Additive, hierarchical and disqualifying decision processes

Technical books about investment tend to focus on quantitative techniques: ratio analysis, DCF and so on. 

Few say much about decision techniques: how do you combine all the quantitative and other inputs to decide whether or not to add the share to your portfolio?  (I am disregarding the “textbook” answer of mean-variance optimisation , which is useless to me in practice, because my investment thinking doesn’t produce, and can’t easily be translated into, estimates of means and variances.  I agree with Vernon (chapter 7 in the book): “Learning modern portfolio theory to pick investments is like learning physics to play snooker.”)

Investment decision techniques can be characterised as additive, hierarchical and disqualifying processes.

Weighted additive decision processes weight and sum all relevant factors about a share to arrive at a decision. 

Hierarchical decision processes group factors according to their importance.  The process recommended by Vernon (chapter 7) is an example: a core thesis (a sentence or two); a few secondary factors; and a larger number of ‘due diligence’ checks on hygiene factors.   

Disqualifying decision processes exclude a share from further consideration as soon as a significant negative feature is found.  Rather than the negative feature being weighted against other more positive factors (as in an additive or possibly hierarchical process), it disqualifies the share from further consideration.  For example: high debt? Forget it. Low operating margin? Forget it.  Doubts about management integrity? Forget it.

A disqualifying process probably leads to more type II errors (rejection of good investments) than other types of decision process. But it’s probably much quicker than other processes, so you can evaluate many more shares. This may be a good trade-off.

Guy Thomas Saturday 19 November 2011 at 11:01 am | ΒΆ | Default | No comments