Mauboussin

Professor Shyam Sunder
September 28, 2005
Attributes of a Good Investment Process

The Critical Role of Decision Making
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management
Decision-making for Investors
The Investment Process
Information
analysis
Information
Sources
Diversity
Weighing
Economic focus
Competitive strategy
Analogy and metaphor
Decision
making
Proper framing
Avoid pitfalls
Internalize techniques
Agenda
1.
Practices of the best
2.
Expected value
3.
Probabilities
Outcomes
Why we are suboptimal
Process versus outcome

Odds in your favor
Understanding the role of time
Heuristics and biases

How we can benefit
The T Theory
The best in all probabilistic fields

Focus on process versus outcome
Always try to have the odds in their favor
Understand the role of time
The best have more in common with one another

than they do with the average participant in their
field
Process versus Outcome

In
any probabilistic situation, you must develop

a disciplined and economic process
You
must recognize that even an excellent

process will yield bad results some of the time
The
investment communitylargely reflecting

incentivesnow seems too focused on
outcomes and not enough on process

Outcome
Process Used to Make the Decision
Good
Bad
Good
Bad
Deserved Success
Dumb Luck
Bad Break
Poetic Justice
Source: J. Edward Russo and Paul J.H. Schoemaker, Winning Decisions (New York: Doubleday,
2002), 5.
Try not to confuse outcomes and process

Any time you make a bet with the best of it, where the
odds are in your favor, you have earned something on
that bet, whether you actually win or lose the bet. By the
same token, when you make a bet with the worst of it,
where the odds are not in your favor, you have lost
something, whether you actually win or lose the bet.
David Sklansky, The Theory of Poker, 4th ed.
(Henderson, NV: Two Plus Two Publishing, 1999), 10.

Any individual decisions can be badly thought through, and
yet be successful, or exceedingly well thought through, but
be unsuccessful, because the recognized possibility of
failure in fact occurs. But over time, more thoughtful
decision-making will lead to better overall results, and more
thoughtful decision-making can be encouraged by
evaluating decisions on how well they were made rather
than on outcome.
Robert Rubin
Harvard Commencement Address, 2001
Odds In Your Favor

Asset prices reflect a set of expectations
Investors must understand those expectations
Expectations are analogous to the oddsand
the goal of the process is finding mispricings
Perhaps the single greatest error in the
investment business is a failure to distinguish
between knowledge of a companys
fundamentals and the expectations implied by
the price
Odds In Your Favor

The issue is not which horse in the race is the most
likely winner, but which horse or horses are offering
odds that exceed their actual chances of victory . . .
This may sound elementary, and many players may
think that they are following this principle, but few
actually do. Under this mindset, everything but the odds
fades from view. There is no such thing as liking a
horse to win a race, only an attractive discrepancy
between his chances and his price.
Steven Crist, Crist on Value, in Beyer, et al., Bet with the Best
(New York: Daily Racing Form Press, 2001), 64.
10
Odds In Your Favor

I defined variant perception as holding a well-founded view
that was meaningfully different from the market consensus
. . . Understanding market expectation was at least as
important as, and often different from, the fundamental
knowledge.
Michael Steinhardt, No Bull: My Life in and Out of Markets
(New York: John Wiley & Sons, 2001), 129.
11
The Role of Time

Because investing is about probabilities, the
short-term does not distinguish between good
and poor processes
A quality process has a long-term focus
The investment communitys short-term focus
is costly, and undermines a quality long-term
process
12
The Role of Time

Over a long season the luck evens out, and skill shines
through. But in a series of three out of five, or even four out
of seven, anything can happen. In a five-game series, the
worst team in baseball will beat the best about 15 percent
of the time. Baseball science may still give a team a slight
edge, but that edge is overwhelmed by chance.
Michael Lewis, Moneyball: The Art of Winning an Unfair Game
(New York: W.W. Norton & Company, 2003), 274.
13
The Role of Time

The result of one particular game doesnt mean a damn
thing, and thats why one of my mantras has always
been Decisions, not results. Do the right thing enough
times and the results will take care of themselves in the
long run.
Amarillo Slim, Amarillo Slim in a World of Fat People
(New York: Harper Collins, 2003), 101.
14
0.9
0.9
0.8
0.8
Percentage of Heads
Percentage of Heads
The Role of Time
0.7
0.6
0.5
0.4
0.3
0.6
0.5
0.4
0.3
0.2
0.2
0.1
0.1
0
1 2 3 4
5 6 7 8
9 10 11 12 13 14 15 16 17 18 19 20
Trial Number
15
0.7
21
41
61
Trial Number
81
From Theory to Practice
Principles of expected value

How do you set probabilities?
How do you consider outcomes?
16
Expected Value
Expected value is the weighted average value
for a distribution of possible outcomes
Take the probability of loss times the amount of
possible loss from the probability of gain times the
amount of possible gain. That is what were trying to
do. Its imperfect, but thats what its all about.
Warren E. Buffett
Berkshire Hathaway Annual Meeting, 1989.
17
Expected Value
Expected valuedrug
development
Scenario
Breakthrough
Above average
Average
Below average
Dog
Probability
10%
10
60
10
10
100%
Value (outcome) Weighted Value

$1,323,920
661,960
66,200
7,440
6,620
$132,392
66,196
39,720
744
662
Expected Value $239,714
Source: David Kellogg and John M. Charnes, Real Options Valuation for a Biotechnology Company,
Financial Analysts Journal, May/June, 2000, 76-84.
18
Expected Value
Risk versus uncertainty
Risk we dont know outcome, but we know what the
underlying distribution looks like
incorporates the element of loss/harm
Uncertainty we dont know the outcome, and we dont

know what the underlying distribution looks like
need not incorporate loss/harm
Source: Frank H. Knight, Risk, Uncertainty, and Profit (Boston: Houghton and Mifflin, 1921).
19
How do we Think about

Probabilities?
Three ways to set probability
1. Degrees of belief
Subjective probabilities
Satisfy probability laws
2. Propensity
Reflect properties of object or system

Roll of a die: one-in-six probability
3. Frequencies
Large sample of appropriate reference class

Finance community largely in this camp
Source: Gerd Gigerenzer, Calculated Risks (New York: Simon & Schuster, 2002), 26-28.
20
How do we Think about Probabilities?
Beware of nonstationarity
For past averages to be meaningful, the data being
averaged must be drawn from the same population. If
this is not the caseif the data come from populations
that are differentthe data are said to be
nonstationary. When data are nonstationary, projecting
past averages typically produces nonsensical results.
Bradford Cornell, The Equity Risk Premium
(New York: John Wiley & Sons, 1999), 45-46.
21
Multiples are probably nonstationary
How do we Think about Outcomes?

Frequency Distribution of S&P 500 Daily Returns
December 29, 1977 - March 3, 2005
250
Frequency
200
150
100
50
0
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
10
Standard Deviation
Frequency Difference: Normal versus Actual Daily Returns

December 29, 1977 - March 3, 2005
100
Difference in Frequency
80
60
40
20
0
-10 -9
-8
-7
-6
-5
-4
-3
-2
-1
-20
-40
-60
Source: Factset.
22
Standard Deviation
10

Value
Triggers
Value
Factors
Volume
Price
and Mix
Sales
Operating
Value
Drivers
Sales
Growth
Rate (%)
Operating
Profit
Margin (%)
Operating
Leverage
Economies
of Scale
Operating
Costs
Investments
23
Cost
Efficiencies
Investment
Efficiencies
Incremental
Investment
Rate (%)

Google Options Implied Distribution
0.60
Implied Probability
0.50
0.40
0.30
0.20
0.10
150
200
250
300
350
Stock Price
24
400
450
500
Frequency versus Magnitude
Both frequency (probability) and magnitude

(outcome) matter
Good probability, bad expected value
Probability
Outcome
Weighted Value
70%
+1 %
+0.7%
30%
100%
-10
-3.0
-2.3%
Bad probability, good expected value

Probability
25
Outcome
Weighted Value
70%
-1 %
-0.7%
30%
100%
+10
+3.0
+2.3%
Frequency versus Magnitude

Indeed, I can be wrong more often than I am right, so long
as the leverage on my correct judgments compensates for
my mistakes. At least that is how my investments have
worked out thus far. A statistician might deplore this
approach, but it has worked for me for a half century.
Leon Levy, The Mind of Wall Street
(New York: PublicAffairs, 2002), 197.
.
26
Role of TimeLoss Aversion
Samuelsons lunch bet

Flip a fair coin
Correct call you win $200
Incorrect call you lose $100
Samuelson proved that if you are willing to play

100 times, you should play once
Samuelsons theory doesnt feel right
See: Paul A. Samuelson, Risk and Uncertainty: A Fallacy of Large Numbers, Scientia, XCVIII, 1963, 108-113.
27

Myopic Loss Aversion
We regret losses more than similar-sized gains. Since

the stock price is typically the frame of reference, the
probability of loss or gain is important. A longer holding
period means a higher probability of a gain.
The more frequently we evaluate our portfolios, the

more likely we are to see losses and hence suffer from
loss aversion.
Source: Shlomo Benartzi and Richard H. Thaler, Myopic Loss Aversion and The Equity Premium Puzzle,
The Quarterly Journal of Economics, February 1995, 79-92.
28

As
a result, a long-term investor is willing to

place a higher value on a risky asset than a
short-term investor
Valuation
29
depends on your time horizon
Overconfidence
We consistently overrate our capabilities,

knowledge, and skill
We tend to project outcome ranges that are

too narrow
Overconfidence can lead to excessive trading
See: Brad Barber and Terrance Odean, Trading is Hazardous to Your Wealth: The Common Stock
Investment
Performance of Individual Investors, Journal of Finance, 55, April 2000, 773-806.
30
Heuristics
Other pitfalls
Framing
Anchoring and adjusting
Confirmation trap
31
How Can We Benefit?
32
Look for diversity breakdowns
We often make decisions by observing others
Information cascadesa reasoned or arbitrary

decision by one individual triggers action by many
Herdingwhen a large group of investors make the

same choice based on the observations of others,
independent of their own knowledge
How Can We Benefit?
How do we lose diversity?
Imitation
Solomon Asch experiment
Illustration by LMCM based on S. E. Asch, Effects of Group Pressure Upon the Modification and
Distortion of Judgment, in Harold Guetzkow, ed., Groups, Leadership and Men (Pittsburgh, PA: Carnegie
Press, 1951).
33
How Can We Benefit?
Asch always wondered: Did the people who gave in to the group
do so knowing that their answers were wrong? Or did the social
pressure actually change their perceptions?
The new study tried to find an answer using fMRI scanners.
The researchers found that social conformity showed up in the
brain as activity in regions that are entirely devoted to
perception.
But independence of judgmentstanding up for one's beliefs
showed up as activity in brain areas involved in emotion.
"We like to think that seeing is believing," said Dr. Gregory
Berns, a psychiatrist and neuroscientist at Emory University who
led the study.
But the study's findings show that seeing is believing what the
group tells you to believe.
Source: Sandra Blakeslee, What Other People Say May Change What You See, The New York Times, June
28, 2005.
34
Takeaways
Investing is a probabilistic exercise
Expected value is the proper way to think
about stocks
There are many pitfalls in objectively
assessing probabilities and outcomes
We need to practice mental discipline or else
well lose long-term to someone who is
practicing that discipline
Markets periodically go to excesses
35
Legg Mason Capital Management ("LMCM":) is comprised of (i) Legg Mason Capital Management, Inc. ("LMCI"), (ii) Legg
Mason Funds Management, Inc. ("LMFM"), and (iii) LMM LLC ("LMM").
The views expressed in this commentary reflect those of LMCM as of the date of this commentary. These views are subject to
change at any time based on market or other conditions, and LMCM disclaims any responsibility to update such views. These
views may not be relied upon as investment advice and, because investment decisions for clients of LMCM are based on
numerous factors, may not be relied upon as an indication of trading intent on behalf of the firm. The information provided in this
commentary should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. To the
extent specific securities are mentioned in the commentary, they have been selected by the author on an objective basis to
illustrate views expressed in the commentary. If specific securities are mentioned, they do not represent all of the securities
purchased, sold or recommended for clients of LMCM and it should not be assumed that investments in such securities have
been or will be profitable. There is no assurance that any security mentioned in the commentary has ever been, or will in the
future be, recommended to clients of LMCM. Employees of LMCM and its affiliates may own securities referenced herein.
36
Professor Shyam Sunder

September 28, 2005
Attributes of a Good Investment Process

The Critical Role of Decision Making
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management

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Professor Shyam Sunder

September 28, 2005

Attributes of a Good Investment Process

The Investment Process

Decision-making for Investors

Practices of the best

Why we are suboptimal

Process versus outcome

Heuristics and biases

Decision-making for Investors

The best in all probabilistic fields

The best have more in common with one another

Decision-making for Investors

Process versus Outcome

any probabilistic situation, you must develop

must recognize that even an excellent

investment communitylargely reflecting

Decision-making for Investors

Process versus Outcome

Process Used to Make the Decision

Try not to confuse outcomes and process

Decision-making for Investors

Process versus Outcome

Decision-making for Investors

Process versus Outcome

Decision-making for Investors

Odds In Your Favor

Decision-making for Investors

Odds In Your Favor

Decision-making for Investors

Odds In Your Favor

Decision-making for Investors

The Role of Time

Decision-making for Investors

The Role of Time

Decision-making for Investors

The Role of Time

Decision-making for Investors

The Role of Time

Decision-making for Investors

From Theory to Practice

Principles of expected value

Decision-making for Investors

Decision-making for Investors

Value (outcome) Weighted Value

Expected Value $239,714

Decision-making for Investors

incorporates the element of loss/harm

Uncertainty we dont know the outcome, and we dont

need not incorporate loss/harm

Decision-making for Investors

How do we Think about

Reflect properties of object or system

Large sample of appropriate reference class

Decision-making for Investors

How do we Think about Probabilities?

Multiples are probably nonstationary

Decision-making for Investors

How do we Think about Outcomes?

Frequency Difference: Normal versus Actual Daily Returns

Decision-making for Investors

How do we Think about Outcomes?

Decision-making for Investors

How do we Think about Outcomes?