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Horizons: Family Office & Investor Magazine

Better Decision Making: Left/Right Brain in a VUCA world

Saturday, November 03, 2018

Ian Toner, CIO of Verus, recently said in a discussion with Dr. Philipp Hensler, President & COO of Epoch Investment Partners, that "at its heart investment is entirely about decision making. But because decision making science is fuzzy and isn't easily or often quantifiable and doesn't fit well into the spread sheet, it's very easy for us to just brush it off."

And decision making science—the emotional element, how to deal with uncertainty in the investment business, thinking about decisions and creating organizations that make decisions effectively—is the key to success, Toner continues.

Seeking Alpha requires left and right brains

For his doctoral research Philipp Hensler conducted at Case Western University in 2010, he interviewed investors about their experience during the financial crisis.

"Not very surprisingly, everybody I interviewed said it was a game changer, that life will never be the same again, and all the models investors used to rely on no longer hold true."

He then asked them to tell him what they had done differently since the crisis and 80% of the interviewees said that they had changed nothing at all.

Hensler said his first research paper was a discussion of how this 80% bridged this cognitive dissonance. The majority showed a steadfast reliance to a rules based investment approach although despite the fact it had just failed them. Regardless of whether the rule was based on an algorithm, a time horizon or an asset allocation methodology, they even showed an increasing commitment to it.

He noted that 20% of the interviewees, however, had done something fundamentally different since the crisis. He said this group had four characteristics:

While the first point was interesting, Hensler's research focused on the last three dimensions, which showed that this group had a high degree of "contextual sensitivity". This cohort was labeled by Hensler as the mindfulness group based on those three dimensions. What surprised me was that "the behavior of the 80% resembled that of a passive investments, such as ETFs—they simply adhered to a predetermined rule irrespective of the changes in the environment," Hensler said.

This behavior can get you into a trouble if markets behave in unpredictable ways

"To be clear, I am not dismissing passive investment strategies outright. There is a time for active and a time for passive investing," he said, adding that "if you believe in a future environment of synchronized growth and low dispersion of returns, it is perfectly rational to buy passive investments or ETFs. All you need is efficient access to equites market." Unfortunately, the world is not that simple. It is far more uncertain, complex and ambiguous, and the term the military uses for such an environment is VUCA (Volatility, Uncertainty, Complexity and Ambiguity).

There are similarities between the armed forces and asset management, Hensler suggested: "NAVY Seals are extremely well trained, they are very, very skilled and have the best equipment and the most accurate intelligence at their disposal when they go into battle. But what happens is the moment they land in a danger zone, the environment can change in a heartbeat and if you are unable to adapt, you might actually die."

If NAVY Seals want to be successful, they must possess a high degree of contextual sensitivity to operate in a highly complex, non-linear environment. Similarly, financial markets can be erratic and irrational and investors need to be mindful if they want to successfully navigate unforgiving market conditions.

Unfortunately, an entire generation of investment professionals have been brought up learning the concepts of neo-classical economic models. The problem is that these models rely on a normative world view that fail us every single time the market's behavior is outside the model parameters. While this has been well documented, what is surprising is that a large number of investment professionals continue to rely on these models, despite their shortcomings. "Finance academics are still reliant on linear models and they believe that finance is a hard science like physics. In other words, they are suffering from physics envy.", Hensler declared

Unlike physics and other hard sciences, finance is a social science, which is subject to a "reflexive feedback loop." We influence the system with our actions and in return our actions are influenced by the system. The interaction among actors in financial markets matters greatly.

Hensler posited that the neo-classical economic theory is ill equipped to deal with a VUCA world because it starts with a top down view how the system is supposed to work and deducts the optimal behavior of individuals. Although we know that this model doesn't work, unfortunately, we haven't come up yet with an alternative.

There is promising work done in many areas. One of Hensler's favorite is the agent-based theory. It starts with a bottom-up view of how individuals actually make decisions and tries to incorporate emergent behavior, which can often times lead to non-linear outcomes "You look at the behavior of individuals and try to make sense of it."

Left Brain vs. Right Brain

Hensler explained that though he has been juxtaposing the passive group and the active group, one could also term the groups the left brain group and the right brain group. "The left brain group is people that exclusively rely on algorithms and analytics based on historic data for decision making — a skill that computers do much better than humans, quite frankly. This approach works as long as the world behaves within the model parameters. However, I‘ve found that if the market starts to misbehaving people with strong right brain capabilities—and based on my research that is especially true for women—they tend to adapt and absorb new information much quicker, which allows them to take decisive action when it

To be clear, investors that have strong right brain capabilities are also guided by investment philosophies and processes but they are not that strict about it, he said. "They have a high capacity to learn. They fail as well, they are not perfect. But when they fail, they start to realize what was going on and try to incorporate that learning into their decision-making processes.

Environmentally agnostic behavior, on the other hand, is often exhibited by investors that are not mindful or contextually sensitive, according to Hensler. "They have no motivation to make any changes because their rules are absolutely binding. Those would be true for ETFs or similar passive investment strategies, as an example.

So the question is how does one become contextually sensitive? Hensler said there is interesting research on so called high-reliability organizations (Weick and Sutcliffe, 2007) that might provide some guidance

High-reliability organizations ("HRO") operate under challenging conditions yet experience fewer problems than would be anticipated. They have developed ways of "managing the unexpected" better than most organizations, he said. He pointed to aircraft carriers and nuclear power plants as examples. "As you can imagine, one little mistake in the operations can have devastating consequences."

Hensler said there are five traits exhibited by HROs can also be translated into asset management:

They have a preoccupation with failure—They are always worried that something will go wrong and fight overconfidence along the way. Asset managers should always question their investment thesis and exhibit humility;

They are reluctant to simplify—the world simply isn't linear. Neo-classical economic models are beautiful, very elegant, but they just are not a fair representation of reality. Asset managers should avoid linear extrapolation, have a strong commitment to forward-looking fundamental research, and understand that ignorance and knowledge generation go hand in hand.

They have a sensitivity to operations. "The best active managers only invest in companies, which business model and value drivers they fully understand in order to avoid unpleasant surprises.

They have a commitment to resilience—asset managers should accept that failure is inevitable and learn from failures and adapt quickly.

To defer to experience—that is almost the most important. Many of the large organizations in asset management are very hierarchical. However, some of best asset management organizations have a rather flat hierarchy, an open communication culture where the best idea wins irrespective of rank

Only a strong investment culture brings the above points together, Hensler argues. "I'm convinced that culture is one of the most important things in active asset management. We need to create a safe environment in which people feel comfortable to voice an unconventional opinion or point of view. That safety makes for very fertile ground to come up with interesting ideas that are the ingredient of successful active management." Hensler concluded

 
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