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« Alpha Theory Best Practices (Part One) | Main | Alpha Theory Best Practices (Part Three) »

August 30, 2013

Alpha Theory Best Practices (Part Two)


This is a continuation from our previous post (Alpha Theory Best Practices (Part One))


After suggesting a solution and getting no negative feedback - “Gentlemen, I take it we are all in complete agreement on the decision here…Then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.” – Alfred P. Sloan, former Chairman of General Motors

The culture of the Devil’s Advocate comes from the top-down. Portfolio managers that are comfortable with criticism and questions foster an environment where the counter-point is encouraged. Research meetings should require “poking holes” in the thesis. If that doesn’t seem to be working, designate someone as the Devil’s Advocate for each investment. Require that analyst contact the most bearish analyst on long ideas and most bullish on short ideas. Create premortems that ask the question, “it is one year from now and the stock has lost half its value, what happened?” In the scientific process, all these tools are part of Hypothesis Testing. They’re essential because the easiest way to prove the validity of a thesis is to try and prove it wrong.

So why is the culture of the Devil’s Advocate important to the success of a fund? Because analysts are humans and human behavior leads them to become myopic when developing a narrative for an investment idea. Myopia leads to new information being poorly assimilated by simply folding it into the existing narrative when a new narrative should be explored or, even worse, it is ignored because it doesn’t fit nicely into the current thesis. The Devil’s Advocate protects the downside (I will discuss further in my next Best Practice #3: PROTECTING THE DOWNSIDE why this is so important).

The Devil’s Advocate culture is built by the portfolio manager. There should be a “No Sycophants Allowed” sign on the door of the PM. If the PM encourages questions then everyone will embrace the practice of the Devil’s Advocate. Remember, it’s not usually what you know, but what you don’t know that kills you. Create a process that begs the question, “what are we missing?” and you will see marked improvement in the quality of ideas going into the fund.