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Dont Be Heroes at All Costs in Complex Times 2012 Update

Dont Be Heroes at All Costs in Complex Times 2012 Update

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Published by shortplay
When complexity becomes overwhelming, checklists can save us from ourselves
Flying an airplane today means using checklists. But this was not always the case. In his
book, The Checklist Manifesto, the Boston-based writer and physician Atul Gawande
explains how checklists became indispensible for modern aviation.
It was 1935. The four-engine aircraft that would become the celebrated B-17 bomber
during World War II had crashed during a test flight. The cause was not mechanical, but
pilot error. While the pilot was one of the most experienced in the US armed forces at the
time, the new plane was more complicated than anything before.
What saved the B-17 was the introduction of checklists. A group of test pilots created a
series of checks to perform when operating the plane. This innovation led to an
unparalleled safety record—1.8 million miles without an accident.
From flying to surgical procedures to investing
Gawande introduced checklists into surgical procedures. Not everyone approved. Many
doctors asserted that medicine could not be reduced to checklists or algorithms.
Nevertheless, the impact was clear. For example, line infection rates fell from 11% to 0%
in one hospital. No one claims doctors were poorly trained or inexperienced. But in an
environment of high complexity, it is inevitable things get overlooked without a checklist.
The example of 2008—investors focused on “the big theme”, forgetting the rest
There are lots of things to keep track of in the bond market. Inflation, growth, risk aversion,
carry and momentum are some of the more important ones. But investors have trouble
remembering them all, much less balancing them. They tend to focus on “the big theme”.
In 2008, crude oil prices were making all-time highs prior to the Lehman crisis, reaching
nearly $150 as shown in Figure 2. This made for great television coverage, with special
reports live from Saudi Arabia and the like. The big theme of the time was the danger of
stagflation, as the 1970s were coming back. Or were they?
Our Duration Scorecard was long government bonds at the time. Yes, inflation was a
problem, and the inflation category produced a negative signal, as shown in Figure 3. In
other words, if inflation had been the only indicator, the Scorecard would have been short
duration. But inflation was just one of four categories it considered for duration. The other
three were resolutely positive for bonds, as shown in Figure 3. For example, risk aversion
had increased and real growth was slowing markedly. Since the Scorecard enforces
balance (and does not watch CNBC or try to look hip), it was long duration. As shown in
Figure 4, the Scorecard portfolio navigated 2008 far better than the population of
discretionary hedge funds.
One example is not conclusive. But looking over the last 10 years, discretionary managers
(and who has more discretion than hedge funds?) have delivered no alpha, but checklists
(proxied by our Scorecard portfolio) have delivered it in spades. No surprise for pilots.
When complexity becomes overwhelming, checklists can save us from ourselves
Flying an airplane today means using checklists. But this was not always the case. In his
book, The Checklist Manifesto, the Boston-based writer and physician Atul Gawande
explains how checklists became indispensible for modern aviation.
It was 1935. The four-engine aircraft that would become the celebrated B-17 bomber
during World War II had crashed during a test flight. The cause was not mechanical, but
pilot error. While the pilot was one of the most experienced in the US armed forces at the
time, the new plane was more complicated than anything before.
What saved the B-17 was the introduction of checklists. A group of test pilots created a
series of checks to perform when operating the plane. This innovation led to an
unparalleled safety record—1.8 million miles without an accident.
From flying to surgical procedures to investing
Gawande introduced checklists into surgical procedures. Not everyone approved. Many
doctors asserted that medicine could not be reduced to checklists or algorithms.
Nevertheless, the impact was clear. For example, line infection rates fell from 11% to 0%
in one hospital. No one claims doctors were poorly trained or inexperienced. But in an
environment of high complexity, it is inevitable things get overlooked without a checklist.
The example of 2008—investors focused on “the big theme”, forgetting the rest
There are lots of things to keep track of in the bond market. Inflation, growth, risk aversion,
carry and momentum are some of the more important ones. But investors have trouble
remembering them all, much less balancing them. They tend to focus on “the big theme”.
In 2008, crude oil prices were making all-time highs prior to the Lehman crisis, reaching
nearly $150 as shown in Figure 2. This made for great television coverage, with special
reports live from Saudi Arabia and the like. The big theme of the time was the danger of
stagflation, as the 1970s were coming back. Or were they?
Our Duration Scorecard was long government bonds at the time. Yes, inflation was a
problem, and the inflation category produced a negative signal, as shown in Figure 3. In
other words, if inflation had been the only indicator, the Scorecard would have been short
duration. But inflation was just one of four categories it considered for duration. The other
three were resolutely positive for bonds, as shown in Figure 3. For example, risk aversion
had increased and real growth was slowing markedly. Since the Scorecard enforces
balance (and does not watch CNBC or try to look hip), it was long duration. As shown in
Figure 4, the Scorecard portfolio navigated 2008 far better than the population of
discretionary hedge funds.
One example is not conclusive. But looking over the last 10 years, discretionary managers
(and who has more discretion than hedge funds?) have delivered no alpha, but checklists
(proxied by our Scorecard portfolio) have delivered it in spades. No surprise for pilots.

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Published by: shortplay on Apr 20, 2012
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