In my two previous posts, I discussed Atul Gawande, author of The Checklist Manifesto, and his contention that simple checklists can make an incredibly complex processes like surgery or flying an airplane safer and more effective. While reading his book, I was happy to see that Gawande also has something to say about checklists and investing.

In chapter 8, Gawande states that regimentation - sticking to a disciplined, repeatable process - can offer many benefits beyond the area of medicine, and he cites finance as an example. While researching his book, he talked with a number of portfolio managers who employ checklists; hedge fund manager Mohnish Pabrai's comments were especially interesting.

Pabrai is from India. He was trained as an engineer and then built a successful technology company before starting his investment firm where he manages a 500 million dollar fund. Gawande says Pabrai ought to know a thing or two about being dispassionate and unemotional about decision-making given his background. But when it comes to investing, Pabrai actually has to fight to control his emotions.

"No matter how objective he tried to be ...he found his brain working against him, latching on to evidence that confirmed his initial hunch and dismissing the signs of the downside. It's what the brain does." Gawande wrote. Readers of The Naked Portfolio Manager know this phenomenon as "confirmation bias," as discussed in chapters 7 and 8 of my book.

Or in a bear market he can go into "fear mode" and start seeing risks where they don't exist. "You see people around you losing their shirts, and you overestimate the danger."

Another portfolio manager that Gawande intervied, Guy Spier, also talked about "greed mode." That means the investor sees an exciting investment and starts to think about the hundreds of millions of dollars he can make. Spier calls it "cocaine brain."

I have personally experienced cocaine brain myself. (I am speaking metaphorically here. I have never used illegal drugs of any sort in my life). I remember in 1999 I was using a judgment-based portfolio approach that relied heavily on chart reading. I bought several stocks that climbed many points over my buy price immediately after I bought them. I experienced a tremendous rush of adrenaline and began to feel as if I could make money at will. Still, a little voice inside me kept saying, "This can't be so easy." Then the bear market came along and fortunately I realized that naked investing strategies were a much better approach.

While I agree with Gawande that a checklist can be an effective tool for judgment-based portfolio managers to reduce the risk of making emotional decisions, remember that the best tool to avoid emotional errors is rules-based investing, a.k.a. naked strategies. I think Gawande really caught Speir and Parabai with their guards down and got them to speak candidly about how emotions effect their judgment. All the more reason to use naked strategies!