Saturday, October 14, 2006

Best Practice: The Elaboration Process and Effect

Best Practice: The Elaboration Process and Effect
By Bud Labitan
Labitan Partners, llc.
October 14, 2006

The investing ideas of Benjamin Graham, Warren Buffett, Charles Munger, and Phil Fisher are sensible and tested by time. And, there are many good books that cover their history and investment processes. In 1995 I read: Buffett : The Making of an American Capitalist by Roger Lowenstein. ( ISBN: 0385484917 ). This is how I started to learn about intrinsic value investing. Buffett and Munger’s long-term economic goal for Berkshire Hathaway is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. How do we maximize our returns on each decision we attempt to make? There are many sensible ideas to read about in learning to be a better investor. In my view, serious students of sound investing should read the writings of Graham, Buffett, Munger, and Fisher. In this article, I focus on one specific process within successful decision making. I also relate this idea to the field of Behavioral Finance.

I hope that this article will help you become a more thoughtful and productive decision maker. Framing in the field of behavioral finance has been described as the process of choosing particular words to present a given set of facts. And, how a question is framed can influence our choices. Tversky and Kahneman described "Prospect Theory" in 1979 using framed questions. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They also found that individuals are much more distressed by prospective losses than they are happy by equivalent gains.

Generally, studies in Behavioral Finance help to explain patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. People tend to take more risks when seeking to avoid losses as opposed to securing gains. In 1992, Takemura showed that the effects of framing are likely to be lower when subjects are warned in advance that they will be required to justify their choices, and when more time is allowed for arriving at their choices. In a paper of 2003, this was described as “The Elaboration Effect.”
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Reading about the Elaboration Effect got me thinking: How does Warren Buffett frame an investment decision? Mr. Buffett has stated that he is guided by a set of sensible investment principles. He has also stated that he uses four main filters. These filters include understanding, enduring competitive advantages, trustworthy and able management, and a bargain price. Perhaps, this Buffett quote provides a good view of the proper starting frame of mind: ”If I were looking at a company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones.”

The Elaboration Effect refers to the inhibition of common framing effects when decision makers are asked to elaborate their decision making process. The process of elaboration appears to work because one allows himself or herself to eliminate less than optimal choices. Buffett has always told students to be able to "explain why you are buying a stock." In my view, Warren Buffett knew the benefits of practicing "the elaboration process/effect" when framing a decision long before Satoshi Fujii & Kazuhisa Takemura wrote about it in their 2003 paper.

Seeking and finding rewarding ideas like these is an exciting challenge. I believe that we can use the elaboration process to help us make more rewarding investment decisions. Use good guiding principles, best practices, and a positive attitude to help you develop an enhanced investing frame of mind. In Warren Buffett’s words: “Our advantage, is attitude. We learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.” While Warren Buffett has described “The Margin of Safety” as the three most important words in investing, Buffett has also given credit to Charlie Munger for understanding the power of a “wonderful business” and its enduring competitive advantages. Looking for the wonderful business is one of the best practices to use. This is an important concept to remember when elaborating your thoughts about investment possibilities.

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