Downside Protection: The Changing Methods and Mindset of Investment Research

Conducting the best research is an ongoing challenge for even the most organized investment firms with the most resources. For individuals and small institutions, however, it can be frustrating and outright overwhelming. Fortunately, there is a useful analogue with the intelligence community that provides instructive lessons on how to approach the task.

Certainly parallels exist. In both investment research and intelligence efforts, masses of information flooding in need to evaluated. In both efforts, information and themes need to be prioritized such that the most important receive the most attention. In both efforts, the possibilities of very significant, non-linear events also exist. One silver lining resulting from the events of 9/11 was that we also learned a lot about what not to do when conducting research -- and these lessons apply to the financial crashes of 2000 and 2008.



In the New York Times Magazine article, "Open-Source Spying" [here], Clive Thompson quickly identifies the paradox of U.S intelligence systems. According to the chief information officer for the office of the director of national intelligence at the time, "The 16 intelligence organizations of the U.S. are without peer. They are the best in the world." The question he raises, however, is "Are they collectively the best?"

In hindsight, they quite clearly were not. Closer inspection revealed all kinds of obstacles that emerged from the interrelationships of the various intelligence agencies and that prevented useful insights from being made. Unfortunately, "None of the agents knew about the existence of the other evidence. The report concluded that the agencies failed to 'connect the dots'."

Further, some of the obstacles were structural: "If an analyst requested information from another agency, that request traveled through elaborate formal channels." Worse, "In the past, each agency chose its own outside contractor to build customized software -- creating proprietary systems, each of which stored data in totally different file formats." While ideally any effort to increase knowledge ought to revolve around sharing information, in practice, the intelligence agencies kept information in silos.

For those involved in investment research many of these issues will sound familiar. Individual excellence is lauded for many participants such as industry analysts and subject matter experts such as economists. While much of the information gathered by such experts may be very good, too often structures and incentives prevent the complete assimilation of insights. For one, the aggregation of narrowly focused expertise creates many "cracks" through which important information can fall. The bigger problem, however, is often cultural. When the ethos of "need to know" is more important than the mandate of "need to share", assimilation will suffer.

These are not the only costs of siloed and proprietary information though. In such a system, holders of unique knowledge also often hold the power to create a narrative around that knowledge. Not surprisingly, that narrative can be created partly or wholly out of self-interest and it can be extremely difficult to effectively challenge that narrative or to detect potential flaws. Indeed this is increasingly recognized as a problem at the highest levels of corporate decision making. As Ann Mule and Charles Elson point out in "A new kind of captured board" [here], having sufficient representation by independent directors with industry expertise is essential in preventing the board from being "captured" by the knowledge of management.

While it became increasingly clear what didn't work, it still wasn't clear how best to resolve the primary challenge: "What the agencies needed was a way to take the thousands of disparate, unorganized pieces of intel they generate every day and somehow divine which are the most important." To this end, the success of the internet in helping people find information proved a guiding insight. The hypothesis that, "the real power of the Internet comes from the boom in self-publishing: everyday people surging online to impart their thoughts and views," further focused where improvements could be made.

Whereas the boom in self-publishing has certainly opened a window to the world that didn't exist before, the near ubiquity of smartphones and other connected devices has pushed that window even much further open. The consequences for research are quite meaningful. On one hand, "Top-secret information is becoming less useful than it used to be," because so many people now have good access to what is going on all over the world. On the other, "more value can be generated by analysts sharing bits of 'open source' information -- the nonclassified material in the broad world, like foreign newspapers, newsletters, and blogs."

One key lesson from the analysis is that the nexus of value for research is evolving and this has very significant implications for investors and investment committees. As technology is gradually eroding the value of "secrets," it is also increasing the value of assimilating, curating, and synthesizing information. As a result, it is no longer sufficient to have individually excellent, but collectively deficient research sources and research organizations will need to adapt to this reality.

A more dramatic lesson is that for many the entire mindset towards research will need to change. The overarching purpose of any research effort is to understand what is going on such that you can benefit from the landscape. In times of low volatility and complacency, it's not surprising that many focus on incremental gains. As the events of 9/11 reveal all too clearly, however, the avoidance of catastrophic losses is also an important "benefit" of truly understanding one's environment. Further, the avoidance of losses requires a constant and ongoing effort, regardless of whether those losses materialize or not. This applies to investment portfolios just as much as it does in real life. Many of the lessons from 9/11 have been learned and applied in the intelligence community; it's not so clear the same has happened in regards to the financial crashes of 2000 and 2008.

© Arete Asset Management

© Arete Asset Management

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