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Monday, February 7, 2011

The case for being sceptical in the finance world

  Pick up 'popular' analyst recommendations/research reports and you notice a 'story'. Communication experts prescribe stories as the way to impress others as mentioned in this book. While we enjoy stories in mass media(movies, books, TV, news), they are dangerous to use in investing.As Howard Marks puts it in his excellent letter to investors here,  
getting the most out of a book, play or movie usually requires “willing suspension of disbelief.”  We’re glad to overlook the occasional plot glitch, historical inaccuracy or physical impossibility because it increases our enjoyment. 

This is manifested in the 'confirmation bias' seen in investors where they
 selectively pick information that supports their hypothesis, or ignore information that goes against the hypothesis. Chartered Accountants(CAs) are trained(and if licensed in public practice, must) to adopt 'professional skepticism'. It does not mean being cynical or prejudiced against the client but means that one should keep an alert, inquisitive  and open mind for any inconsistencies/issues. This sort of training helps in investing because even the best executed frauds have some minor inconsistency which a well trained & receptive mind can capture. Whether you are an investment banker signing off an client due diligence, a trader deciding on increasing the limits of a client or a risk manager doubtful about data accuracy, that skeptical attitude can pay rich dividends.

Some readers may feel that this is merely 'intuition' learnt from the school of hard knocks. To them, I say that being systematic and following checklists(allowing for skepticism) hastens the process.

Moral:- If you do not want to get seduced by flowery stories, do keep a skeptical eye on the infirmation you get-including this post(!)

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