The Compound and Friends - Overcoming Biases with Josh and Drew Dickson

Episode Date: April 1, 2019

Josh's guest today is portfolio manager Drew Dickson, who manages a concentrated portfolio of favorite stocks for Albert Bridge Capital. In a recent blog post, Drew explains the four "tools" he uses to overcome the biases that can cloud an investor's judgement and threaten a portfolio manager's ability to look at holdings objectively. Josh talks to Drew briefly about these ideas in today's The Compound mini podcast. You can read Drew's post here: https://www.albertbridgecapital.com/drew-views/2019/3/26/dampa-debiasing-and-alpha And be sure to enable our skill on Amazon - "Alexa, play the Compound show!" https://www.amazon.com/Ritholtz-Wealth-Management-LLC-Compound/dp/B07P777QBZ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi, Drew. How's everything going? It's all right, Josh. How are you doing? I'm doing well. For those listening in, this is Drew Dixon, who is the CIO of Albert Bridge Capital. And where are you guys based out of, by the way? We're in London. Okay, cool. And how long have you been managing money? I moved over here 20 years ago. Originally as an analyst with Fidelity Investments and then Oxif. And then through various different entities, we've launched the Alpha Europe Fund since 2008.

And we're still here doing it. All right. So I want to talk to you about this post that you did, Debiasing and Alpha. So you're running a concentrated portfolio. It sounds like it's kind of a best ideas portfolio, which I want to get into. But you were doing this thing about what if you took your favorite stocks or your favorite ideas and you forced yourself to de-bias by writing up the short thesis on each of those stocks? Talk a little bit about that. Yeah, I think it's just a sort of an integral part to,

if we want to take the risk of being concentrated, and I'm all in, by the way, on, for most folks, the passive low-cost way to get exposure to whatever it is that you want makes complete sense. But in the case for us, if we're managing a small portion of the money of some university endowments or foundations, they're looking for some uncorrelated excess types of returns and the only way to get there is is through concentration and yeah they don't write they don't want you to look like the index they don't want the index and in so from our from my perspective we need to remain concentrated it needs to be the best ideas portfolio as you said Josh and and

I think at least some portion of the industry uh is coming around to uh or at least believing that the if there is an edge out there it's it's it's not as much from getting information before then before the next guy does like maybe it used to be but it's more about what you do with it when you get it and we can all say we're smart but at the end of the day everyone is as smart as everyone else in this industry. And I think the real trick is to try to take advantage of potential biases. If we treat the other side of the trade,

if we treat him as this sort of Warren Buffett's proverbial, or Ben Graham's proverbial Mr. Market, if we can think of that person as one person, we can ask ourselves, okay, what, you know, in the spirit of Danny Kahneman or Richard Thaler or any of these guys, what behavioral mistake is Mr. Market making preventing him from being objective about this information? And that's all great. A lot of people are now talking about that.

We've been talking about it for a long time. But now a lot of folks are talking about it. If you designate 20 stocks as your favorite 20 stocks, doesn't that introduce that bias risk right off the bat because you've now put your stamp on a company? And so as things change with the company, that forces you to say, okay, I was wrong about that. Isn't that one of the hardest parts of this? That absolutely is. And that's the whole point. We can all pretend that we've got some analytical edge in terms of seeing the mistakes the market makes. But most of the

mistakes that we make in investing are our own. It's these biases that you say, Josh. You buy a stock, you meet a company 100 times over five years. You know it inside out. You start drinking the Kool-Aid. You start being tied to their view. And that's not unbiased. That's not objective. start being tied to their view and that's not unbiased, that's not objective. And so for us, even before we get these 20 best ideas in the portfolio, it's got to be a process of us identifying not only finding businesses which are fundamentally improving over an intermediate to long term, but identifying a specific bias that the market has is preventing us from seeing what we see and mitigating our own. That was mitigating our own biases, that was the subject of this piece I put out last week. people forever for decades and even he admitted I don't think even with as much awareness as I have

about these cognitive biases I don't think that I'm good enough to even spot them in my own behavior that's remarkable that's remarkable and he wrote that in taking fast and slow and he came up with all these things uh he and Amos Tversky and uh he says he still suffers from them each day and so from that perspective if we've got the father of all this telling us that even he suffers from these biases. Yeah, what chance do we, right, what chance do any of us have? What chance do the rest of us have? I want to ask you about, you're saying we can do too much work.

So I've heard this before phrased as the sunk cost fallacy or the sunk cost bias, where you say, I've spent a year researching this company. There is going to be a trade. I didn't do all this work for no reason. Like that's a really, to me, that's a really big one, right? It's a huge one. If you do a ton of work, you want the idea to work. And then if you've communicated that idea to your investors, to your friends, to your bosses, your career is almost tied to it. You need it to work. And that's one of the hardest ones. It really, I think, our view is that really creates a lot of the confirmation bias that happens with the market. And it also impacts

individual analysts or me after doing that work. You don't want to process information which disconfirms your pre-existing view and you tend to ignore the stuff that matters. And you don't want to throw it out. You also say, we think we are smarter than we are. So this one's tough because if you're going to do a concentrated portfolio, you have to have a belief system that allows for you to think, I am smarter than the market. So you have to have some confidence even to attempt this. So how do you know when you have too much? So I think for us, at least, and maybe for others, it's got, it's, it's, it's the confidence in the process. We don't think we're smarter than the next guy. We think we maybe are potentially more

objective than the next guy. And if we can eliminate our own confirmation biases as we're doing our research, perhaps we have a chance of being more objective than our enemy, who is Mr. Market. And that leads us into this whole concept of writing short cases for everything that you want to buy. Which to me is the best de-biasing tool we have. Okay, so you have a few of these de-biasing rules, and that's one of them. That's number three. What are one and two? What would you do even before that to start stripping out some of the biases that infect the process? Well, the first one for, so I call it the four P's, process,

philosophy, pre-definition, and then who your partner is. And the process part of it, and everyone has their investment process. In our case, our goal is to expertly and rigorously analyze all these company fundamentals and to be as subjective as we can, but then to discover some bias that's preventing Mr. Market from doing the same. And that's sometimes really hard. You find a great management team improving ROICs, all the financials look fantastic, people don't like it. There's this wonderful story, it's ahead of you, especially if the business is going to be improving secularly. But you can't identify a specific bias.

You can't see where the market's overreacting to bad news. You can't see the potential good news they're underreacting to. It's just basically cheap. And that's a trap a lot of us fall into. It's okay, the stock looks cheap. That's Mr. Market telling us he doesn't like it. It doesn't necessarily tell us that if all the sell-side analysts have sales on the stock and all your buddies are wrong. We've got to find something that we think is unconventional. And I'm kind of jumping ahead, but if we can stick to that process,

even when our body is begging us to go buy this stock because it looks so cheap or such an opportunity. And then you're saying another de-biasing rule is to pre-define mistakes. So know in advance what would make you wrong. Like say, I'm definitely wrong if something like this were to happen. Yeah, and that comes from the short thesis. And I think most on the buy side will, know if when I was an analyst fidelity or even today folks will write it's on the sell side or the buy side everyone will kind of write up a buy pieces here's why I love this doc and they might have a little paragraph saying here's the

risks to the buy case in other words here's the here's where I would change my mind here's here's the here's where I would change my mind or here's where I would change my mind or here's why the buy case might not work. All right. And then the last thing, so before we run out of time, it is a mini pod. I wanted to ask you, your de-biasing rule four is to learn what your partners want, educate them about what you do, seek alignment, and reward them for tenure. So that's like almost conditioning the client. It's like a behavioral de-biasing rule, I guess. Making sure that we're managing folks with the same philosophy that we have.

And so we tell them, hey, we're going to be concentrated. We're going to be doing unconventional things that are going to look really strange to you and weird. And you'll ask us why we own this company. things that look really strange to you and weird and you ask us why we own this company and you're going to see volatility in any short term over any quarter or year or five-year period. But with a three and five-year view, you look back and you have a lot of alpha. Hopefully, you have historically and hopefully prospectively, but they've got to be almost underwriting that volatility.

And they have to be aligned not only themselves but also with their investment committees and with others about what we do and what it is I know it's a mini pod Josh but what I was going to expand on this on that on that cell case stuff it's not just writing risk to the buy case we've got to write an actual short thesis like how are we going to make money on the short side do work as if we were short we've got a long short background so dive into these things that we love, and if we can flip it around

and really come up with a constructive self thesis that sounds good, then we know the other side.