complicated decisions (Robyn Dawes article).