The subject of this month’s blog is a shameless copy of a chapter from the book Complications by Dr. Atul Gawande. The book provides a fascinating insight into the error prone world of doctors. In the chapter “When doctors make mistakes”, Dr. Gawande takes us through a near fatal incident involving a patient for whom he was primarily in-charge.

In the chapter Dr. Gawande tells us that fatalities resulting from anaesthesia which were about 1 in 10,000(0.01%) operations in the 1980s, dropped within a decade to about 1 in 200,000 (0.0005%) operations. This 20X reduction in fatalities was achieved through systematic process driven improvements including machine re-design, standardized dials, interlocks to prevent accidental administration of more than one anaesthetic gas, change in controls so that oxygen cannot be turned down to zero, use of monitors that can detect if the anaesthetic tube was in the trachea instead of the oesophagus and so on.

The role of due process in error reduction is a widely accepted idea and is put to effective use in manufacturing and as shown by Dr. Gawande, to success even in the practice of certain fields of medicine. What then is “due process” to the profession of Investment Advise? Does “due process” help in eliminating mistakes in Investment Advise? An evolving consensus seems to be pointing to a tool called the Investment Policy Statement that is used for the broad asset allocation strategy for the investor. I will take the opportunity of this blog to elucidate how due process in asset allocation is practically employed through the application of an Investment Policy Statement.

An Investment Policy Statement (IPS) is an attempt to provide the broad contours of an asset allocation strategy. The elements of an IPS include an investor’s (i) current financial position, (ii) financial goals and (iii) emotional comfort with risk. The current financial position is a statement of the assets, liabilities, income, savings, immediate liquidity requirements and insurance coverage of the investor. This is probably the most objective of the three items above and relatively easy to compile. Once this is compiled, an assessment can be made about the client’s “ABILITY” to tolerate fluctuations in asset prices (risk). The ABILITY to take risk must take into account the current financial health of the investor, the dependability of his income stream and the onset of any immediate financial liabilities that may constrain exposure to volatile assets.

The second element of the IPS is an articulation of the investor’s financial goals. While many financial goals are pretty straightforward and do not need to make too many assumptions, the further away the financial goal, the more assumptions that get built into the articulation of the goal. Financial goals are made independent of the ability of the investor to finance these goals. It is here that a “REQUIRED” return is placed upon the investor’s investible portfolio. The “REQUIRED” return places a floor on the minimum exposure to higher return (hence more volatile) assets that the investor must have.

The third element of the IPS is the investor’s emotional comfort with asset price fluctuation. This emotional comfort is measured as a risk “TOLERANCE” and puts an upper limit on the investor’s exposure to volatile assets. Risk “TOLERANCE” is measured through psychometric tests. The idea here is that even if the client has the ability to take risk and also is required to take risk, it may be unwise to take risk beyond the TOLERANCE or emotional comfort the investor has with price fluctuation.

We now have three independent spokes -- RISK ABILITY, RISK REQUIRED and RISK TOLERANCE. As each of these is independently arrived at, it is but natural that they could be at odds with each other. The investor’s goals may be unrealistic in comparison to his earning power or an investor may have an excessive risk appetite that is not supported by his financial status or the client may be too timid in his risk appetite as compared to his financial ability. It is the job of the Investment Adviser to discuss the various contradictions that exist and work with the investor to resolve these conflicts. It is through the resolution of these conflicts that it is hoped error in asset allocation is reduced. There is no doubt that this is still an inexact science.

The IPS covers only the % allocation to risky assets. What about the advice that goes into the selection of each one of the individual securities that the investor buys into within each asset class? As I run the risk of making this blog too long, I would like to dedicate a future blog to how we follow due process in the selection of individual securities.

Should we then simply assume that following due process is sufficient? Aren’t robots better suited at following due process? Do we need human intervention at all? Wouldn’t a robot adviser do this job much better? There are no easy answers. All I have to say is that systems and processes help in error elimination, but they do not talk about people. Investment is a profoundly human endeavour that is not just an act on the part of the investor but also an experience. Investors seek human interaction and approval. Until robots can become intelligent enough to have meaningful conversations with investors on the inherent contradictions in their IPS and walk investors through their decision making, the role of a professional Investment Adviser may continue to remain relevant.

In an honest acknowledgement of having fallen short in the near fatal incident involving a patient of his, on page 43 of the book, Dr. Gawande writes : “ But for whatever reasons -- hubris, inattention, wishful thinking, hesitation or the uncertainty of the moment -- I let the moment pass ”. Which professional has never been in such a situation? The question Dr. Gawande poses is whether given that statistically, even the most skilled and experienced surgeon is bound to make an avoidable mistake, should surgeons simply accept this and give up their belief in human perfectibility? In his words : “ The statistics may say someday I will sever someone’s main bile duct (by mistake), but each time I go into a gall-bladder operation I believe that with enough effort I can beat the odds. This isn’t just professional vanity. It’s a necessary part of good medicine, even in superbly ‘optimized’ systems ” He concludes by saying : “ it isn’t reasonable to ask that we achieve perfection. What is reasonable is to ask that we never cease to aim for it