Portfolio managers and investment analysts like to say that due diligence, a deep review or audit of a potential investment, is an integral part of their business. They are most probably lying, or if we want to be charitable, they are deluded.
Due diligence is not considered sexy. It involves legal, financial and operational reviews. Where are the six screens with hundreds of flashing numbers? Where are the bank of telephones with people shouting orders into them? Where are the oak-panelled boardrooms? The late nights at Cipriani’s and Harry’s? Where, when all is said and done, are the … well, let us not get too carried away.
Portfolio managers and investment analysts rarely perform due diligence personally. They rarely even lead the process. Just look at all the professionals taken in by the Madoff scandal. This is a shame, as due diligence is the only way to consistently make money.
The areas of legal and financial due diligence are well known and, to a lesser extent, so is operational due diligence. But one area that is surprisingly absent is psychological due diligence. Nearly every investment involves human capital either as investment managers or as operational executives. This human capital has a material effect on the outcome of the investment. Would it not make sense to perform due diligence on their psychological health?
A major warning sign is the level of narcissism exhibited. A narcissist is basically someone who needs to be seen as perfect, while at the same time feeling worthless. The danger here is that when things go wrong the narcissistic manager will do anything to hide the initial and subsequent errors until everything is lost. Think Nick Leeson and the Barings Bank fiasco.
Recognising a narcissist is not necessarily easy, but as a first step someone who keeps talking about themselves and not their team when it comes to success, but vice versa when it comes to failures, should be considered a candidate. A good test is to deliberately criticise the suspected narcissist and see how aggressively he reacts.
The second major psychological indicator is the arrogance-competence gap. Arrogance is an exaggerated belief in your competence, as opposed to narcissism’s need for others to perceive you as perfect. When the belief in your competence is equal to your actual competence this is called confidence.
Clearly, the larger the arrogance-competence gap the greater the risk. The mistake investors make is assuming that they just need to filter out the incompetent. This is not enough, not least because the arrogant are actually usually quite competent. They are just not as competent as they believe they are, and so they take risks that they do not understand and cannot manage – repeatedly.
People who have a large arrogance-competence gap are easily recognised by their continuous excuses and promises that the future will be better. The investment manager complaining that all the deals he missed or which failed are not due to any fault of his, but that there is a pipeline that will yield great returns, is a prime example.
The best is kept for last – the sociopath. The sociopath is many things but chief among them is that he lacks empathy, the ability to feel what another is feeling. If you cannot empathise, then you will not feel any guilt in taking advantage of another. Draining another person’s bank account will feel the same as finding some loose change on the pavement.
Sociopaths are extremely difficult to detect in the moment, since even though they have no empathy, they can be charming to get what they want. It is only when they have drained your life savings or destroyed your company that they will show their true nature and discard you.
This behaviour suggests that uncovering a sociopath is best done by talking to old acquaintances – and the older the better. If one or two complain, then maybe it is sour grapes but if there is a pattern, watch out.
There is an argument to be made that psychological due diligence should precede the other types of diligence. As it is much harder to perform it is unlikely that there will be a change any time soon in due diligence practice. After all, financial diligence requires PwC/KPMG/Deloitte to audit your books. It is unlikely that investment managers will allow Dr Phil to audit their minds.
Epilogue. Studies show that it is men who predominantly exhibit the three traits discussed above. Perhaps a firm led by women might be a natural hedge to the Hannibal Lecters of the financial world?
This article was originally published in The National.