L Burke Files examines the necessity for due diligence, of understanding the risks of the choices we make. He outlines the need for a holistic approach to due diligence and risk management.
The point of due diligence is the process of doing one’s homework to correctly identify and understand the risks of a choice. It is not the process of eliminating risk, just identifying that risk
The errors most people make with due diligence is in their knowledge foundations and their mental constructs behind a choice. Most of the errors made by, what are otherwise purported to be very smart people, are the result of cognitive thought errors and a key modelling error. The thought errors are, Heuristics and Biases, and the Ludic Fallacy is the modelling error.
Why do we make these cognitive thought errors?
Heuristics are cognitive strategies people use to make assessments or judgments of a given probability simpler. We use heuristics to filter out informational noise so we can come to a choice quickly. These are also called intuitive inferences. This process of choice-making is used when we lack sufficient, unbiased information, to judge the probability of choice making. It is a process of generalisation.
Note the emphasis – heuristics strategies are used when we lack sufficient unbiased information to judge the probability of different outcomes. This is the heart of why due diligence is so important – it helps gather that independent information.
When useful heuristics can lead to systematic errors these are labelled ‘biases’.
These inferences, filters, opinions are preconceived notions that we all have are the biases. The problem with biases is that if left unchecked or more importantly, we remain unaware of them and their impact, the errors produced can be systematic and large.
Due diligence exists, especially independent due diligence, to check those biases and alter the choice maker to their biases.
Some examples of biases are:
Authority Bias is moving your perception of something based upon the perception of an authority figure, boss or an expert.
Confirmation Bias is interpreting data on events in such a way as to confirm what you already believe.
Conservative Bias is ignoring the impact of new information and evidence.
Halo Effect Bias is where you allow one positive trait, such as fame or prior success in another discipline, to spill over in areas requiring a more dispassionate assessment.
It would take only a few minutes of a commercial to see that many of the biases we have are used to sell us goods and services - just think of Authority and Halo Effect biases. A celebrity uses a toothpaste so we should use the toothpaste, or a business leader is discussing international diplomacy – because he has had success in a separate unrelated field we need to acknowledge that this experience has no bearing on the area he now pertains knowledge of. It does not take much imagination to see the many choices we make, each and every day, based solely on these biases or many other we possess.
Understanding our biases is the key to understanding the process of how we can and are led by others. People and corporations can use a number of our biases to get us to make choices that help them, often against our better interests. Just think of how many credentials a conman may purport to have that give him instant credibility, or how we often mistake excellent manners and the services of a good tailor for credibility trust.
Due diligence helps us to overcome our choice making events that are led by others who use the knowledge of our biases to direct our choices. Here the due diligence process only serves as a check to save us from ourselves and our biases when making a choice.
The last significant impairment we need to be aware of is the ‘ludic fallacy’, from the Latin ludus, meaning 'play'. It is summarised as "the misuse of games to model real-life situations".
The fallacy is mistaking the map (model) for the reality, an inductive side effect of human cognition.
These statistical models (games) only work in some domains like casinos in which the odds are visible and defined.
One example is the following thought experiment: There are two people: Dr. John, who is regarded as a man of science and logical thinking and Fat Tony, who is regarded as a man who lives by his wits.
A third party asks them, "assume a fair coin is flipped 99 times, and each time it comes up heads. What are the odds that the 100th flip would also come up heads?"
Dr John says that the odds are not affected by the previous outcomes. Just because a coin has a head does not mean it has any memory. The odds are still 50/50.
Fat Tony says that the odds of the coin coming up heads 99 times in a row are so low (less than 1 in 633 billion) that the initial assumption that the coin had a 50/50 chance of coming up heads is most likely incorrect. More likely da fix is in and he knows a guy who told him so.
The ludic fallacy here would be to assume that in real life the rules from the purely hypothetical model (where Dr John is correct) apply. Would a reasonable person bet on black on a roulette table that has come up red 99 times in a row (especially as the reward for a correct guess are so low when compared with the probable odds that the game is fixed)?
The problem we get from the ludic fallacy is our reliance upon models to predict outcomes and our failure to be able to understand the limits of the model and to ask the right questions of the model’s output.
There have been so many frauds that one finds behind them very reasonable mathematical models. As financial professionals how many times have we seen many of these models tied to MTN trading, CFX deals, commodities trading models etc? I have also seen many well-meaning investment disasters predicated on great mathematical models of a given market.
The most stunning disaster I have seen to date was a model for value predictions in the art market. It was used to raise money and take investors’ money to speculate in art. Math models for markets have two basic assumptions underlying a given market model. They are so basic we often do not even think of them. The first is that the goods of exchange are uniform and second that there is a fair and open market. The prices of art are prices on unique items and the exchange is not an open and fair market but one that is engineered, contrived and has very high transactions fees.
If you cannot even grasp the basic requirement for a model to be relevant, all of the remaining assumptions are the fiscal equivalent of cleaning up spilled milk with a rake.
The real impact...
When we fail to recognise our cognitive errors, when we fail to understand our numbers or models, we are subject to Black Swan Events (thank you Taleb). In statistics it is called fat tails, which are deviations well outside the norms of a bell curve that can occur on either side of the bell curve. They are rare events with significant outcomes.
From a risk management publication: "Earthquakes, typhoons, cyclones and hurricanes continued to devastate populous regions, and their increasing frequency and severity have stimulated new studies on causes, effects, and prediction, all part of the evolution of risk management."
One of the assumptive errors in that statement is that Magnitude seven earthquakes are more frequent - in actually they are not, there are just more people around to witness them or have moved into areas that have earthquakes.
Another error is to link frequency with amount of impact or potential damages as in a natural disaster.
For example a one in 20 year storm versus a one in 100 year storm does not mean the 100-year storm is only five times as destructive - it may be 1,000 times more destructive.
An example of a rare event with large impact was the financial crisis of 1986, where the banks lost more money than they had cumulatively made over history! I myself, when I was a trader in commodities, have also seen moves in a market of over 50s in a day. This type of move is earth shattering if you are on the wrong side.
Rare big changes can be more significant that than the sum of many small changes. The idea is not to position ourselves, or our clients, to be exposed to these rare events if negative, unprotected.
So what does this mean for us as financial professionals? We will need to be more rounded in our approach to due diligence. No one person or department can do it all. A holistic approach is the best fit for most financial professionals and their organisation. We now need to look for both the common events and also the rare negative events and to be able to make informed choices.
The risks in the future are going to be more dynamic and their impact of either a correct choice or a wrong choice will be swifter than ever before. Ideally, one would want to expose themselves to the upside of one of these events - if they can be foreseen.
The Internet is contributing to greater fluctuations and quicker fluctuations - for example JK Rowling and Harry Potter - everyone around the world is reading the same book - which, to my limited knowledge has not happened before in the history of publishing. This type of instant worldwide communication, with the resulting rapidity of cumulative market choices is now common.
Club goers in Los Angles text a photo of cool new shoes to a friend in London and Moscow - now the fad from Sunday is worldwide by Monday. Fluctuations have already increased a great deal and will grow larger for the foreseeable future.
We all make errors, it is part of life and a real part of the life of making choices. Ideally, if we have a better understanding of how we cognitively make choices we may be able to make more informed choices and ones with more solid foundations.
Often, we abdicate our choice making ability and responsibility to mathematical models and mysterious algorithms. These can be an aid, but they too have their limits. One of their limits is they rarely understand the impact of rare dramatic movements that I argue are going to be more common because of our reliance on these mathematical models and mysterious algorithms since so few are building them with the correct assumptions and failing to ask the right questions of the output. Those dramatic swings in culture and thus the markets will be more common and we must prepare for them with a holistic approach to our due diligence and risk management.
The most important part of due diligence is do diligence.
L. Burke Files Burke Files has been involved in finance since 1982 and in international finance since 1986. He has also served as the Director of Corporate Finance for an investment banking company; President of a business and venture capital consulting firm; and a commodities specialist trading gold, silver, and foreign currencies 24 hours a day. In the past, Mr Files has served as a member of the Governor's Board on Solid Waste Management; as an advisor to the Governor's Board on Economic Planning and Development; and as a former Commissioner of the City of Tempe Transportation Commission. Mr Files has also received a Commission and a Medal of Merit from the President of the United States. He has written extensively and been quoted in many publications. He is a frequently quoted source for articles regarding financial investigation and due diligence. Among the publications in which he has been quoted are: Chief Executive Officer, The American Southwest Quarterly, Offshore Journal, Cayman Today, Aegis e-Journal, John Cooke Fraud Report, El Cosario, European Business, NPR Market Watch, Bloomberg, USA Today and Associated Press. In addition to numerous published articles, Mr. Files is the author of many articles and several books including Due Diligence for the Financial Professional and Money and Budgets