4/22/2020 Evaluating management: Bayesian reasoning and fallacy of obviousness | Intelligent investing
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Understanding and applying value investing principles
Aug
Evaluating management: Bayesian reasoning and
fallacy of obviousness
Comment
Rohit Chauhan
Investing Philosophy
When I invest in companies, I don’t vouch for or give a character certificate to
management. I look at the past and current behavior and then try to arrive at a
judgement. In majority of the cases, past behavior is a good indicator, but we do get
surprises from time to time (see the case of company X here).
If new developments make me change my view, I will not try to defend my past decision
which was made on a different set of facts. The key is to rationality is to evaluate new
facts appropriately and move on from there. As John Maynard Keynes said a long time
ago – when facts change, I change my mind. What do you do sir?
Let’s move to the point of how to evaluate management quality in light of poor behavior?
For starter, there is no formulae which will give the answer. The best analogy to judge
management quality comes from the court system in passing verdict on defendants. A
defendant is assumed innocent till proven guilty.
I personally try to look at management with a neutral view when I start analyzing a
company. They are neither good nor bad. This is a very important point. I have seen
majority of investors start with a presumption of a good or bad management and then
collect evidence to prove it. It is very easy to make an assumption and gather enough
evidence to prove your point.
The fallacy of obviousness
See this wonderful article which makes the same point. I would highly recommend
reading this article. Some excerpts –
So, given the problem of too much evidence – again, think of all the things that are
evident in the gorilla clip – humans try to hone in on what might be relevant for
answering particular questions. We attend to what might be meaningful and useful
However, computers and algorithms – even the most sophisticated ones – cannot
address the fallacy of obviousness. Put differently, they can never know what might be
relevant. Some of the early proponents of AI recognised this limitation (for example, the
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4/22/2020 Evaluating management: Bayesian reasoning and fallacy of obviousness | Intelligent investing
computer scientists John McCarthy and Patrick Hayes in their 1969 paper, which
discusses ‘representation’ and the frame problem).
In short, as Albert Einstein put it in 1926: ‘Whether you can observe a thing or not
depends on the theory which you use. It is the theory which decides what can be
observed.’ The same applies whether we are talking about chest-thumping gorillas or
efforts to probe the very nature of reality
Equal priors
The key is to start without an assumption (50-50 probability for both scenarios or equal
priors) and look at the meaningful (and not trivial) evidence to come to a conclusion.
Once you have done that, your conclusion should not be set in stone, but treated as a
hypothesis which can change based on new evidence.
If the management continues to behave well, your confidence is increased. If you start
seeing negative behavior, your confidence goes down and at some point (which cannot
be mathematically defined), you may lose faith in the management and exit the position.
The above approach is fancifully also called Bayesian reasoning.
One should think probabilistically when evaluating management and not consider these
issues as black or white. That’s the essence of Bayesian reasoning.
The central point of this approach is to look at new evidence in light of your prior
conclusion and change it in proportion to the evidence. In some case, the new episode
may be a small one and will cause you to reduce your level of confidence a bit. In other
cases, either the episode or series of episodes will be so awful, that you will be forced to
change your mind completely.
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