Building an Investment Checklist - Part 1

Investing can be a daunting task requiring the analysis of complex data which is often in a state of flux. Decisions often must be made in the absence of complete information, under time constraints and emotional pressure.  The investor's role is not dissimilar to a pilot or surgeon, who is also dealing with many unknowns and changing circumstances, and where time is of the essence.  There are often significant consequences for a pilot or surgeon if or when basic errors – such as omitting a key fact – are made.  Likewise, an investor can face negative consequences, thankfully in the form of capital losses and not death, if errors are made.

To assist in the evaluation process both pilots and surgeons have turned to the basic “checklist” to help minimise errors.  In study after study, it has been found that a checklist approach to analysing a complex situation has prevented errors and raised the effectiveness of both amateurs and experts alike. Even the most experienced airline pilot or surgeon with the most advanced equipment would never perform routine tasks in the aircraft or operating room without using a checklist.  

Atul Gawande, a surgeon and associate professor at Harvard Medical School, is a leading proponent of checklists. His book The Checklist Manifesto” discusses the benefits of implementing a checklist procedure:

"We need a different strategy for overcoming failure, one that builds on experience and takes advantage of the knowledge people have but somehow also makes up for our inevitable human inadequacies. And there is such a strategy - though it will seem almost ridiculous in its simplicity, maybe even crazy to those of us who have spent years carefully developing ever more advanced skills and technologies. It is a checklist.

It’s no wonder, many of the Investment Masters have recognised the power of checklists and implemented their adoption in the investment process.

Charlie Munger, Warren Buffett’s partner, and one of the world's greatest investors has spent his life observing, studying and understanding human cognition and its limitations. Mr Munger, like many of the Investment Masters, acknowledges the benefits of checklists and has adopted them in his investing.

"Checklist routines avoid a lot of errors. You should have all this elementary [worldly] wisdom and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well."  Charlie Munger

"No wise pilot, no matter how great his talent and experience, fails to use a checklist." Charlie Munger

"We're big believers in checklists, which are the best tools available to reduce preventable human errors" Joel Hirsch

"I'm a prolific maker of lists, and the more trouble I had in the early 1990s, the more I attacked it and dealt with it by making lists and checking off items as we accomplished them" Sam Zell

Unfortunately investors miss things, it’s human nature. Humans have learnt to survive by taking mental short-cuts. While useful in the wilderness, these can be detrimental to investing. 

"Why are checklists so effective? We think we're very smart; we take shortcuts, especially in investing.  We get euphoric about all the money we're going to make, and we are just a mix of rationality and emotions.  We see a great undervalued business, we ask ourselves a bunch of questions, but we don't go through a systematic process of looking at every nook and cranny to figure out whether we got it right or not" Mohnish Pabrai

One mental short-cut is jumping to conclusions. Often an investor, sees only what they are looking for.  Here is a good example from Richards Heuer, author of the CIA handbook, the 'Psychology of Intelligence Analysts' ..

When you looked at the figure above what did you see?  The simple experiment demonstrates one of the most fundamental principles concerning perception: We tend to perceive what we expect to perceive [note each triangle contains two 'the''s or 'A's']. Mr Heuer noted:

"Many experiments have been conducted to show the extraordinary extent to which the information obtained by an observer depends upon the observer's own assumptions and pre-conceptions."

"Patterns of expectations tell analysts, subconsciously, what to look for, what is important, and how to interpret what is seen.  These patterns form a mind-set that predisposes analysts to think in certain ways.”

Daniel Khaneman, in his highly regarded book on human cognition and biases, "Thinking Fast and Slow" noted :

"Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. These are the circumstances where intuitive errors are probable"

A tendency also exists for people to search for confirming evidence and ignore or overlook disconfirming evidence. Given an investors initial decision to analyse a stock is grounded in the perception it may be an attractive 'buy' [or 'short'], all investors tend to carry a bias.

"We tend unconsciously to select evidence that will support our point of view" Bennett Goodspeed

"Contrary to the rules of philosophy of science, who advise testing hypothesis by trying to refute them, people seek data that are likely to be compatible with the beliefs they currently hold" Daniel Khaneman

In his excellent book 'The Tao Jones Averages', Bennett Goodspeed noted:

"Most of our personal, business, and investment problems are not caused because we lack intelligence or are lazy. Rather, the most common cause of failure is that we fail to see and/or otherwise ignore the numerous yellow and red warning signals that are waved before our eyes. One reason is that warning signals are but one of the many information inputs vying for our attention.. Another reason why we see reality so poorly, and often miss the warning signs, is that our logical left hemisphere interferes with the seeing abilities of the right brain."

Mr Goodspeed provides the following example: read carefully the sentence below and count the number of f's in the sentence. Re-read it again carefully:

Did you find all six f's? If not, you shouldn't be surprised, as only 15% of people who take the text get it correct. If you counted less than six (most count three) you likely missed the f's in the words 'of'.  Your error was not that you did not see the f's in the of's (you did), but that you failed to count them. Since 'of'' is phonetically 'ov' the verbal left hemisphere, by taking the verbal clue, overrode the right, 'seeing' hemisphere and thus forced the wrong conclusion.  The checklist will help avoid simple misses.

“Before I make the final decision to buy any stock, I turn to my checklist in a last-ditch effort to prevent my unreliable brain from overlooking any potential warning sign that I might have missed” Guy Spier

“I’m a great believer in solving hard problems by using a checklist. You need to get all the likely and unlikely answers before you; otherwise it’s easy to miss something important.” Charlie Munger

In the example above, you wouldn't have made the mistake if the words had been reversed and you couldn't read the sentence.  Bennnett Goodspeed shares the story of an art teacher who revolutionized the way art was taught. In her six-week drawing class, the improvement of her students was not gradual, but dramatic. Her technique for teaching art served to turn off the left brain hemisphere. She recognised that the left brain interferes with perception because of its simplistic certainty. If it can name and categorize something, it need not look carefully.

One of the instructional drawing exercises the teacher taught was to draw the picture upside down. The idea is to "trick" the left brain so that it is unable to characterize the facial components. In a like manner, forgers commonly copy signatures upside down in order to eliminate the bias of their own writing.  Many famous painters check there work in the reflection of a mirror for the same reason.

In a similar fashion, many of the Investment Masters invert their analysis, something that can be helped with the aid of a checklist.

"Our checklists have been invaluable in helping us reduce pilot error and they have become a platform to remind us of previous lessons learned. These lessons can be soon forgotten when animal spirits and biases emerge to prove a theory. Our checklists were built to invert our thinking the way a scientist would seek to prove the null hypothesis. For example, if we want to know if the investment is mispriced, the checklist seeks to invert the question to solve why the investment is NOT mispriced. We have found that this inversion helps reduce the biases that bleed into any investment process." Christopher Begg

Is it time you considered adopting checklists in your investment process? .... Stay tuned for Part 2 which will detail the attributes of a good checklist and provide the foundation for building your own...


Further Reading: 'Checklists Tutorial' - Investment Masters Class