Noise - Chapter 11
Sources Of Noise: Investment Team
Briefly: Investment Team
The members of your investment team are a source of noise when:
Hiring. They’re hired for similarity rather than diversity.
Rewarding. They’re rewarded for luck rather than contribution.
Aggregating. Their contributions are poorly aggregated.
The members of your investment team are there to support you in your quest to find and capture alpha opportunities for your clients. But your team can also hinder your ability to generate alpha.
There are two ways in which your team can be a source of noise, depending upon the interpersonal dynamics within the team.
Acrimony. Strong personalities can engage in a ruthless struggle for dominance. The type of noise generated in an acrimonious team is manifest noise; it’s easy to spot, and it’s clearly destructive.
Harmony. Individuals can go to great lengths to avoid conflict and maintain cohesion. The type of noise generated in a harmonious team is latent noise; it’s not obviously noise, but it’s surprisingly dangerous.
Acrimony
You will have acrimonious relationships when there is more than one strong personality in a team that has an unsettled dominance hierarchy. What is ostensibly a vigorous debate about the merits of an investment idea is really an ego-driven fight to establish dominance. This produces more noise than information. The focus of the protagonists is on winning the fight with one another, and to them the ensuing destruction of alpha is merely collateral damage.
When an individual has established dominance in their area they will go to great lengths to suppress the threat of dissenting opinions. Those who have been defeated in battle, and who choose to stay with the firm, will defer to the opinions of the team’s top dog. The focus of the vanquished is on career survival, and their submission to the bigger ego means that potentially productive discussion about investment opportunities does not take place. Others will not tolerate suppression and will choose to leave the team and join the opposition.
Example: Soros Fund Management
George Soros founded his firm in 1970 with a staff complement of three: Soros himself; his partner, Jim Rogers; and a secretary. The combination of Soros’ trading skill and Rogers’ research made for a very successful partnership that lasted until 1980.
Soros said that they needed to grow the fund management team to cope with their growth in assets, and he and Rogers decided to bring in talented people with little experience who they could train up to share the workload. While this was fine in theory, it didn’t work out quite so well in practice. Rogers’ inability to tolerate dissent from junior members of the team became a major obstacle to this process. Soros said, “When they began to learn and started to take issue with Jim, Jim couldn’t stand the criticism coming from below.”
Soros said that Rogers had no problem dealing with disagreement between the two senior members of the team, where each had his own turf: Soros the trader and Rogers the analyst. “[But] he couldn’t stand his disciples criticising him or disagreeing with him, so as soon as they became really productive, he would go out of his way to destroy them.” This degree of acrimony in the team led to the loss of talented people in whom the organisation had invested, and it created intolerable strain on the relationship between Soros and Rogers. Soros said, “It eventually came to the point where it broke up our partnership.”
The noise created by Rogers’ behaviour towards the members of his team had very negative consequences for those team members, for Rogers himself, and for one of the most successful investment partnerships. It ended badly because of the levels of acrimony in the team.
Harmony
You will have harmonious relationships in your team when the opinions of each team member are heard and respected, and everyone’s ideas are treated as equal. This is a team operating as a democracy, where the harmonious feelings are more highly valued than the results generated by the team. While harmony can be attractive, it is not necessarily productive. Harmony is not the absence of noise, it is noise in latent form that will manifest at some time, usually in the shape of poor investment results.
This team will be beaten because its focus is on avoiding friction rather than generating alpha. The members of an investment team must be focused on finding the best ideas and stress-testing those ideas before they get implemented in the portfolio. This process calls for vigorous debate, which can cause great discomfort. If that discomfort is inadequately tolerated, then vital information and insight will remain obscured, and the preference for a veneer of harmony ultimately will show up as a hole in the team’s track record.
You can transcend the acrimony/harmony duality and deliver better investment results if you ensure that these three conditions are met:
Diversity. The members of the team see and think differently to one another.
Incentives. The right behaviours are rewarded.
Aggregation. The best ideas are heard and implemented.
Diversity
Often, though, organisations hire for similarity rather than diversity. The false calculus of this practice is that hiring people who share similar philosophical, professional and academic backgrounds seems to make for a better fit, which makes for a better team and for better results. Not so: if you have five people in a room who see the world the same way, you have four people too many, or four of the wrong people. A team that lacks diversity is prone to groupthink and overconfidence. The whole is less than the sum of the parts.
Incentives
And, often, members of a team are rewarded for investment performance. This seems sensible, given the fact that performance numbers are objective, and individuals and teams live or die by their performance. However, the time scale used for calculating performance is usually way too short for it to be possible to make any meaningful assessment of the relative contributions of skill and luck to the performance number.
The best performance numbers are not necessarily a function of the greatest skill because skill is always entangled with random luck or noise. You can diverge from your well-designed process, make poorly grounded decisions, get lucky and beat your benchmark, and get richly rewarded. This unskillful behaviour is not what should be rewarded and encouraged, but it often is, and it creates distortions and problems.
Aggregation
Most usually, it is the loudest voice that is heard when a team debates an investment idea. But the most valuable contribution to the team is seldom best measured in decibels, a literal manifestation of noise.
Investment teams are famously bad at ensuring that the best ideas are heard. Many teams are highly political, despite protestations to the contrary, where ideas are shared tactically to serve individuals’ career advancement rather than alpha generation.
Non-consensus ideas are those that contain alpha-potential, but they are also a difficult sell. Members of your team, particularly the more cerebral and reticent, can opt to not use their political capital on an idea that is unlikely to be given due airtime and ready acceptance, and they can choose to play it safe or say nothing, neither of which puts you ahead of your competitors in the search for alpha.
One of the reasons that few teams seek to be better at the aggregation of ideas is because of the prevalence of the myth of the lone genius. This myth suggests that the smartest guy in the room (that’s generally how fund managers see themselves) is better left alone, undisturbed and undiluted by the involvement of lesser mortals. A close cousin of the lone-genius myth is the antipathy for group decision-making. This antipathy makes sense because teams do generate noise, and management by committee almost inevitably leads to mediocre results.
This is captured by a quote ascribed to Peter Lynch, who managed the Magellan Fund at Fidelity Investments between 1977 and 1990, during which time it was the world’s best performing mutual fund, compounding at 29% p.a.: “If no great book or symphony was ever written by committee, no great portfolio has ever been selected by one either.”
This very quote perpetuates the myth, the lone genius Lynch decrying management by committee, but it is somewhat disingenuous because Lynch did not manage the $14 billion fund with its 1,000+ positions all on his own. He had input from a team, and he was very skillful at aggregating that input and coming to investment decisions that resulted in above-average returns. That his successors were not as successful as Lynch underscores his skill at aggregation. It is an error to assume that skillful aggregation is the same thing as management by committee.
It is also falsely assumed that groups give rise to groupthink, a behavioural form of latent noise that is responsible for a significant share of decision errors, and therefore that groups are something to be avoided. This is wrong because it is not groups per se that give rise to groupthink, but rather it is poor aggregation that gives rise to the suppression of dissenting opinions (often by the “lone genius”) that characterises groupthink.
Another reason that few teams aggregate well is that it’s difficult. The simple fact that so many investment teams are so profoundly bad at intelligent aggregation means that the way that you collaborate is a source of competitive advantage, possibly even the single greatest source. There is one organisation that has invested significant effort in the science of aggregation, and the results are evident in the firm’s investment performance.
Example: Bridgewater Associates
Ray Dalio founded Bridgewater Associates in 1975 as an investment advisory service, and he transformed it into the largest hedge fund in the world with $160 billion under management and 1,700 employees (as of 2017). During this time the firm generated cumulative dollar-returns of $50 billion for its investors, more than any other hedge fund in history.
Dalio ascribes this success to the firm’s philosophy of cultivating a meritocracy of ideas that is based on a pursuit of radical truth through radical transparency. Dalio’s co-CEO, Eileen Murray, told Bloomberg, “What really distinguishes Bridgewater is truth at all costs.” While the quest for transparency and truth has served the firm and its clients well, the costs associated with near-constant surveillance (most meetings are recorded) and the relentless criticism and probing are too high for some to bear. About 20% of recruits quit or are fired within their first year and a further 10% leave before the end of their second year. According to the Wall Street Journal: “The pressure is such that those who stay sometimes are seen crying in the bathrooms, said five current and former staff members.”
The way in which the opinions of individuals are aggregated is key to the firm’s success. Dalio said in a TED talk: “Collective decision-making is so much better than individual decision-making if it’s done well.” As an example, members of the investment team, as well as other employees, are required to use an in-house app, called the Dot Collector, to rate one another in real time on about 75 attributes so that opinions can be aggregated and weighted according to each individual’s “believability”.
Dalio says in his book, Principles, that the Dot Collector “...promotes open-minded, idea-meritocratic, collective decision making.” It is a grounded way of reaching better decisions, based on the collective input of team members, but crucially by aggregating their opinions in a way that more heavily weights the opinions of those that have greater credibility on the issue being discussed. This allows Bridgewater to make decisions that are neither democratic nor autocratic, but meritocratic. It is not the boss’s idea that gets implemented, or the average idea, but the best idea.
References
Train, J. (2000) Money masters of our time. New York: HarperCollins.
Soros, G. (1995) Soros on Soros: staying ahead of the curve. New York: John Wiley & Sons.
Mauboussin, M. (2013) Think twice: harnessing the power of counterintuition. Boston: Harvard Business Review Press.
Dalio, R. (2017). Principles. New York: Simon & Schuster.
Kegan, R. & Lahey, L. (2016). An everyone culture: becoming a deliberately developmental organisation. Boston: Harvard Business Review Press.
Article in The New Yorker on 25 July 2011 by John Cassidy: ‘Mastering the machine: how Ray Dalio built the world’s richest and strangest hedge fund.’
Article in The Wall Street Journal on 22 December 2016 by Rob Copeland & Bradley Hope: ‘The world’s largest hedge fund is building an algorithmic model from its employees’ brains.’
Article in The New York Times on 4 September 2017 by Andrew Ross Sorkin: ‘Bridgewater’s Ray Dalio dives deeper in the ‘Principles’ of tough love.’
Article in Bloomberg Markets on 10 August 2017 by Katherine Burton & Saijel Kishan: ‘Dalio’s quest to outlive himself.’
Talk given on TED.com in April 2017 by Ray Dalio: ‘How to build a company where the best ideas win.’