Adapted from Better Than Alpha: Three Steps to Capturing Excess Returns in a Changing World
On the age-old question of whether investing is more art or science, luminaries of the industry have long squared off on opposing sides of the argument.
On one side are flexible value investors like Seth Klarman of Baupost Group and Howard Marks, co-founder of Oaktree Capital Management, who tend to describe building portfolios as a craft, with the investor as artisan. In fact, Marks is supposed to have once explicitly stated, “Investing is more art than science.” These investors look for value wherever it can be found and are able to invest across markets and up and down the capital stack. That can mean public stocks, private credit, and anywhere in between as long as the risk-return trade-off makes sense.
On the other side of the discussion, we find quantitatively inclined investors. Adherents of a more systematic approach to value investing, such as University of Chicago alumni David Booth of Dimensional Fund Advisors and Cliff Asness of AQR, focus on the science of it. These investors believe a disciplined and repeatable approach to building portfolios based on evidence gleaned through rigorous empirical research is the way to consistently generate more-predictable investment outcomes.
I think there are elements of truth to both points of view, and the same can be applied to manager selection. In fact, I’ve argued for both, writing that the scientific method can improve due diligence processes but at the same time acknowledging that as a science, manager selection is certainly an imperfect one.
But before we go any further, it’s important to understand human decision making and how these two opposing viewpoints may have bases in psychology.
In his book Thinking, Fast and Slow, Nobel Prize–winning behavioral expert Daniel Kahneman describes two systems of thinking. System 1 is a quick, intuitive processor that favors the efficiency and speed characteristic of snap judgments. This system, although fast and decisive, is prone to errors in many complex situations. Kahneman’s book is packed with examples of how a gut response can lead us astray.
System 2 is a more deliberate and logical process, but it is also much more effortful. System 2 is the cognitive engine we engage when reading a textbook, taking an exam, or writing an essay. In short, it is intentional, measured thinking. But because System 2 is far more energy-intensive than System 1, our natural proclivity is to bypass it, much to our own detriment. Of the approximately 40,000 discrete decisions we make daily, the vast majority rely on our imperfect, reactive thinking.
So if we can’t get away from using System 1 entirely, can we at least mitigate the effects of some of its worst errors and cognitive biases?
It is fairly hard to do, but you can in fact train System 1 to get better at making intuitive responses. And it just so happens that there is a good deal of research showing that this approach can actually improve outcomes in fields outside of investing.
In the 1990s, researchers at the University of Iowa conducted a study in which participants could draw cards from one of four decks for a cash reward. What students did not realize was that the decks were rigged. Two were stacked with cards offering small gains but no risk, and the other two had cards with high gains but high risk. On average, after choosing 50 cards, participants were able to respond intuitively, demonstrating that they recognized the pattern — subconsciously, at least. However, it took a full 80 cards on average before they could clearly articulate the pattern to the researchers.
Even more remarkable is that after only ten cards, participants displayed a measurable rise in anxiety when reaching for the high-risk decks of cards, including faster pulses and increased perspiration. A subconscious, emotional process was already at work far before they could consciously act on it or describe the pattern.
Further, articles in medical literature that reviewed the clinical assessment procedures of experienced nurses in mental health and medical settings have come up with some interesting findings. Although the National Health Service currently places great emphasis on purely evidence-based practices in making clinical assessments, these nurses often include other factors in their process. Several studies have shown that a holistic approach incorporating the tacit knowledge and intuition gained from experience improves both diagnostic speed and accuracy.
These studies demonstrate that nurses who have seen clusters of symptoms previously, even if they can’t technically articulate them all, are more accurate than a diagnostic checklist alone in identifying specific disorders. This supports the idea that experience-based intuition, when used in conjunction with evidence-based practice, achieves better outcomes and should play a role in clinical practices.
Sounds a lot like our System 1.
However, not all processes respond as favorably to this sort of intuitive training. The research on improving System 1 thinking has identified three critical characteristics of a task that make training your intuition possible. The successful improvement of rapid, intuitive decision making requires:
- lots of trials;
- clearly measurable outcomes; and
- relatively rapid feedback.
When those things are in place, System 1 can be trained. For really high-frequency, immediate-feedback tasks, such as identifying patterns in decks of cards, improvement can occur quite rapidly. In other situations, where feedback on performance may take months or even years, such as in diagnosing traits of chronic disorders, teaching System 1 can take much longer. But it is still possible.
What this means for manager selection is pretty clear. Although creating a disciplined and systematic approach to vetting managers using deliberate thinking can in fact create a repeatable process, the accuracy of the selection process — or the investment returns as output — can probably be improved by including the use of experiential judgment.
Provided an investment team has met with thousands of managers, documented specific characteristics of these managers, and tracked subsequent performance over long periods, incorporating experiential intuition into a disciplined, evidence-based approach — merging art and science, if you will — may allow investors to leverage the best of both worlds.
So in the end, is investing an art or a science? The answer appears to be a resounding yes!
Christopher M. Schelling is an author, an educator, and the director of alternative investments for Venturi Private Wealth. With degrees in psychology, business, and finance, Chris is an expert at incorporating insights from behavioral finance into investment decision making. As an institutional investor, Chris has allocated roughly $5 billion and met with more than 3,500 managers across hedge funds, real assets, private credit, and private equity.
