Great post for people in the investment field:
Farnham Street is an amazing blog dedicated to discussing mental models and they do a great job of explaining the challenges of proximate vs root causes and how to deal with the deductive problems that can occur when we jump to conclusions too quickly.
In investments we are always coming up with narrative to explain what happened. The financial press exist purely on this, reporting the day after on why the markets have moved the way they have as if it’s an obvious truth. Making an investment is much harder, you need to look forward to what is likely to happen.
When assessing our investment outcomes we are also immensely susceptible to a whole range of behavioural biases. The issue of proximate cause and narrative fallacy often comes up.
Proximate cause: The manager lost a lot of money because the position was very big and the stock blew up because company management were hiding what they were really doing and no one could have know. Root causes: they failed to size the position correctly because they failed to assess the risk in the investment correctly, they failed to assess the risk because they were trying to cover too many different investments without enough resource, or they failed to assess the risk properly because they did not have enough independent challenge to the key decision maker, or they failed to assess the risk properly because the analyst was not diligent enough/experienced enough to identify the risks…
Each of those different causes has very different corrective actions and very different reactions that we should have as asset allocators.
The opposite can also be true: the manager lost money, what an idiot, obviously they should have seen the risks, because now with hindsight we have the narrative stating how obvious it was. But at the time they understood the risks. They sized appropriately for the risks. And things just didn’t go their way this time, which will happen 45% of the time for most money managers.
The key to differentiating between these different potential cases is asking the right questions, and asking more and more questions. Digging deeper and challenging your assumptions.
In the Farnham Street article the particular route I like is asking “Why?” 5 times?
Why did you lose money? We sized it to big and got it wrong.
Why did you size it to big? We misestimated the risk.
Why did you misestaimate the risk? The analyst was an idiot.
Why was the analyst an idiot? Oh they are not really an idiot. It’s because we left him to do the work on their own and did not provide independent challenge
Why did you not provide independent challenge? Because I was too distracted on something else.
It reminds me of Ricardo Semler, who applies this approach to much of his business decisions, for him it seems to work when you just ask Why three times?
He is interviewed by Tim Ferriss episode 229 which can be found here. It’s a really inspirational podcast that covers his approach to building a phenomenally successful business with a very unconventional management style, well worth a listen for all sorts of good reasons.
The Farnham Street post also has a great explanation of other mental models which are all relevant to Investment decision making if you read down to the end.