How Do Investment Managers Think? A Framework for Decision-Making Due Diligence

Abstract

The quality of decision-making is often as important as the performance results when distinguishing investment professionals, and it is fundamental for any due diligence analysis. The process or skill of decision making will be affected by the type of problem and information available. The traditional expected utility framework (EUF) explores decision- making through forming probabilities for the range of all outcomes. The traditional EUF can be contrasted with the cognitive approach of case-based reasoning (CBR) as an alternative framework for decision-making. Under this approach, managers look for similarity and decide the best action based on performance relative to past situations. This cognitive approach is both descriptive and effective for explaining how managers think. In this article the EUF and CBR frameworks are employed to assess the decision process of investment managers against the problem of accounting for knowledge and the type of investment decision faced. Categorizing and contrasting these frameworks can provide a means for distinguishing managers beyond their performance and provide a rich method for analysis of fund behavior by potential investors. Analyzing how decisions are made provides an enhanced framework to supplement the traditional three Ps approach of Performance, Philosophy, and Pedigree that is often used as the foundation for investment due diligence.