A few months ago, we interviewed hedge fund manager Peter Lupoff, who is the founder of Tiburon Capital Management. Peter is thoughtful in his analysis and in my opinion, one of the best emerging event-driven hedge fund managers out there right now. Given where valuations are in both the credit and equity markets, allocating capital to those managers that can profit in both up and down markets (versus being long beta) seem like a winning strategy to me.
Peter sent me a letter he recently penned to investors regarding "Confirmation Bias" in analyzing investment opportunities. In the past, we have constantly hammered the point that searching out opinions that go CONTRARY to your perceived notions is a key ingredient for success in producing out sized risk adjusted returns. The letter is a fantastic read. I hope you enjoy:
Tiburon Capital Management
Shark Bites Volume 1 Article 1 November, 2009
Risk: Confirmation Bias and the Onset of Blindness as We Develop “Clarity”
As we know, there are known knowns. There are things we know we know. We also know There are known unknowns. That is to say We know there are some things We do not know. But there are also unknown unknowns, The ones we don't know We don't know.
—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing
Who knew that Donald Rumsfeld was such an adept Risk Manager? The point is well taken. With regard to our investments, as you likely know, every trade idea at Tiburon is looked at through the lens of our Five Pronged Methodology. This is the linchpin, in our view, of a scalable business, creating peer-beating returns with low downside deviation. Nonetheless, every trade idea has risk exogenous to the trade. That is, there are at least two critical, broad risks to consider: 1) There are the risks we contemplate and that we seek and receive compensation for as part of the risk/reward assessment. For us, this is the risk of the occurrence of our foreseen Revaluation Catalyst(s) – that/those event(s) that will move securities we may be long or short, in a step-function change to fair value. 2) There are those risks we identify to be outside of the trade thesis, i.e., exogenous to the trade thesis. Tiburon professionals and risk management (internal and external) will conceive the most correlated and effective hedges to wring this risk out. However, as Donald Rumsfeld would point out, we’ve then contemplated, probability weighted and where effective and desirable, hedged out the known risks - what about the risks we don’t know that we don’t know?
The Dangers of Bogus Math and Observances that Seem “Empirical”
Not only are there risks we don’t know we don’t know, but we routinely gather data deemed empirical that reinforce our beliefs, eventually blinding us to, or lessening our sense of the probabilities of risk. I will pull another reference out in demonstrating this concept of risks we don’t know that we don’t know (at the risk of angering some of my quant and academic friends).
An acquaintance of mine, Nassim Taleb, the writer of “The Black Swan” puts it this way:
I start with my old crusade against "quants" (people like me who do mathematical work in finance), economists, and bank risk managers, my prime perpetrators of iatrogenic risks (the healer killing the patient). Why iatrogenic risks? Because, not only have economists been unable to prove that their models work, but no one managed to prove that the use of a model that does not work is neutral, that it does not increase blind risk taking, hence the accumulation of hidden risks.
The More Clarity the Less Vision
Investment professionals will spend endless hours tinkering with models, listening to company conference calls, doing channel checks, meeting management, competitors, etc. Few, however can ring Confirmation Bias out of their work. Like the turkey, actively chronicling its daily access to housing and food from altruistic humans, most investment professionals have a tendency to develop an impartial view and then actively seek data that support their supposition. Confirmation Bias, the human trait of seeking and interpreting evidence that is partial to existing beliefs, expectation and hypothesis, is a risk of human bias that can only be wrung out of portfolio, in my view, with a rigorous and agnostic investment methodology and risk culture that actively engages in objective scenario analysis. A recent Wall Street Journal article quoted a vast psychological study that concluded that people were twice as likely to seek information that confirms what they already believe as they are to consider evidence that would question those beliefs. Do we not have some covenantal obligation to investors as a fiduciary to wring out this risk as well?
A Third Eye for More Clarity of Vision?
Absent stepping to the challenge of projecting all downside scenarios that can be concocted, we too, would be in the business of simply putting on trades and then earnestly capturing all the data that supports the trade thesis. As part of the way we think about risk at the research level, we imagine a bad outcome for the trade and then attempt to list the most compelling reasons for the trade’s failure. This is a form of projected forensics, for lack of a better way to describe it.
The Deception of a Reinforcing Market Price and the Wall Street Feedback Loop
So here we are again in late 2009 with rising asset prices, providing investors with confirmation that everything is fine and the pundits that reassure that doomsday scenarists are always early. At Tiburon, our take is “who cares”? I don’t mean to be flip on this point. Yes, we do care and work vigorously to cultivate our dynamic world view. Aren’t we supposed to make money in all markets? The point is that the portfolio is granularly conceived at the trade level. Risks exogenous are managed at the trade level. If this is done, we’ve done as well as most professional investors do. However, taking our blinders off as we systematically build the case for the investment allows us to see all data with impartiality. Defining the compelling reasons why we are wrong is part of this process. The point is to make good decisions – not to achieve consensus or arm ourselves with data to rationalize mistakes. We often talk about how conviction level about our Revaluation Catalyst shapes position sizing. This is true, but greater conviction does not create a greater probability of being right absent correcting the very human Confirmation Bias.