Late one night the other week, I turned on the television as a diversion from thinking about a unique investment structure I was researching. This private investment opportunity had the potential to generate substantial distributions, as well as upside appreciation, with a possibly perpetual holding period. With several types of investors interested — from family offices to pensions and funds of funds — there was significant debate around the appropriate fund structure.
That night, a rerun of The Big Bang Theory was on. As a dyed-in-the-wool nerd, I must confess that I love me some Sheldon Cooper. In this episode, Sheldon had been struggling with an especially vexing theoretical physics question. Unable to see a solution — and recalling how his hero Albert Einstein had made intuitive leaps while working as a patent clerk — Sheldon set out to find a menial job to engage his conscious mind while freeing up his subconscious thoughts to ruminate on the problem.
After unsuccessfully pursuing a few other options, Sheldon finally settled on cleaning tables at the local diner frequented by his friends. While distracted by a conversation with his colleagues, our intrepid physicist-turned-busboy dropped an entire tray of dishes, staring helplessly as the dinnerware shattered, scattering across the floor. After chastising the patrons for mocking him, our protagonist looked down at his mess. He saw a pattern in the debris, and a solution to his problem clicked in his head: He had solved it!
Unfortunately, the show provided me with no such eureka moment to my dilemma, but it did provide a blueprint for how I might arrive at one. As it turns out, this is exactly how the brain works. In his book Scatterbrain, German neuroscientist Henning Beck shows us that it is precisely the foibles of our error-prone brain that allow us to generate creative solutions to complex problems.
Humans are great at deciding but poor at selecting, particularly when myriad complex choices and solutions present themselves to a specific problem. Our attention wanders, often focusing on precisely the wrong things, and we aren’t great at working out probabilities in our head naturally. Our thoughts tend to zig when we want them to zag, leaping from one random idea to the next and making snap judgments. In fact, many times we can’t even remember most of the potential choices when deciding on a course of action!
Beck flips these problems on their head and shows us the upside to such imperfect cognitive processes. For example, looking at our forgetfulness, he argues that temporarily forgotten information is not lost forever, just held in storage to be combined with other data and retrieved at a later time, often in an intuitive leap forward. And he also notes that intense or unusual experiences stand out in the memory, while routine ones are compressed and often overlooked as we synthesize experience into a framework. While I’ve written about the downside of this salience bias, Beck points out that sometimes anchoring on highly relevant features can make particular memories easier to recall in future situations, which is probably what allows us to make connections between seemingly unrelated concepts.
It’s true that our human brain is always busy categorizing information, putting it into context, and making connections across time, all while filtering out what’s unimportant in the short term. Beck claims that by taking occasional breaks and mixing up workloads, one can mitigate the impact of distractions or boredom, and subconsciously combine ostensibly distinct information in new and creative ways. Sometimes this happens when we are occupied with mindless tasks, like Sheldon in our story above. Or sometimes these intuitive leaps occur when we are actively engaged in deep thinking on otherwise unconnected topics.
Basically, Beck argues that most great thinking in life is the result of a mistake. It’s a blip in our cognitive processing, and only after the fact — only after the thought that seemed to be a throwaway — are we able recognize the value in the idea. This is the type of creative thinking that allowed Fischer Black and Myron Scholes to connect Brownian motion — a concept from physics that describes the movement of particles in a liquid — with the random prices of stocks for the Black-Scholes option pricing model.
Which brings us back to investing.
Most professional investors and asset allocators focus heavily on process, as that’s the only thing we can truly control. And we try to systematize as much of it as possible, effectively trying to build an assembly line for investment returns. For instance, in manager selection, due diligence typically involves a checklist approach to working through various to-do items.
Process is all well and good; it is certainly helpful for ensuring that every step on the flowchart has been completed and nothing missed. However, process shouldn’t be turned into a closed-end formula where we “set it and forget it.” As much as I love process — building the assembly line — I’ve come to the realization that sustained success in alternatives requires balancing repeatability and consistency with flexibility and adaptability. The investment industry is probably the most competitive and dynamic industry in the world. Things change, and investment processes, much like a fitness regime, should change over time as well. I’m certainly not 20 anymore, and I can’t act like it in the gym.
Similarly, investment strategies that generate predictable excess returns often experience an increase in competition that erodes those excess return over time, like convertible arbitrage. From 1994 until 2006, convert arb funds were able to churn out an average annualized return of 8.6 percent. However, as the market got more competitive, and the cost of capital for convert issuers fell, the arbs were only able to grind out half that return from 2010 until 2022, a paltry 4.3 percent. Or sometimes we observe the emergence of completely new assets, like cryptocurrency, which upend existing investment frameworks for thinking about asset classes.
Static checklists and stagnant processes might make it harder for investment professionals to recognize and interpret these changes in real time. So how can we harness our imperfect brains to promote creative thinking in alternatives — and, importantly, do so prudently?
In the past, I employed tactics like building in white space in my work calendar for reading, researching, or simply unstructured thinking. In fact, one of my favorite general partners — a private equity investor who specializes in transformational deals — is known for hanging a sign on his door that reads “Big Thinking in Progress” to zealously guard his white space. And these methods probably work better than doing nothing at all.
However, after reading Beck’s book, I think a better way to encourage creative, cross-functional thinking on investment teams is to aggressively break down the silos. Historically, many institutional investors have segmented teams by public versus private markets, or even more narrowly by asset class. Instead of sticking people into a permanent track on the hedge fund team or private-equity asset class, for instance, perhaps institutional investors should work harder to move people around more frequently. T.J. Carlson did that with our teams at Kentucky Retirement Systems and Texas Municipal Retirement System, and I certainly benefited from moving across hedge funds, real assets, private credit, and private equity.
Today, some institutional investors have completely discarded separate teams, opting instead for a nimbler, generalist approach. For example, outside of its efforts in direct real estate, MIT Investment Management Co. has one “global investment team” to flexibly source, vet, and manage investments across the entire universe of investable opportunities. And it’s no coincidence that they are perennially at or near the top of the performance tables published by the National Association of College and University Business Officers.
Investment professionals should spend time underwriting credit managers and building quantitative risk models. Move them from public to private markets, across manager selection and security selection. Not only would forcing people out of their comfort zones allow them to get more experience in other functional areas, but it would also help them grow as investment professionals.
Of course, we still need professional processes and oversight to make sure we’re not dropping the metaphorical dishes; that goes without saying. But with so much uncertainty in the capital markets — including inflation, energy price volatility, rising interest rates, and geopolitical instability — along with a rapidly evolving alternative investment landscape, maybe actively pushing investment professionals into different workflows would free up their scatterbrains to put new ideas together in unexpected ways.
And a bit more intentional creativity might help investors better meet their investment objectives.
Christopher M. Schelling is the founder and chief investment officer of 512 Alternatives, a boutique consulting firm dedicated to helping wealth managers, family offices, and small institutions understand and access alternative investments.
