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Professor Shyam Sunder
September 28, 2005
Attributes of a Good Investment Process
The Critical Role of Decision Making
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management
Decision-making for Investors
The Investment Process
Information
analysis
Information
Sources
 Diversity
 Weighing

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Decision-making for Investors
Economic focus
 Competitive strategy
 Analogy and metaphor

Decision
making
Proper framing
 Avoid pitfalls
 Internalize techniques

Agenda
1.
Practices of the best



2.
Expected value


3.
Probabilities
Outcomes
Why we are suboptimal


3
Process versus outcome
Odds in your favor
Understanding the role of time
Heuristics and biases
How we can benefit
Decision-making for Investors
The T Theory

The best in all probabilistic fields
Focus on process versus outcome
 Always try to have the odds in their favor
 Understand the role of time


4
The best have more in common with one another
than they do with the average participant in their
field
Decision-making for Investors
Process versus Outcome
 In
any probabilistic situation, you must develop
a disciplined and economic process
 You
must recognize that even an excellent
process will yield bad results some of the time
 The
investment community—largely reflecting
incentives—now seems too focused on
outcomes and not enough on process
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Decision-making for Investors
Process versus Outcome
Outcome
Process Used to Make the Decision
Good
Bad
Good
Bad
Deserved Success
Dumb Luck
Bad Break
Poetic Justice
Source: J. Edward Russo and Paul J.H. Schoemaker, Winning Decisions (New York: Doubleday,
2002), 5.
Try not to confuse outcomes and process
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Decision-making for Investors
Process versus Outcome
Any time you make a bet with the best of it, where the
odds are in your favor, you have earned something on that
bet, whether you actually win or lose the bet. By the same
token, when you make a bet with the worst of it, where the
odds are not in your favor, you have lost something,
whether you actually win or lose the bet.
David Sklansky, The Theory of Poker, 4th ed.
(Henderson, NV: Two Plus Two Publishing, 1999), 10.
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Decision-making for Investors
Process versus Outcome
Any individual decisions can be badly thought through, and
yet be successful, or exceedingly well thought through, but
be unsuccessful, because the recognized possibility of
failure in fact occurs. But over time, more thoughtful
decision-making will lead to better overall results, and more
thoughtful decision-making can be encouraged by
evaluating decisions on how well they were made rather
than on outcome.
Robert Rubin
Harvard Commencement Address, 2001
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Decision-making for Investors
Odds In Your Favor
Asset prices reflect a set of expectations
 Investors must understand those expectations
 Expectations are analogous to the odds—and
the goal of the process is finding mispricings
 Perhaps the single greatest error in the
investment business is a failure to distinguish
between knowledge of a company’s
fundamentals and the expectations implied by
the price

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Decision-making for Investors
Odds In Your Favor
The issue is not which horse in the race is the most
likely winner, but which horse or horses are offering
odds that exceed their actual chances of victory . . .
This may sound elementary, and many players may
think that they are following this principle, but few
actually do. Under this mindset, everything but the odds
fades from view. There is no such thing as “liking” a
horse to win a race, only an attractive discrepancy
between his chances and his price.
Steven Crist, “Crist on Value,” in Beyer, et al., Bet with the Best
(New York: Daily Racing Form Press, 2001), 64.
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Decision-making for Investors
Odds In Your Favor
I defined variant perception as holding a well-founded view
that was meaningfully different from the market consensus
. . . Understanding market expectation was at least as
important as, and often different from, the fundamental
knowledge.
Michael Steinhardt, No Bull: My Life in and Out of Markets
(New York: John Wiley & Sons, 2001), 129.
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Decision-making for Investors
The Role of Time
Because investing is about probabilities, the
short-term does not distinguish between good
and poor processes
 A quality process has a long-term focus
 The investment community’s short-term focus
is costly, and undermines a quality long-term
process

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Decision-making for Investors
The Role of Time
Over a long season the luck evens out, and skill shines
through. But in a series of three out of five, or even four out
of seven, anything can happen. In a five-game series, the
worst team in baseball will beat the best about 15 percent
of the time. Baseball science may still give a team a slight
edge, but that edge is overwhelmed by chance.
Michael Lewis, Moneyball: The Art of Winning an Unfair Game
(New York: W.W. Norton & Company, 2003), 274.
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Decision-making for Investors
The Role of Time
The result of one particular game doesn’t mean a damn
thing, and that’s why one of my mantras has always
been “Decisions, not results.” Do the right thing enough
times and the results will take care of themselves in the
long run.
Amarillo Slim, Amarillo Slim in a World of Fat People
(New York: Harper Collins, 2003), 101.
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Decision-making for Investors
1
1
0.9
0.9
0.8
0.8
Percentage of Heads
Percentage of Heads
The Role of Time
0.7
0.6
0.5
0.4
0.3
0.6
0.5
0.4
0.3
0.2
0.2
0.1
0.1
0
0
1 2 3 4
5 6 7 8
9 10 11 12 13 14 15 16 17 18 19 20
Trial Number
15
0.7
Decision-making for Investors
1
21
41
61
Trial Number
81
From Theory to Practice

Principles of expected value
How do you set probabilities?
 How do you consider outcomes?

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Decision-making for Investors
Expected Value
Expected value is the weighted average value
for a distribution of possible outcomes
Take the probability of loss times the amount of
possible loss from the probability of gain times the
amount of possible gain. That is what we’re trying to
do. It’s imperfect, but that’s what it’s all about.
Warren E. Buffett
Berkshire Hathaway Annual Meeting, 1989.
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Decision-making for Investors
Expected Value
Expected value—drug
development
Scenario
Breakthrough
Above average
Average
Below average
Dog
Probability
10%
10
60
10
10
100%
Value (outcome) Weighted Value
$1,323,920
661,960
66,200
7,440
6,620
$132,392
66,196
39,720
744
662
Expected Value $239,714
Source: David Kellogg and John M. Charnes, “Real Options Valuation for a Biotechnology Company,”
Financial Analysts Journal, May/June, 2000, 76-84.
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Decision-making for Investors
Expected Value
Risk versus uncertainty
Risk – we don’t know outcome, but we know what the
underlying distribution looks like

incorporates the element of loss/harm
Uncertainty – we don’t know the outcome, and we don’t
know what the underlying distribution looks like

need not incorporate loss/harm
Source: Frank H. Knight, Risk, Uncertainty, and Profit (Boston: Houghton and Mifflin, 1921).
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Decision-making for Investors
How do we Think about
Probabilities?
Three ways to set probability
1. Degrees of belief


Subjective probabilities
Satisfy probability laws
2. Propensity


Reflect properties of object or system
Roll of a die: one-in-six probability
3. Frequencies


Large sample of appropriate reference class
Finance community largely in this camp
Source: Gerd Gigerenzer, Calculated Risks (New York: Simon & Schuster, 2002), 26-28.
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Decision-making for Investors
How do we Think about Probabilities?

Beware of nonstationarity
For past averages to be meaningful, the data being
averaged must be drawn from the same population. If
this is not the case—if the data come from populations
that are different—the data are said to be
nonstationary. When data are nonstationary, projecting
past averages typically produces nonsensical results.
Bradford Cornell, The Equity Risk Premium
(New York: John Wiley & Sons, 1999), 45-46.

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Multiples are probably nonstationary
Decision-making for Investors
How do we Think about Outcomes?
Frequency Distribution of S&P 500 Daily Returns
December 29, 1977 - March 3, 2005
250
Frequency
200
150
100
50
0
-10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
Standard Deviation
Frequency Difference: Normal versus Actual Daily Returns
December 29, 1977 - March 3, 2005
100
Difference in Frequency
80
60
40
20
0
-10 -9
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
-20
-40
-60
Source: Factset.
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Decision-making for Investors
Standard Deviation
3
4
5
6
7
8
9
10
How do we Think about Outcomes?
Value
Triggers
Value
Factors
Volume
Price
and Mix
Sales
Operating
Value
Drivers
Sales
Growth
Rate (%)
Operating
Profit
Margin (%)
Operating
Leverage
Economies
of Scale
Operating
Costs
Investments
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Decision-making for Investors
Cost
Efficiencies
Investment
Efficiencies
Incremental
Investment
Rate (%)
How do we Think about Outcomes?
Google Options Implied Distribution
0.60
Implied Probability
0.50
0.40
0.30
0.20
0.10
150
200
250
300
350
Stock Price
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Decision-making for Investors
400
450
500
Frequency versus Magnitude

Both frequency (probability) and magnitude
(outcome) matter
Good probability, bad expected value
Probability
Outcome
Weighted Value
70%
+1 %
+0.7%
30%
100%
-10
-3.0
-2.3%
Bad probability, good expected value
Probability
25
Outcome
Weighted Value
70%
-1 %
-0.7%
30%
100%
+10
+3.0
+2.3%
Decision-making for Investors
Frequency versus Magnitude
Indeed, I can be wrong more often than I am right, so long
as the leverage on my correct judgments compensates for
my mistakes. At least that is how my investments have
worked out thus far. A statistician might deplore this
approach, but it has worked for me for a half century.
Leon Levy, The Mind of Wall Street
(New York: PublicAffairs, 2002), 197.
.
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Decision-making for Investors
Role of Time—Loss Aversion

Samuelson’s lunch bet
Flip a fair coin
 Correct call you win $200
 Incorrect call you lose $100

 Samuelson
proved that if you are willing to play
100 times, you should play once

Samuelson’s theory doesn’t feel right
See: Paul A. Samuelson, “Risk and Uncertainty: A Fallacy of Large Numbers,” Scientia, XCVIII, 1963, 108-113.
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Decision-making for Investors
Role of Time—Loss Aversion
Myopic Loss Aversion

We regret losses more than similar-sized gains. Since
the stock price is typically the frame of reference, the
probability of loss or gain is important. A longer holding
period means a higher probability of a gain.

The more frequently we evaluate our portfolios, the
more likely we are to see losses and hence suffer from
loss aversion.
Source: Shlomo Benartzi and Richard H. Thaler, “Myopic Loss Aversion and The Equity Premium Puzzle,”
The Quarterly Journal of Economics, February 1995, 79-92.
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Decision-making for Investors
Role of Time—Loss Aversion
29

As a result, a long-term investor is willing to
place a higher value on a risky asset than a
short-term investor

Valuation depends on your time horizon
Decision-making for Investors
Overconfidence

We consistently overrate our capabilities,
knowledge, and skill

We tend to project outcome ranges that are
too narrow

Overconfidence can lead to excessive trading
See: Brad Barber and Terrance Odean, “Trading is Hazardous to Your Wealth: The Common Stock
Investment
Performance of Individual Investors,” Journal of Finance, 55, April 2000, 773-806.
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Decision-making for Investors
Heuristics

Other pitfalls
Framing
 Anchoring and adjusting
 Confirmation trap

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Decision-making for Investors
How Can We Benefit?

32
Look for diversity breakdowns

We often make decisions by observing others

Information cascades―a reasoned or arbitrary
decision by one individual triggers action by many

Herding―when a large group of investors make the
same choice based on the observations of others,
independent of their own knowledge
Decision-making for Investors
How Can We Benefit?

How do we lose diversity?

Imitation

Solomon Asch experiment
X
A
B
C
Illustration by LMCM based on S. E. Asch, “Effects of Group Pressure Upon the Modification and
Distortion of Judgment,” in Harold Guetzkow, ed., Groups, Leadership and Men (Pittsburgh, PA: Carnegie
Press, 1951).
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Decision-making for Investors
How Can We Benefit?






Asch always wondered: Did the people who gave in to the group
do so knowing that their answers were wrong? Or did the social
pressure actually change their perceptions?
The new study tried to find an answer using fMRI scanners.
The researchers found that social conformity showed up in the
brain as activity in regions that are entirely devoted to
perception.
But independence of judgment—standing up for one's beliefs—
showed up as activity in brain areas involved in emotion.
"We like to think that seeing is believing," said Dr. Gregory
Berns, a psychiatrist and neuroscientist at Emory University who
led the study.
But the study's findings show that seeing is believing what the
group tells you to believe.
Source: Sandra Blakeslee, “What Other People Say May Change What You See,” The New York Times, June
28, 2005.
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Decision-making for Investors
Takeaways
Investing is a probabilistic exercise
 Expected value is the proper way to think
about stocks
 There are many pitfalls in objectively
assessing probabilities and outcomes
 We need to practice mental discipline or else
we’ll lose long-term to someone who is
practicing that discipline
 Markets periodically go to excesses

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Decision-making for Investors
Legg Mason Capital Management ("LMCM":) is comprised of (i) Legg Mason Capital Management, Inc. ("LMCI"), (ii) Legg
Mason Funds Management, Inc. ("LMFM"), and (iii) LMM LLC ("LMM").
The views expressed in this commentary reflect those of LMCM as of the date of this commentary. These views are subject to
change at any time based on market or other conditions, and LMCM disclaims any responsibility to update such views. These
views may not be relied upon as investment advice and, because investment decisions for clients of LMCM are based on
numerous factors, may not be relied upon as an indication of trading intent on behalf of the firm. The information provided in this
commentary should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. To the
extent specific securities are mentioned in the commentary, they have been selected by the author on an objective basis to
illustrate views expressed in the commentary. If specific securities are mentioned, they do not represent all of the securities
purchased, sold or recommended for clients of LMCM and it should not be assumed that investments in such securities have
been or will be profitable. There is no assurance that any security mentioned in the commentary has ever been, or will in the
future be, recommended to clients of LMCM. Employees of LMCM and its affiliates may own securities referenced herein.
36
Decision-making for Investors
Professor Shyam Sunder
September 28, 2005
Attributes of a Good Investment Process
The Critical Role of Decision Making
Michael J. Mauboussin
Chief Investment Strategist
Legg Mason Capital Management
Decision-making for Investors