Why Can’t We Stop Changing Our Investment Process?

Imagine we are attempting to design a stock picking model that will outperform the market over the next ten years. After a great deal of forensic research and testing we finalise our approach. Although we couldn’t know this in advance, the system we devise is optimal – there is no better way of tackling the problem we are trying to solve. Given this, what are we likely to do with the investment process we have developed over the coming years?

Change it and make it worse.

Even if we design a perfect investment approach the temptation to tinker and adjust is likely to prove irresistible. Why is it so difficult to persevere even when we have a sound method?

There is a mismatch between short-term feedback and long-term goals: If the objective of our investment process is long-term in nature; using short-term performance as a means of assessing its robustness is likely to be at best meaningless and at worst entirely counter-productive. All investment approaches will endure spells in the doldrums and reacting to these with constant process modifications is a certain path to poor results.  

The need to always be doing something:
Keeping faith with an investment process for the long-term means a lot of time doing nothing. This sounds easy but is anything but. Financial markets are in a constant state of flux, perpetually generating new and persuasive narratives. Temporary fluctuations in markets often feel like a secular sea change when we are living through them. The urge to act is strong.

Doubting the process:
When our approach suffers from poor short-term performance there will be intense pressure to change. This will be through internal doubt (what if my process is broken?) and, for professional investors, external pressures – ‘you are underperforming, do something about it’. Changing our process can make us feel better (less stressed, pressured, anxious) even if we don’t believe it is the right thing to do.

Feeling in control: The instability and uncertainty in financial markets can be deeply disconcerting; process adjustments can, erroneously, feel like we are wrestling back some form of control.

Overweighting recent information:
Recency bias means that we will tend to overweight the importance of current events and heavily discount the past. Given the inherent variability of financial markets over short time periods this will mean we are continually tempted to adjust our process based on what is happening right now.

Our ability to have a positive impact is hugely overstated. If we have a prudent investment approach to start with, improving it is not likely to be easy. We will inevitably grossly exaggerate our ability to implement changes that will improve our odds of success.

Optimising not satisficing:
Our desire to adjust and attempt to enhance our investment process is driven by a belief that we should be optimising – finding the very best solution. While this is a noble aim in theory, the profound uncertainty of financial markets makes it dangerous in practice. An eternal and elusive search for the best investment process is likely to lead to at least as many bad decisions as good ones. Satisficing – adopting a strategy that is good enough – and maintaining it is likely to be the best route for most of us.

Intellect over behaviour:
Our process changes will tend to be focused on the intellectual pursuit of finding new sources of information or applying them in different ways. Scant attention seems to be paid to the behavioural challenges of investing. The most robust investment approach will be torn asunder if we don’t have the fortitude to persevere with it.

It may seem as if I am suggesting that we should never attempt to improve our investment process. This is not the case. Striving to learn and develop is vital. It is critical to understand, however, that our tendency will inevitably be to do too much, often at the wrong time. We need to have an appropriately high threshold for change.

Never underestimate the advantage gained by an investor who has a sensible method and can stick with it.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here.

Our Future Decisions Will Be Defined by Our Past Decisions

A friend of mine was out on a run. He was on his usual route going down a narrow lane when he came across an ominously large puddle – it had been raining torrentially for the past few days. There was no way around it, he either had to turn back or go through it. Although the puddle was long, he assumed it would be shallow, so forged ahead. It was deeper than he expected, the icy water quickly covered his shoes. Thinking that would be the worst of it he carried on. But it kept getting deeper. The water went past his ankles and he wasn’t quite halfway through. As he was already cold and wet there was no point turning back, so he checked to see if anyone was watching and continued his increasingly slow paddle.  As he persevered and the water splashed up to his knees he wondered how long he would keep going if the puddle got deeper still. He had visions of just his head bobbing above the water. Fortunately, knee-height was as deep as the puddle got and he didn’t get to test quite how far his prior commitment would take him.

This must have been a bizarre sight for any onlooker.  Why would someone try to run through a puddle that deep? No rational human would consider that to be a sensible idea. Yet, of course, my friend would have agreed with this, right up until the point that he decided to put his foot in the puddle. As soon as he made that decision, everything changed.

It is easy to think of the choices we face as discrete, one-off decisions with a set of specific consequences (good and bad), but they are not. Each time we make a decision it impacts the choices we will be able to make in the future – it might commit us to a certain direction or close off other potential routes. There is a huge amount of path dependency in the decisions we make. This means that we should not consider only the immediate implications of any option we pursue but also its consequences for our subsequent behaviour.

Why did my friend continue running through a ridiculously deep puddle? Because he had already committed to the action. Not only had he incurred the cost of being wet, but he also didn’t want to feel or look stupid for choosing to do it in the first place. If he persevered it might look intentional.

He had set a new path.

There are three aspects to a decision that tend to influence how influential it might be over our future choices:

1) Does it impact our identity?

2) Does it change our incentives?

3) What costs will it incur?

Although these are inter-related, we can consider them separately:


Whether a decision serves to shape our identity can be critical to our future choices. How we see ourselves or how we wish other people to see us will have profound implications for the choices we make or even the opinions we express. Once we make the implicit or explicit choice to create a particular identity, every subsequent judgement we make is framed by a desire to manage and bolster that it. We strive to make decisions that are consistent with our desired image.  

We see this behaviour clearly in politics – once we make a choice to align with a particular party or doctrine, everything we see is through that lens. Investors are also frequently guilty of allowing views and opinions to morph into an identity, through which all subsequent judgements are filtered. Often irrespective of evidence.


Incentives drive behaviour, so we must be particularly wary of any decision that materially shifts our incentive structure. We are likely to significantly understate how influential varying incentives will be on our future choices. The most painful and damaging scenarios are where there is a dissonance between what we believe and the direction that our incentives are pointed – “I believe that financial markets are highly uncertain over the short-term, but I make money if my clients trade more”. To resolve such friction, we will tell ourselves all sorts of stories to provide psychological comfort. In the end it is likely that our incentives will re-shape our beliefs.


Sunk costs wreak havoc with future decisions. Whenever we expended significant time, effort or money on a choice, we find it incredibly difficult to change course. The idea of the sunk cost fallacy is now ubiquitous but it does not make it any easier to overcome.  Admitting we were wrong, moving backwards, or accepting ‘wasted money’ are too often deemed unpalatable. When we think about sunk costs we shouldn’t consider them as historic mistakes, instead they are very much recurring costs that are impairing the choices we are making right now.   

When my friend was considering whether to run through the puddle, he was judging how likely it was to be deep, whether he minded soaking his feet and if it would ruin his running shoes.  What he should have been assessing is what he would do if he decided to go ahead and the water was too deep – how could he turn back? The consequences for his future decisions were just as important. 

If a choice has implications for our identity, the incentives we face or the costs we incur, we should be especially careful when making it. This is not just about the difficulty of quitting or the problem of commitment escalation, but how decisions made today can change everything about the decisions we will make tomorrow.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

Three Questions to Answer Before Investing in an Active Fund

There are still too many people investing in active funds. Not because they are unnecessary, but because owning them comes with a unique set of behavioural challenges that we are often unprepared for. If we are to have any hope of benefitting from holding them, we must accept and embrace these. The worst – and all too common – scenario is investing in active funds whilst holding entirely unrealistic expectations about the realities of doing so. This dooms us to almost inevitable failure and disappointment. Before investing in active funds there are three questions we need to answer:

– Am I willing to own a fund for the long-term?

– Can I discount short-term performance?

– Can I withstand long periods of underperformance?

Let’s take these in turn:

Am I investing for the long-term?

As the investment industry has become increasingly myopic, I have had to moderate my view on what the long-term is because it seems too outlandish. I have heard people discuss the long-term as three years or more, but this is far too short  – it is much closer to 10 years. The longer our time horizon, the greater the odds of investment success.  Why is an extended time horizon so important? Because the shorter it is, the more our results are beholden to randomness and fickle swings in market sentiment. If we believe there is a strategy with an edge, we must give it time to play out, for fundamentals to exert themselves over noise. This does not mean that we must persist with an active fund whatever happens or that simply increasing our time horizon guarantees better results, but it at least gives us a fighting chance.

Can I discount short-term performance?

It is one thing to say that we are willing to own a fund for the long-term, doing it is another thing entirely. The biggest impediment to long-term investing is obsessing over short-term performance. Not only is it an entirely fruitless activity that sees us attempt to read patterns in the chaotic fluctuations of financial markets, but we persistently make poor decisions based on such fleeting observations. Each time we check performance, write a report or hold a meeting we are creating a decision point; another opportunity to make a near-sighted judgment. We need to be realistic about our situation – if the short-term matters (whether we want it to or not) active funds really should not be for us – it will simply mean constant anxiety and frequently poor choices.

Can I withstand long periods of underperformance?

Although incredibly damaging, the hardest part of active fund investing is not the senseless fascination with short-term performance, but the prolonged and painful periods of underperformance that are an inevitable feature of any active strategy. All skilful (and unskilful) active fund managers will go through years of underperformance – this is inescapable. Living though this on a day-by-day basis is exhausting and exacting. The doubts about the strategy – whether the manager has lost her edge, whether the process is broken or the market environment irrecoverably changed – will often be overwhelming. Yet if we want to successfully invest in active funds then we need to find a way to withstand them.  The alternative is believing that we can time our investment into active funds so that we capture the good times and avoid the bad (we can’t).

The problem with this required fortitude is that it is music to the ears of the unskilled active fund manager who will be delighted if we persist in investing with them despite their lack of ability, but this is the job of the active fund investor – to identify skill without relying on past performance.  If we cannot tolerate lengthy spells of poor relative returns, we should not be investing in active funds.

If we answer these three questions in the affirmative, it does not mean that we should invest in active funds; these are simply the minimum entry requirements before we even consider attempting it. If we answer any of them negatively, we really should not be doing it at all.

None of these features are easy to deal with or manage, in fact the behavioural aspects of active fund investing are just as tough as finding a manager or strategy with an edge. Far too many investors neglect this and leave themselves in a position where the odds of success become vanishingly small. 

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

Should We Listen to Outperforming Fund Managers?

Outperforming fund managers are dangerous for investors. Performance is cyclical and often mean reverting, and we tend to invest after periods of unsustainably strong returns. If these features aren’t damaging enough, there is another problem. If a fund manager has a strong track record we listen with rapt attention to everything they say about anything. If their returns are poor, we disregard their words. This may sound sensible but it is anything but.

We can see this phenomenon with certain growth / quality orientated active fund managers in recent times. As they generated stellar returns for a decade, we were hanging off their every word. Happy to treat them as sagacious on whatever subject they chose to opine on. Now performance has deteriorated our reaction to their utterances is more likely to be: “why would we listen to this idiot, haven’t you seen their returns over the past year?”

This mindset set is steeped in two behavioural issues: outcome bias and the halo effect.  Outcome bias means that once we see the result (in this case fund performance) we jump to a conclusion about the quality of the process that led to it. The halo effect is where an individual’s success in one field means that we (usually erroneously) hold a positive view of anything else they turn their hand to.

This is a toxic combination, which leads us to pay attention to people we shouldn’t and ignore those we should take heed of.

Why is it such an issue?  

There is a huge amount of luck involved in investment outcomes: From the unique life experience of a star fund manager to the early morning ice bath routine of a successful entrepreneur, we cannot help drawing a causal link between an individual’s success and their past actions. Yet so often the outcomes we see are nothing more than a mix of luck and survivorship bias, this is particularly true in the field of fund management.

Fund manager performance is cyclical: For even the most talented investor their fortunes will move in cycles. Periods in the sun will inevitably be followed by spells in the doldrums, even if the long-term trend is positive. Our use of performance as a marker for credibility means that we will frequently see the words of the prosperous chancer as more convincing than someone with genuine expertise.

Expertise is particular: Skill in investing, where it exists, is narrow and specific. Yet once a manager is outperforming, they have the freedom to confidently pronounce on any subject within the universe of financial markets (and sometimes far wider than that). Not only do they pontificate on these issues but we are willing listeners – their track record doesn’t lie! The pinnacle of this behaviour is where a fund manager – through some combination of hubris and necessity – shifts into an entirely different area to the one in which they forged their reputation and investors follow in their droves. This always ends well. 

We use past performance as a heuristic. In this context, as a quick and simple shorthand to give us an easy answer to the complex question: Should I pay attention to what this person is saying?

Amidst the squall of investment voices that surround us applying a (industrial strength) filter is essential, but if past performance is fickle and ineffective how do we go about it? There are three simple questions we should be considering:
1) Is it a relevant subject? The critical starting point is asking whether the subject is even worth our time. Is it something that matters to our investment outcomes and where expertise can exert an influence? If it is someone speculating on what will happen in markets over the next three months, we can happily disregard it.

 2) What are their motives?  We should always be sceptical in listening to a perspective from someone who is trying to sell us something, but this is not as straightforward as it may seem. If an investor genuinely believes in what they are doing, then they will inevitably be seen as “talking their book” but what else would they talk? It is not always easy to separate a knowledgeable advocate from a slick salesperson. The best differentiators are probably consistency, humility and depth.

3) What is their circle of competence? Judging an individual’s circle of competence is essential, and there are two aspects to consider. First, we need to understand the specific expertise they may possess. We should be as precise as possible here – “investing” does not count! Second, we must gauge why the individual has pedigree and credibility in their field, particularly relative to others.  

This approach may not quite be as effortless as checking whether a fund manager has produced stellar performance before deciding whether to pay attention, but it is likely to be more effective. The fact that there are far too many voices distracting investors is problem enough, we don’t need to compound the situation by listening to the wrong ones.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here.

Do Active Funds Need a New Fee Model?

The long-term struggles of active funds versus index funds is primarily a problem of fees. There are other factors that influence the success rate of active strategies – most notably, in equities, the performance of small and medium sized companies relative to their larger counterparts – but it is the compound impact of highs costs over the long-term that causes most of the damage. Attempts to create charging structures that diverge from the simple % of assets under management model are typically focused on the use of performance-based fees, but in the vast majority of cases these (somewhat counter-intuitively) increase the negative asymmetry experienced by investors. Too often we pay lavish short-term rewards for underwhelming long-term results. To improve the odds of active fund success, the fee model needs a rethink.

One of the most egregious problems faced by fund investors is the problem of scale. As the size of a fund grows its profitability for an asset manager increases materially. Not just in terms of the revenues generated, but the profit margins. High operating leverage means that the marginal cost of an additional $100m invested into a $10bn fund is low. It is in the interests of asset managers to keep growing their largest funds.

There are two major difficulties that this model causes investors. First, is that the benefits of scale rarely have a material impact on the costs that they incur. As fund size grows and costs are spread across a greater revenue base this results in an improved margin for the asset manager but rarely a meaningful fee saving for the investor. Second, above a minimum threshold the growth in assets of a fund reduces the potential for future excess returns. Rising fund size means that the opportunity set is reduced, flexibility is compromised, and liquidity deteriorates.  

We are left with a situation where the investor faces a lower probability of outperformance whilst the profitability of a fund for an asset manager increases.

This is a major incentive problem for asset managers and creates a jarring misalignment with the objectives of their investors. Undoubtedly it is one of the primary reasons that funds are so rarely closed due to capacity constraints.

Is there a way of mitigating this problem and improving the situation for fund investors?

One option is to apply a $ revenue cap. How would this work?

A fund would launch with a standard fee level, let’s say 0.5%; but there would be a provision stating that all revenue earned over a certain amount ($Xm) would be reinvested into the fund. This would mean that above a given threshold of assets under management the benefits of scale would accrue to the underlying investors and provide compensation for the cost of asset growth in terms of declining performance potential. It would also greatly reduce the incentives of asset managers to ride roughshod over capacity concerns.

The advantages of such an approach are clear, but what are the potential drawbacks:

– Asset managers might increase fee levels to compensate for the cap. This is certainly possible but would only serve to further inhibit future performance.

Asset managers may launch more products to mitigate the impact of capped costs, in particular launching similar / mirror versions of the constrained strategy. The last thing anybody needs is more funds.

It might subdue innovation and development as large, ultra-profitable funds are no longer able to subsidise fledgling ventures or research. I am not sure I believe this is a genuine problem even as I write it.

There may be technical difficulties (documentation etc…) if the size of a fund declines and investor fees increase. This doesn’t seem to be an insurmountable hurdle, but fee variability is not ideal.

A $ revenue fee cap is clearly going to be unattractive to the largest and most profitable asset managers, and this is not the only way that the current fee model can be improved. It is, however, an area that is ripe for disruption and where there is significant potential to improve both investor alignment and outcomes.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here.

How Will Investors Behave in 2023?

Although many people do it, making forecasts about how financial markets will fare in 2023 is an entirely pointless endeavour. What we can predict with some confidence, however, is how investors will behave – that doesn’t change much. So, what will we all be doing in 2023?

– We will spend a lot of time dealing with an event that hasn’t yet occurred and which will not matter to our long-term returns.

– We will make changes to our portfolios based on what happened in 2022. Not because it makes sense from an investment perspective, but so we can avoid having painful conversations about underperforming funds and assets.  

– We will speculate that an asset class or investment strategy is dead and no longer works.

– We will forget that we once said an asset class or strategy was dead after it makes a dramatic resurgence.

– We will become an ‘expert’ on an issue that we don’t currently know anything about.

– We will view what occurs in 2023 as inevitable, after it has happened.

– We will wonder what an underperforming fund manager is “doing about” their poor returns.

– We (alongside 7,534 other people) will spend a lot of time writing meaningless, short-term market commentary that few people will read, nobody will remember and pray that ChatGPT will soon come to our rescue.

– We will check markets and our portfolios far too much.

– We will have even less time to think than we anticipate.   

– We will tell somebody that the free time in our diary wasn’t an available slot for a meeting, but actually an opportunity to do some work.

– We will talk in certainties, not probabilities.

– We will speak confidently about short-term market performance as if it isn’t just random noise.

– We will extrapolate whatever happens in 2023 long into the future.

– We will not spend any time on how to improve our behaviour or think long-term, even though it always seems like such a good idea.

We know that these behaviours are damaging, but it is difficult to stop them. It is in our interests to play the game. It is more lucrative and less personally risky to be part of the problem. We either feed the monster or get eaten by it.

What should investors be doing? Thinking, reading, walking, ignoring and trying to appreciate how much of the behaviour that is expected of us is of detriment to our long-term results.

If nothing else, we should all spend 2023 trying to give off a little less heat and a little more light.

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

The Intelligent Fund Investor

The moment has finally arrived. The Intelligent Fund Investor is published today!

Most of us invest in funds and the choices we make will have a profound impact on our financial futures. The problem is that fund investing is a decision-making nightmare. We are faced with a bewildering assortment of options and are constantly buffeted by market noise and narratives. Against this backdrop practising good investing behaviours is incredibly difficult. 

Despite these challenges there are surprisingly few books available to help us with the unique set of problems fund investing poses. The aim of The Intelligent Fund Investor is to fill this gap. I hope it can help all types of investors avoid costly mistakes and make better decisions.

You can buy a copy here right now.

If you enjoy the book, I would be incredibly grateful if you could leave a review. If you don’t like it, please don’t tell anyone!

What Next for Defensive and Cautious Investors After a Torrid 2022?

2022 has been an incredibly difficult year for investors. Not only have we seen steep declines in equity markets, but this has been coupled with sharply rising bond yields. The negative correlation between equities and high-quality bonds that has served investors well in times of stress has broken down, leaving many investors holding cautious and defensive funds nursing losses similar to those seen in far higher risk portfolios. Does this shift in asset class behaviour mean that cautious investors need to rethink their approach?

An Unusual Environment for Cautious Funds

First, it is important to consider how rare the returns delivered in 2022 are for conservatively allocated investors. If we go back to 1999 – before the bursting of the tech bubble – and look at the one-year returns of a simple, hypothetical cautious portfolio (70% global bonds / 30% equities) * we can see how extreme the environment has been:

Losses are comparable with 2008 but have been generated in a very different manner. During the Global Financial Crisis equity returns were far worse, but some protection was provided by falling bond yields. In 2022, equity losses have not (yet) been comparable, but bond exposure has compounded investor problems, not mitigated them:

This is incredibly painful for cautious investors and has led to some results that are at the extreme end of reasonable expectations for this type of risk appetite. In such situations it is easy to make rash decisions, but it is crucial to reflect on what has happened and what the long-term implications may be.

A Valuation Windfall

Over recent years a combination of falling bond yields and rising equity valuations has meant that cautious investors earnt returns that were higher than might have been reasonably anticipated from the cash flow prospects of their investments. We can visualise this by looking at a simple yield-based expected return for the hypothetical cautious portfolio (calculated by combining the earnings yield on equities with the yield to worst on bonds)** with the subsequent five year return delivered:

The blue line is what we might have realistically anticipated our return to be, given the yield of equities and bonds, while the orange line is the realised five year performance from that point. The realised return is five years out (on the chart the orange line ends in 2017/18, as it is the return five years from that point until today). The gap between the two shows that returns have been consistently above a reasonable projection of what such an asset allocation might deliver. This has been caused – at least in part – by what Antti Ilmanen of AQR refers to as a valuation ‘windfall’ – a one-off return that occurs when asset class valuations become significantly more expensive over a certain holding period. This type of performance tailwind does not persist forever and can move in the opposite direction if assets become considerably cheaper – as we have seen with bonds this year.

Periods of unusually high returns are often a prelude to weaker returns in the future. Although the human tendency is to extrapolate strong past performance, we should instead be moderating our expectations.   

If Not Long Duration Bonds, Then What?

The cautious and defensive funds that have been most susceptible to losses in 2022 have been those using long duration bonds as a significant portion of their low-risk asset allocation – particularly those with a passive or quasi-passive approach. This strategy has been incredibly successful and effective for several years but did lead to many portfolios increasing their duration sensitivity as yields continued to fall (higher risk and lower returns, the so-called ‘return free risk’ trade).

Given the environment the results from many cautious funds this year should not be surprising – it is entirely consistent with their design – but does the recent experience mean that the approach adopted requires a rethink?

Not necessarily. No investment approach works in every situation, and we must be realistic about the drawbacks of any strategy in which we invest.  

Much of the pain this year has been caused by being exposed to long duration bonds in an uncommon environment of sharply rising bond yields and declining equity markets. What options do cautious investors have if they wish to avoid this type of scenario?

Market timing: They could attempt to adjust exposures based on an assessment of the prevailing market environment. The problem is such tactical approaches are incredibly difficult to do well. The track record of investors making consistently successful interest rate and bond yield forecasts is poor.  

Valuation-led approach: Rather than predict when things will occur as in a market timing strategy, they could adjust duration sensitivity based on the risk-reward characteristics of fixed income. For example, holding a short duration position when the yield available relative to the interest rate sensitivity is unattractive. The challenge here is that they must wait for valuations to normalise, and that can be a long wait.

Short duration: One option, particularly considering higher cash rates, is to run with a far shorter level of duration in their fixed income exposure, leaving them less sensitive to a more prolonged change in the relationship between movements in equities and bonds. Although this is a prudent approach, there are two potential drawbacks. First, if investors are comparing the performance of their cautious fund with a simple passive alternative there will be a large duration mismatch – are they willing to accept the underperformance that might stem from that? Second, in a recessionary bear market for equities we might again see significant declines in bond yields and their short duration approach may well offer us less protection in such a scenario.

Non-bond diversification: When bonds are failing to diversify our portfolios, particularly in difficult market conditions, there is always a great temptation to look for other sources of diversification. While this is a great option in theory there are dangers. There is often a temptation to invest in complex strategies that we do not truly understand, or asset classes that are not genuinely diversifying but simply look it because they are illiquid and have stale, mark to model pricing. Both scenarios lead to the assumption of a whole new host of risks.

As our tendency is to compare the (short-term) results of our cautious fund to a simple passive (equity / bond) comparator, adopting any of these approaches would have in all likelihood come with a prolonged and considerable performance cost in recent years. This does not mean all these methods are inferior, but investors need to be willing to bear the periods of underperformance that will inevitably occur.

There is a real danger that as investors we extol the virtues of a particular fund when it is delivering (often ignoring the inherent risks) and then abandon it when we are surprised by a period of poor performance. We are prone to adjust our fund holdings to deal with the risk that has just been realised, rather than those that may come to pass in the future. Consistently repeating this behaviour is likely to erode returns through time.

Deteriorating Performance and Improving Valuations

Given recent market performance there is a great deal of speculation about the negative correlation between equites and bonds that we have witnessed in recent decades being broken and becoming an artefact of an era defined by persistently falling bond yields. Whilst this is possible, it is extraordinarily difficult to predict with any level of conviction.

Rather than attempt to make such heroic forecasts, it is more prudent to look at areas where we can have greater confidence. The weakness in bonds and equities through 2022 means that our expected long-term returns for a typical cautious portfolio have improved significantly:

Unfortunately such valuation measures provide very little guide to the short-term outlook for cautious investors, but higher bond yields and lower equity prices do increase the probability of improved returns as we extend our time horizon.

Whichever approach to cautious investing we adopt, we need to understand both its benefits and limitations, and then decide whether we are behaviourally disposed to sticking with those for the long-term.

* The hypothetical cautious portfolio is comprised of a 70% allocation to a global aggregate bond index (USD hedged) and a 30% allocation to a global equity index. All returns in USD.

** This is a very simple model combining the earnings yields of equities and the yield to worst on bonds. It is meant to be instructive rather than a precise forecast.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Investment Bubbles and Frauds Have a Lot in Common

Expensive investor mistakes come in two forms. We can either lose money slowly or quickly. Slow losses are small and compound over time – largely unnoticed – growing into a major cost; these can be through high fees or persistent performance chasing. Rapid losses are far more dramatic and are often a result of us having our investments unnecessarily concentrated in an asset class, fund or scheme that suffers a savage and irrecoverable decline. The most damaging sudden loss scenarios are typically investment bubbles and outright frauds. Although these two phenomena appear distinct, they exploit the same behavioural vulnerabilities. 

An investment fraud is a situation where an individual (or group) makes a deliberate and nefarious attempt to mislead people about the characteristics of an investment for their own benefit. Contrastingly, an investment bubble occurs when there is a crowd delusion about the prospects for a particular security that sees its price detach from its underlying value by a dramatic margin; there may be disreputable individuals seeking to profit from a bubble, but no one person creates it.

Although these appear to be entirely separate episodes, they are deeply entwined. The life of an investment bubble or fraud is predicated on three critical aspects. The story, the performance and the social proof. These operate as a virtuous and vicious circle through the emergence and death of both bubbles and frauds:

Let’s take each element in turn:

Story: The narrative supporting an investment bubble or fraud is the critical underpinning. Stories not only provide a simple and compelling tale about why an investment opportunity is so attractive, they are also an incredibly effective means of disguising complexities and unpleasant realities. Successful stories make us blind to the risks and shortcomings. Tell us a gripping and believable story – one that ends with us making a lot of money – and that is often all we need to hear.

The influence of stories is intensified by the involvement of individuals with charisma. In frauds, they are often the person at the forefront telling the enthralling yarn, while in an investment bubble they are the main protagonists – the people that have already made a fortune and who we want to follow. Powerful storytellers and compelling characters make us even more susceptible to a story.

Performance: Strong past returns are also a vital feature of the most dangerous bubbles and frauds. This works in three ways:

1) It provides validation – we are so biased towards past outcomes that stellar recent performance is taken as a sign that something is being done right – otherwise why would it be working so well?

2) It allows us to extrapolate – we seem ingrained to believe that high returns from the past will continue unabated into the future.

3) It fosters greed – we are attracted to the high, often stratospheric, profits that have been delivered in the past and don’t want to miss out. The performance is far better than we are achieving in our own boring investments.

Social Proof:  The behaviour of other people is also essential in the emergence and persistence of bubbles and frauds. It provokes both confidence and envy. Confidence stems from the idea that there is wisdom in the choices made by other people – this can be particularly true if institutions are involved – it must be okay because those smart people would have done the work. Envy arrives because we see other people making more money than us and cannot help but find it painful.

These three elements feed on each other. A captivating story both boosts performance and corroborates it (the story must be true, haven’t you seen the returns?); while strong performance increases the power of social proof (my friends are making even more money), and new investors becoming involved supports performance. This virtuous circle can be incredibly powerful and self-sustaining. The longer it persists, the more people are drawn in.

The failure of frauds and bubbles occurs when this circle reverts from virtuous to vicious and this can happen suddenly. The catalyst for this shift is impossible to predict. It can be a piece of news or information that punctures the story, or simply a period of poor performance that leads to doubt, scrutiny and, eventually, distress.

Bubbles and frauds not only prey on similar human behaviours, at times they can become one and the same thing. The most perilous situation is when a fraud morphs into a bubble. Here the euphoria that arises around an investment doesn’t lead to the price being detached from reality, but the price being attached to a fantasy.    

For investors this is the worst of all worlds.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

The Power of Not Having a View

If you work in the investment industry then you must have a view. Always. About everything. When will inflation peak? Will the Fed pivot? How will Japanese equities fare over the next six months? Is Amazon expensive? Does this fund manager have skill? If we don’t have an opinion then we either lack knowledge or conviction, perhaps both. As professional investors this is what we are being paid for, isn’t it?

No, it isn’t. Quite the contrary. The ability to not have a view on most subjects is a major advantage, just one that is incredibly difficult to exploit.

There is a stigma attached to saying “I don’t know”, not just in the investment industry but in many walks of life. Nobody wants to sit on the fence or stand in the middle of the road, but for investors this is absolutely the correct place to be most of the time. We are operating in a highly complex, uncertain environment where most predictions are either difficult or impossible. Being well-calibrated means spending a lot of time not having an opinion.

The majority of investors have all sorts of views. Does this mean we are poorly calibrated? In many cases, yes. There are two reasons why investors are so keen to predict everything. The first is simple overconfidence – we think we are better than we are.  The second is because it is expected of us – our clients want us to have a view, so we must form one.

Why is there an expectation for investors to have views on everything? Because it gives a sense of control. Financial markets are messy, chaotic, and anxiety-inducing; when an investor makes predictions and trades on them it feels like there is a steady hand on the tiller, rather than our portfolios being a hostage to fortune.

This is the enduring appeal of tactical asset allocation despite the compelling evidence that people cannot time markets successfully and consistently. Things are happening so investors need to be seen to be doing something about it.

But having wide-ranging and ever-changing views on markets is not harmless, it is damaging. Not only are investors constantly forecasting things when we cannot reasonably expect to have any skill in the task; it also means that we will be trading far more than is necessary – destroying value through transaction costs and the losses that stem from predicting the unpredictable.

The erroneous views that investors hold come in two forms. We can be operating far outside of our circle of competence – it is not feasible to have credible expertise in UK mid cap companies, the Chinese real estate sector, and the implications of the latest US non-farm payrolls report. Most common, however, is simply to have views on subjects that are not reasonably inside anybody’s circle of competence – typically these are short-term market perspectives: how is the Russell 2000 going to fare relative to the S&P 500 over the next six months? Who knows?

The vacillations of deep and intricate financial markets are endlessly fascinating but being intrigued by them does not mean we need to take a position or trade.

When Should Investors Take a View?

So if investors should avoid taking views most of the time, when should they do it?

The critical questions to ask are whether it is reasonable to have a view at all (is it something we or anyone can predict) and are the odds on our side in getting it right?

Let’s take an example.

I am asked to predict whether global equities will generate positive returns over the next six months. I have no idea. Over short run horizons markets are noisy and unpredictable, and I would simply be guessing with little confidence in my outlook.

But what if I am asked to predict whether global equities will generate positive returns over the next ten years. Here I have a view. Over the longer term the performance of equities will likely be driven by the cash flows they generate. History also tells me the odds are in my favour in having a confident (though not certain) perspective.

We should only express forthright views and take positions where we have a long-time horizon and a robust evidence base that suggests the likelihood of our view coming to pass is strong. This will often only occur when markets are priced at extremes, everything else we can think of as noise.

Wilful Ignorance

Not having an investment view on every imponderable in financial markets can seem like ignorance, but it actually shows an acute awareness of the environment in which we operate. It is far more ignorant to believe that we can accurately predict all manner of complex and unfathomable things.

Rather than have an ever-evolving set of views and positions, we would be far better off allowing others to pontificate and trade, and instead wait until there are opportunities where the probability of good outcomes are firmly on our side.

Investors would be far happier (and better off) not having a view on most things most of the time.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.