Every day we make decisions based on some type of information –whether we do intensive research to decide on which college to attend, or simply read the ingredients on the package of bread to choose which brand to purchase. Investment decision-making is no different. Investment professionals, in particular, need to have a reasonable basis from which they form an opinion, make an investment decision or hone their investment process. This requires study, either through proprietary or third party research. Any decision made without research or outside of the established investment process is subject to a high degree of scrutiny and opens the manager up to legal actions should their investments fail.
Competence and Diligence
Each investment manager has a philosophy that governs their decision-making process. Fundamental managers’ processes rely on research that includes understanding a company’s business, its competitors and its financial statements to create a framework to determine if the company’s stock is a good investment. Technical managers look at charts and their patterns to determine if a company’s stock is a good investment. Both types of analysis provide the manager with a reasonable basis to form an investment decision.
Both fundamental and technical managers should base an investment decision on the facts known at the time of the research. The investment decision can change if the facts change, but at the time the manager makes his recommendation, as long as the basis for the decision was reasonable and based on his research in accordance with his process, then the decision is considered “sound.”
For example a manager decides to invest in Stock A because all his fundamental analysis points to an attractive valuation and the introduction of their new product is expected to grow 10% based on all the industry and competitive information gathered. But a month later, a competitor product is launched that has an unexpected better outcome and steals all the market share from Company A. Therefore, the manager decides to sell Stock A because this new information changed his investment decision.
Managers should communicate their process so the client understands the level, type and thoroughness of the information used. Managers will often use third-party research or computer-generated models to assist in their investment decision-making:
- Third-Party Research: Third-party research is research conducted outside of the investment firm, such as research from a bank or brokerage firm. This research needs to also have a sound basis and if the manager has reason to suspect that the third-party research comes from a source that makes poor assumptions or reflects opinion rather than fact, or if the analysis lacks rigor or if it is out-of-date, then the manager should not rely upon the information.
- Quantitative Research: This includes the use of computer-generated models, screening and ranking programs, and valuation models. This is a rapidly expanding area. In the past, computer models were used for back testing investments, but today they have more predictive applications. However, there are often limitations that are poorly understood. For example during the financial crisis of 2008, many of the financial models used to value collateralized debt securities and related derivative products had assumptions and other inputs that were poorly understood. Managers should understand the inputs and parameters used in the model or quantitative research, as well as the limitations and risks.
The Bottom Line
The importance of well-researched, credible and timely information when making a decision cannot be underscored. This is particularly true for investment decisions. The markets are ever changing requiring the ability to know where to get good information, how to synthesize that information into the investment process and how to interpret the output to make a sound investment. Managers are charged with having a sound basis when making an investment decision, and for ensuring the inputs that go into that decision are timely and accurate.