In a world where investors are increasingly being encouraged to react and trade (typically not for their benefit), doing nothing can often prove to be sage investment advice. In a recent paper, Hendrik Bessembinder analysed the performance of “do nothing” portfolios, and shows that even if we are doing very little, the results we achieve will be heavily influenced by the small choices we make.

To run his analysis, Bessembinder created a series of “do nothing” portfolios from the constituents of the S&P 500 at the end of each year from 1970.  The portfolios are “do nothing” as there are no trades after the portfolio is formed, apart from dividend reinvestment. If a stock is delisted, the proceeds are held in cash for the remainder of the period.  The underlying idea is to understand what would happen if we simply bought a selection of stocks on a certain day and then ‘left them in the drawer’. It is not quite a “do nothing” approach, but it gets pretty close.

I don’t want to simply repeat the findings of Bessembinder’s paper, and I would recommend reading it directly, but I thought I would draw out what I thought were the most interesting aspects of the results:

Rebalancing Matters

Over the full 55 year sample, an equally weighted “do nothing” portfolio (holding all available stocks at the same position size) grew from $1 to $678, while a value weighted approach (the typical index market cap structure) grew to only $361. This is a huge advantage for an equal weighted over a market cap strategy. Bessembinder suggests that this could be due to a ‘small cap effect’ boosting returns for the equal weighted approach. While this might explain some of the difference, I am doubtful that this is responsible for the entire gap – the underlying constituents are S&P 500 companies, so nothing is genuinely ‘small’. I think the differential is more likely due to rebalancing.

In the example above, the portfolios are not quite “do nothing” as they are rebalanced back to target weights at the end of each year. The impact of rebalancing is far more significant for an equal weighted approach where target allocations are fixed, unlike market cap where they move with performance. The paper also shows the impact of extending the rebalancing window to only every ten years. Here the gap between the returns of the equal weighted portfolio and the market cap portfolio collapses – the end value of equal weight is $387 and for market cap $342.

It appears that a substantial portion of the return advantage for an equal weighted “do nothing” approach came from a premium attributable to harvesting the volatility of the underlying assets over time. That is selling down stocks after periods of outperformance and vice-versa. Of course, a rebalancing effect does not only stem from an equally weighted portfolio, it comes from any strategy where the weightings of the holdings are not linked to the underlying price of the assets – equal weighting is simply one example.

Even when we wish to take a hands off approach to our investment strategy, there are seemingly innocuous decisions that can have a profound impact on outcomes.

The Two Types of Market Timing

I write frequently about the futility of market timing. I don’t think that people can predict the short-term movements of financial markets, and I wish they wouldn’t try. There is, however, another type of market timing that is far less deliberate, but can be even more influential – our starting point.

Although not a direct angle of the paper, Bessembinder’s work does show how the apparent efficacy of any given strategy is heavily dependent on the period over which we observe its returns.  One of the approaches analysed is simply to buy the largest stock in the index and then “do nothing”.  The fortunes of this admittedly extreme method depend entirely on when you start.

If you did nothing but owned Microsoft from 1999 you would have lost 33% over the subsequent decade, but if you had applied the same strategy in 2016 you would have held Apple and gained 1,046% over the next ten years.  

There are two important takeaways from this (aside from – please don’t invest your entire portfolio in a single stock). First, is that our investment outcomes will be influenced by the point in time when we invest – this will apply to a single stock or a highly diversified 60/40 portfolio. A great deal of this will be down to chance. Second, the more concentrated your investment strategy, the more beholden you become to the point in time you invest, because as concentration increases, so does the range of outcomes. Being diversified mitigates, but does not remove, timing risk.

The Concentration Conundrum

You may recall Hendrik Bessembinder from his previous paper which looked at how concentrated equity market returns were over time – just 46 firms accounted for over half of the $91trn in net wealth created over the course of a century, and the median buy and hold return across individual stocks was negative. When contrasted with Bessembinder’s new paper, this creates something of a puzzle.

His research on concentrated stock market returns implicitly supports taking a diversified, market cap-based approach to equity investing – this ensures that you have an increasing exposure to the companies that matter over time. This new paper, however, highlights the positive impact of an equal weighted approach, which benefits from harvesting a rebalancing premium from volatile equity markets, explicitly cutting the winners and bringing them back to their initial size.  

So, which is better?

It is important to note that the samples used for the two papers are different – his work on concentration incorporates a far greater number of companies assessed over a longer horizon. Although this means that the results of the two studies are not directly comparable, that distinction also brings us to the answer – it depends. The consequence of running winners rather than rebalancing is dependent on the prevailing environment. If performance over an extended spell is skewed towards a select group of large winners allowing concentration to build can pay-off, if this is not the case, the rebalancing effect can win out.

We cannot, however, know in advance if future returns will be concentrated and which companies will be responsible for that concentration. What we do know is that rebalancing and concentration are about trade-offs: rebalancing works because it prevents concentration from building, while a market cap approach works because it allows concentration to develop. The “right” amount of concentration is unknowable in advance, but the more concentrated your approach, the wider the range of outcomes you need to be prepared for.

—

Although not its express purpose, Bessembinder’s research is a timely reminder that there is no investing strategy that really constitutes “doing nothing”. Whether it is the precise approach to rebalancing we adopt, when we start investing or the particular index we select there are always choices that we need to make, and these will be consequential.

It is important to be deliberate when doing nothing.  

–

–

My first book has 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 (UK) or here (US).

I have never been a strong believer in the notion that a fund manager should invest their clients’ assets ‘as if it were their own money’. It is a neat heuristic that I am not sure works consistently in practice. The reality is that there is likely to be a gap between a fund manager’s personal and professional investments, and that difference can tell us a lot about an investor and the environment they operate within.

If we assume consistent objectives, why would a professional investor run their own portfolio in a manner that is different from their clients’? Primarily, because the constraints are distinct. By this, I don’t mean formal aspects such as the range of available assets or fees (although these do matter), but rather the informal restrictions that shape investor behaviour and decision-making. Constraints have a huge impact on investment outcomes but are typically ignored or hidden.

Let’s say a fund manager runs their own portfolio and also a fund for a large asset manager; the goal of both is to generate a 3% real return over 10 years. Why might the approaches be different?

Career risk: The most obvious driver is the spectre of career risk. Professional investors are optimising for two things: delivering on the objectives of their fund over time and keeping their job while they attempt it. Three years of underperformance doesn’t matter for a fund manager’s personal portfolio, but it could matter a great deal for their career. The influence of this factor will depend heavily on the individual.

Keeping their clients invested: While managing career risk may seem like a rational but somewhat self-serving endeavour, there is a closely related behaviour whereby a fund manager adopts a different approach for their clients in an effort to keep them invested. There is no point in having a great investment strategy that nobody can stick with. An investment approach that can deliver 15% annualised over 10 years, but will at some point underperform by 30% over three years, could be ideal for their personal portfolio; it is just that their fund might not have many assets left at the end of the 10 years. Professional investors should seek to run money in a way that keeps clients invested (for the right reasons).

Team over individual: Most professional investors work in teams. The investment process adopted and decisions made are the result of interactions within that group, rather than a reflection of one individual’s ideas. When a fund manager invests for themselves, they can pay attention to, or ignore, their colleagues as much as they wish. It is reasonable to assume that we will overweight the value of our own opinions.

Living through outcomes: Nobody has to live through the short-run outcomes of their personal investments; we can check our portfolios as infrequently as we like. When fund managers make decisions professionally, however, they have to experience those outcomes on a daily basis and are subject to constant scrutiny. Even if they have a resolute belief that an underperforming investment idea will work over the long run, this conviction might be tempered if they have to justify it to a committee every quarter. The emotional toll can be heavy and one that many people would rather avoid.

Managing for the collective: When a fund manager makes investment decisions for their own portfolio, they are doing so with ‘perfect’ knowledge of the person they are investing for and to whom they are accountable. That is entirely different when those decisions are being made for a sizeable, largely unknown and diverse group of people. Managing for the collective is different from running money according to your own personal circumstances and views.

Norms and conventions: Personal portfolios are unseen, so there is absolute freedom to take decisions that may seem odd, anomalous or imprudent relative to industry conventions. This could lead to value-creating liberation or some unmitigated disasters (which clients may be spared)

—

It is easy to assume that the constraints creating a gap between how a professional investor runs their own money and their funds are negative for clients – as if they are receiving an impaired version of a ‘pure’ investment strategy. I don’t think this is always the case. While some constraints can be an impediment, others can serve as an effective limit on sometimes erratic or self-centred individual behaviour.

There is no blanket answer as to whether a gap between personal and professional investment is positive or negative; it is simply important to understand whether it exists and why.

—

—

My first book has 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 (UK) or here (US).

As we are currently in the midst of a wonderful summer of sport, I was considering writing a post about the factors which make some sports boring to watch and others exciting.* I am not, however, brave enough to put my head above the parapet on that subject quite yet. Instead, I decided to write about some vivid human behaviours that arise when we are watching the World Cup, all of which should feel very familiar to investors:

– Extrapolation: We can’t help but believe that what has happened in the past will continue into the future.

All it takes is one England victory and we are immediately checking our wall chart / bracket (delete based on age / location) to see who we will be playing in the final. 

– Momentum matters: Positive or negative progress can become self-perpetuating and an incredibly powerful force.

The wretched hydration breaks and their impact on World Cup games are a great example of how vital momentum is in many walks of life, and how significant interrupting it can be.

– We are overconfident: We all think we are better than we are.

We know more about what England’s starting XI and optimal tactical approach should be than their manager who has deep knowledge of the players and has won nine major trophies in nearly 17 years. 

– Emotions dominate everything: The judgments we make are often overwhelmed by how we feel.

As Paul Slovic highlighted when discussing the affect heuristic – when we feel emotional about something we lose sight of any nuance or reasonable perspective about it. We will see this in stark contrast when people react to England being knocked out (if, indeed, they are).

– Selective perception: We see everything through our own, partial lens.

If a player on your team suffers a potential foul in the area, then it is a certain penalty; if your team commits exactly the same offence at the other end it is absolutely not a penalty, and probably a dive.

– Narrative fallacy: Where there is randomness and chaos, we see compelling stories.

There will be some wonderful stories throughout this World Cup, and many of them will involve far more luck and fortune than anyone will be willing to acknowledge.  

– Halo effect / attribution error: We neglect the role of systems or chance, and focus on the impact of individuals.

We don’t want World Cup wins to be about teams, rather we want to put success or failure down to identifiable, individual agency – whether it is Mbappe driving France towards another title, or Ronaldo being responsible for Portugal’s lacklustre start. 

– Incentives matter: Most decisions are driven by the incentives of those who hold the power.

See: FIFA.

—

Sometimes it is hard to get across behavioural investing concepts amidst the complexity of financial markets, but all of the same issues occur in sport and will be vividly apparent during the 104 games of the World Cup. Keep an eye out.

—

* As a sneak peek, exciting sports (in my opinion) have high and persistent levels of jeopardy, but more on that another time.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

There has been plenty of talk about elevated levels of market uncertainty this year, but until very recently equities have been contradicting this notion. When markets are exhibiting pronounced levels of dispersion driven by a singular theme – in this case AI – it is a sign of conviction rather than doubt. Yet the extreme moves we have witnessed seem like an exaggeration of the level of confidence anyone can have about how the future unfolds.

There are many excellent examples of the intense equity market dispersion that has occurred. It might be the crushing outperformance of momentum versus quality stocks, TSMC holding a substantially higher weight in emerging market indices than India, or more than 50% of the Korean market being made up by two companies. It seems fair to say that the AI trade has been running extremely hot.

The problem with the ferocity of the move in names within the AI eco-system is that it seems misaligned with the vast number of unanswered questions about the longer term impact of AI on markets and the economy.

Here are a few that spring to mind that I don’t have confident answers to, and I doubt anyone does:

– What level of ROI are companies seeing from AI implementation?

– What levels of ROI are companies hoping to deliver in the future from an AI rollout?

– How much are companies willing to pay for tokens when subsidies are reduced?

– What is the moat on an LLM? How do they ‘sustain’ high margins if their only edge is time to market?

– If AI is to be genuinely transformative, why were the corporate users of AI being left behind in the rally?

There are many more questions without clear resolution, and the dramatic level of market dispersion seems at odds with the profound uncertainties ahead.

This is not to say that the most bullish base case is wrong, rather that the probability of it occurring is not 100%.

Of course, I am being a little naïve here. The market conditions we witnessed in recent months had little to do with fundamentals or probabilistic nuance, and much to do with thematic performance chasing driven by an incredibly powerful narrative. Although there has been some respite in recent days, if that environment resumes the danger is that performance pressure eventually drags everyone in.

In times such as these the market becomes starkly binary. The questions are: is the rally justified or not? Is AI in a bubble? Are software company models irrevocably broken?

This is unhelpful and dangerous. The future is messy, complicated and uncertain, that is always the case – even if markets seem to be telling us otherwise. The most important question to answer remains this: am I appropriately diversified given all that I can’t possibly know?

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

I recently read an article about another high-profile ‘star’ fund manager whose performance had been flagging severely. You can probably guess who it was, but that is irrelevant. What matters is the depressingly repetitive pattern of fund managers being lauded as geniuses after a spell of strong returns and dismissed as frauds when gravity brings those returns back to earth. This dramatic shift in sentiment is symptomatic of how most active fund investing works, and it is an almost sure path to failure.

The comments beneath the piece lamenting the latest star fund manager’s downturn were inevitably vitriolic. Here is a sample:

“A has-been definitely proves he is a has-been.”

“Finally exposed.”

“Poor excuses for poor decisions.”

“It was a complete open goal in 2025. Any fool could have made money.”

“Having endured years of presentations from active fund managers, I can confirm that the only real skill they possess is selling snake oil.”

Although I wasn’t surprised by the tone, it did jar with the universally positive perspectives I was sure I had read about this very same fund manager when their relative performance was a little healthier. I looked at the comments responding to a far more positive article from 2021:

“An absolute legend who deserves every penny.”

“Great man – and a great team.”

“Fantastic and fully deserved. May you have many successful years ahead.”

“Great guy. I’m heavily invested. Worth every penny. Those who say he isn’t simply aren’t good at valuing his contribution. Their loss.”

In the space of five years the fund manager has gone from investing genius to greedy and incompetent. I spent years having to justify why I hadn’t invested in this particular manager and was apparently a fool to be missing out on such an obvious winner. Now everyone says they knew all along it wouldn’t last.

Neither of these binary perspectives is true, but they do perfectly represent how most people seem to approach investing in active funds: find the funds that have generated the strongest performance over three to five years, latch onto the narratives that have built up around either the manager or their investment style, and then sit tight for mean reversion to take hold.

It is hard to overstate what a terrible approach to investing this is, yet it is accepted practice across every part of the industry.

All high-conviction actively managed funds will experience prolonged spells of outperformance and underperformance – and by prolonged, I mean years. This is entirely irrespective of whether the manager possesses genuine skill or edge. If a fund is enjoying an unusually strong period of relative returns, it is almost inevitable that leaner times lie ahead, even if the timing is uncertain. Yet each time it happens we act as though we have never witnessed it before.

There is no process, no matter how robust, that works in all environments and at all times.

The endemic performance chasing in the active fund industry is driven by two powerful behaviours: outcome bias and extrapolation. With outcome bias we judge the quality of a process – or a fund manager – purely by the results delivered, which in a noisy system is an incredibly dangerous assumption to make. Extrapolation compounds this. When a fund manager is outperforming, not only is their investing ability considered unimpeachable, we cannot see any end to those high returns.

When a previously high-flying manager begins to struggle, the same outcome bias that gave us such conviction in their acumen now leads us to spot weaknesses in the process. It becomes easy to identify changes in approach and construct plausible-sounding reasons why returns have deteriorated so sharply. The last thing we want is to acknowledge our own failings, or accept that we misjudged the inherent cyclicality of fund manager returns. Instead, we have to build a compelling case for why things outside our control have changed, and why we need to sell.

One of the most frustrating features of this hire-and-fire culture is that we treat each high-profile case as a unique instance with its own particular circumstances. Yet it is the same pattern repeating. It is about our behaviour far more than the capabilities of any individual fund manager.

Few of us readily admit to performance chasing when selecting funds. We always construct persuasive stories justifying our decisions and explaining why historic returns were incidental to the choices we made. It is just a coincidence that, if you know a fund’s past performance, you can almost perfectly predict the outcome of any research carried out on it. It is not merely that we don’t want to admit it – we are genuinely wired to find a good process behind good outcomes, and a flawed one behind poor outcomes.

Even investors who sincerely try to avoid performance chasing find it extraordinarily difficult when it is such a powerful industry norm. Everyone is happy when you sell a struggling fund or buy into one topping the performance charts, despite the evidence suggesting that this is unlikely to be a good idea.

If you want to invest in high-conviction active funds with genuinely differentiated returns, you need to do three things: identify a manager with real skill or edge; be willing to sit through potentially years of underperformance even when you believe in that skill; and develop the ability to distinguish between cyclical underperformance and a genuine deterioration of process. None of these is easy.

The good news is that there is no obligation to do any of it. Index or diversified systematic funds remain a perfectly sensible option and a far better one than investing in high conviction active funds with wholly unreasonable expectations. If you do want to identify skilled, differentiated active managers, it is extraordinarily hard to do well, made significantly harder by a set of very human behaviours. To have a chance of succeeding you need to approach it very differently. Or not do it at all.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Whenever we experience a spell in financial markets where high quality bonds lose value at the same time as equities a glut of commentaries appear either announcing the ‘death of the 60/40’, showing rising equity / bond correlations or proclaiming bonds have lost their diversifying properties. While part of this is usually an effort to sell alternatives, there also seems to be a genuine concern that bonds have evolved to develop a new set of characteristics. I find this puzzling – high quality bonds seem to be behaving just as we might expect them to. They are a good diversifier to equities but not a perfect one.

When bonds and equities lose money in unison there is almost always the same explanation – inflation. Bonds can offer strong protection from equity market risk when there is a growth shock (profits fall, but so do interest rates and inflation); they are not, however, a helpful equity diversifier when an inflationary problem arises (yields push higher and Central Banks are unable to cut rates).

This behaviour has always been a feature of how high quality (nominal) bonds act relative to equities in a portfolio. Very little has changed in that regard. All that has happened is that inflationary shocks have become far more common after decades where disinflationary pressure was the dominant trend.

This doesn’t mean that the relationship between equities and bonds doesn’t matter, it is just that it is important not to misdiagnose the problem. The real issue is that through a prolonged spell of subdued inflation, many investors became complacent about the role bonds play in a portfolio – neglecting the scenarios in which they might struggle.

Since we have experienced a succession of inflationary supply shocks through COVID, Russia-Ukraine and now the Iran conflict, these risks are now front and centre in our thinking. This has been coupled with a huge amount of angst about ‘fiscal sustainability’, which for countries who issue bonds only in a currency that they can also print (such as the UK and US) ultimately comes down to a question about future inflation.

These issues have led to bonds getting a very hard time.

It is worth reiterating that high quality bonds are a superior diversifying asset for portfolios where equities are the most prominent risk factor. Equities are a volatile asset class that can generate high long-term real returns, but are acutely vulnerable to weak growth and recessions. Bonds almost certainly diversify this risk better than any other option. This remains true today.

If an investor is considering reducing their allocation to bonds within their portfolio (which unsurprisingly more people seem keen to do at 5% yields than they did at 0%); it should not be because bonds no longer play a valuable role, but rather because they are attaching a higher probability to the occurrence of troublesome inflation.

This is a perfectly sensible view to hold, but we should remain cognisant of our propensity to exaggerate whatever risk is salient or fresh in our minds. The dangers of the availability heuristic notwithstanding, investors should be seeking to create portfolios that are well-balanced and resilient to a range of economic scenarios, including those in which equity and bond correlation is on the rise.

There are supplementary asset class options that might fill the gaps not covered by high quality bonds – inflation linked bonds, commodities and even trend following strategies. These choices are not unreasonable and a case can be made for their use in a diversified portfolio (alongside many other candidates). They all, however, come with weaknesses and require the acceptance of trade-offs (some very significant). Most importantly, none work as consistently well as a diversifier to equities in a growth downturn.

If we are in a world where the incidence of inflation shocks relative to growth shocks rises then we should expect a higher (average) correlation between equities and bonds, and probably some extra term premium (if inflation risk is greater, I want some additional compensation). This might impact portfolio allocation decisions, but I would be wary about our ability to anticipate future economic environments. I would be more confident in predicting that when the next recession arrives, we will all be glad to be holding high quality bonds in our portfolios.

Despite all the noise, bonds are behaving in just the way we should expect them to. It is probably fair to say that in an era of low inflation and falling yields investors didn’t make their portfolios sufficiently resilient to scenarios where bonds don’t complement equities as effectively. Yet this is the fault of investors, not the bonds. Making some adjustments to portfolios because of this oversight seems prudent, writing off bonds for performing in a perfectly predictable way far less so.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

This is not a piece about banal AI-written investment content, it is an exploration of why a reliance on AI kills the benefits of writing for both reader and author.

When I realise that I am reading a piece of writing that was AI-generated my heart sinks a little. In part this is because of the frustrating style it adopts with its incessant use of antithetical parallelism – “this is not just X, it is Y”. Yet there is something more important than this tedious rhetorical-tic: AI investment content strips all of the value and purpose out of the act of writing and reading.

Most investment writing (apart from generic, turn the handle market commentaries) should be thought of as a process which benefits both reader and author. The reader gets to understand the voice and views of the author, while the author can write as a way of shaping and developing their own thought processes.

If investment writing is just the result of a few prompts, it lacks any original thought and fails to represent the author’s voice. Rather it is simply the output of a predictive system that has no stake in what it generates.

For the author, high quality writing should never be merely an exercise in creating some form of content. Of course, writers are trying to communicate something, but the path to arriving at that communication is as important as the message itself. The process of writing involves exploration, reflection and refinement – all of this is lost if we simply rely on AI.

This loss is most pernicious for those with less experience or without true domain expertise. The process of writing to communicate is also an invaluable form of learning. When the answer is simply to ask an AI model to assume this responsibility for us, not only do we sacrifice the opportunity for slow, deliberative learning, but we also do not have the means or knowledge to question whatever answer AI provides. Writing is about so much more than the output.

Even if we do think only in terms of the end product, the loss from AI-reliance is pronounced. Readers know nothing about the person that (they think) might have written something. They have no sense of their voice, nor can they even provide feedback or challenge to the author, because it is not the author’s work.

Successful investment writing comes largely from a relationship of trust between reader and author that builds over time. As readers, we pay attention to the words and opinions of someone we might have followed for years, and we make judgements about the quality of views offered based on that trust. In a world where AI investment writing dominates, there is no trust, just an absence of it.

While the process of writing informs and enlightens both reader and author, writing can also act as a useful signal of expertise, effort and care. The friction that exists because good investment writing is difficult and complex evaporates when AI can churn out passable flannel in a few seconds.

It is possible to argue that the genuine, higher quality writing will shine through amidst the barrage of generic babble, but it will become increasingly difficult to find amongst the maelstrom of AI generated pieces.

AI writing will also inevitably get better and seem more authentic, so it will become harder to spot than it is now. This will not be a positive development.  As the quality of AI writing improves, the loss from our increasing reliance on it will become more pronounced. As more people turn to it, more of us will lose the benefits that stem from authentic, human writing.

There are, of course, aspects of the process of writing where AI can be incredibly helpful such as researching, fact checking (sometimes) and proof reading. It is also useful in producing the generic work that I imagine no human enjoys having to create, but in writing, and in general, we really need to start being very clear about what AI is good for and where its presence comes with a significant cost.

Investment writing should have a clear purpose and one that is more than simply attempting to communicate a certain message as quickly as possible. For many authors it will be a way of thinking through messy, subjective and complicated problems. While readers want to hear the trusted voice of a writer and understand what they are thinking and why.

All of the meaningful elements of investment writing are human, and most of these have very little to do with the simple production of content. As we increasingly rely on AI, we risk losing the manifold benefits that come from the process of writing and reading.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Although equity markets have thus far proved remarkably resilient in the face of geopolitical and economic risks, it is hard not to argue that we are in an environment of heightened uncertainty. Dispersion within equity markets has been extreme, asset prices are moving dramatically on a single tweet, and there is a daily torrent of erratic news flow. This is clearly a difficult backdrop for investors. Perhaps its most worrisome feature is the temptation to do two things we really shouldn’t.

What are these two things?

• Timing market movements.

• Concentrating our portfolios.

These are both usually bad ideas, but they are particularly pernicious in febrile financial markets. Unfortunately, our desire to undertake such actions seems to be strongest at the worst possible moments.

Time to Time

It seems odd that a reaction to rising market uncertainty is an increasing desire to predict how the market will move, but this is inescapably the case. We have an inherent discomfort with ambiguity, and by investing as if we know the future it can give us a sense of control. We can’t bear to sit and let markets happen to us.

To add to this, we are also loss averse. When people talk of market uncertainty what they really mean is that investors are worried that the chances of losing money are increasing. This is why most market timing behaviour is an attempt to get out of risky assets before a major fall, and then get back in at just the right time.

Trying to invest in such a fashion is a sure route to bad outcomes. Not only is the chance of us getting the initial timing correct incredibly low, but even if we are right we then need to keep making similar decisions. Getting in, and back out again. And what about next time? Do we try to repeat the trick every time we feel that markets are at a precarious point?

We have an incredibly strong instinct to act and to do ‘stuff’ – don’t just sit there, markets are moving! For investors that often means trying to make predictions about what happens next. While the urge to do this can feel irresistible, it flies in the face of the evidence about what is likely to work for us over time.

Lacking in Concentration

It is not just the temptation to trade and predict that arises during periods of heightened volatility and unpredictability – we are also likely to become more concentrated in our portfolios. If we see wide levels of dispersion across stocks, styles, asset classes or sectors, our instinct is to think: “Why am I owning these laggards? Why shouldn’t I focus on the winners?”

This is another form of market prediction, but in a different guise. When we see major performance dispersion in areas of the market (such as energy and software recently), and the compelling stories that are used to explain it, we can’t help but extrapolate. If this trend is going to go on forever, then all we need to do is focus on the right parts of the market.

Losing sight of the principles underpinning prudent diversification is a dangerous game, and can be extremely punitive in choppy markets where dispersion is wide. The cost of not holding certain assets or areas of the market can be heavy if we end up on the wrong side, which at some point we inevitably will.

The idea that diversification is a free lunch has always been a naive one, because it ignores the behavioural element. Being diversified means owning things that are performing poorly and that, in certain environments, we should expect to perform poorly. It is incredibly difficult for investors to embrace this idea – we just want to hold the good things that have been working.

Although I have framed market timing and concentration as distinct activities, they are – in essence – both a form of overconfidence in our ability to predict the future. It’s not that investors are gaining confidence as markets become ever more tricky to anticipate; it is rather that the sense of anxiety stemming from rising volatility makes us behave in ways that appear as if our confidence is on the rise.

Attempting to engage in more difficult activities as a reaction to a feeling that conditions are becoming increasingly challenging is an odd and costly path, but a very human one.

—

The sense that markets are unusually uncertain is the time when behavioural discipline matters most, but also when we are highly likely to abandon it. Market timing and portfolio concentration feel right, but really they are just the easy options that make us feel good, while being very unlikely to work.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Asking questions about what an investor believes, or what their investment philosophy is, can increasingly feel like a mundane tick box exercise quickly covered by some generic, unfalsifiable answers. This really shouldn’t be the case. Investment beliefs are the foundation to any approach and will likely define its success or failure. An underwhelming process supported by some robust beliefs will likely do just fine, whereas flawed beliefs won’t be saved by a good process. The investment beliefs we hold should underpin any decision we make, without them it becomes incredibly difficult to make coherent choices – particularly during spells of market stress.

I have found recent volatility a good time to think about the beliefs that (currently) define how I think about investing. Here they are:

1) Financial markets are wildly inefficient but very hard to beat.

The notion that the aggregate actions of biased and imperfect investors somehow results in market prices being anywhere near ‘efficient’ has always seemed bizarre to me. The only reasonable way to reach such a conclusion is to argue that the ‘wisdom of crowds’ averages out our respective flaws; yet the wisdom of crowds idea only holds if its individual members are independent of each other (which investors are clearly not) and they are all trying to estimate the same thing. If you bring together a day trader, a long-term investor, a momentum investor, a passive investor and a contrarian investor – they are each investing in a different way with distinct objectives, there is no reason that their combined views should get us close to some long-term fair value.

That markets are likely to at times wildly diverge from any reasonable estimate of fair value does not necessarily mean that a more active approach is superior to a more passive one. To make the most of mispriced assets an investor needs to have skill and behavioural fortitude, characteristics that tend to be in short supply. If markets are indeed inefficient, our starting point should be that we are the ones creating the inefficiency rather than exploiting it.

2) Survival is the most important and neglected goal for all investors.

Investors rarely talk about survival, but it is the most important aspect of any strategy. It should define whether we make a particular investment and how it is sized. We should always avoid creating situations where there is a meaningful risk of complete disaster (being wiped out) or where we are unable to withstand spells of poor performance. The best investment is the one we can stick with for the long-run, not the one with the highest potential return. If we don’t survive, nothing else matters.

3) A long-time horizon is the great advantage of most investors, but few use it.

Most investors have long-term horizons but behave as if they are only interested in the next year (at most). This is a terrible waste of a huge advantage. In the short-run, financial markets are driven by sentiment, incessantly noisy and a complete behavioural disaster. They are not much more than a game where investors try to guess how other investors will react to the next piece of news. Over the long-run, more stable and dependable fundamentals like cash flows and profits start to exert their influence, and compounding works its magic. Most investors are too constrained by their psychological wiring and powerful industry incentives to make the most of this tremendous long-term edge.

4) Risk is about potential outcomes and probabilities.

Investors have a strange relationship with risk. We increasingly try to remove it while at the same time trying to take it. We also try to measure it via a host of imperfect means. The easiest and most useful way to think about risk is that it arises in any situation that has more than one potential outcome. A risky situation is simply one where there are several potential paths and some probabilities attached to them. The challenge, of course, is that we can never know with certainty the possible paths nor what the right probabilities are. But whenever we talk about risk – managing it, reducing it, increasing it – what we really mean is that we are trying to change the shape of future outcomes with all the uncertainty and trade-offs that this entails. We should be far more explicit about this.

5) Investors must define what is important and knowable.

The best way to navigate the vast amount of superfluous noise that has come to define financial markets is to ignore it. As that option is not available to many of us, the most feasible alternative is to define clearly the things that are important and knowable. Important things are those that matter to meeting our long-run objectives (and no, last quarter’s returns do not qualify) and being knowable means aspects we can predict with some confidence. If it is not important (and not many things are for long-term investors) we should ignore it. If it is important but not knowable then we can diversify to protect ourselves from the uncertainty.

6) Performance and valuation extremes are where most opportunities and threats exist.

Most price fluctuations in markets can be regarded as random noise and there is not much point in being one of thousands of other people attempting to attach convincing narratives to them. There are, however, certain situations where investor behaviour drives asset class performance and valuation to extreme levels – think bubbles, manias and crashes – where opportunities are created and downside risks are exaggerated. These extremes are a double-edged sword. Certain investors are able to take advantage of unusually compelling valuations and higher expected returns, while many others will be drawn into performance chasing – abandoning out of favour assets and becoming increasingly concentrated in expensive assets with unsustainably strong performance. Behaviour always matters for investors and matters even more at extremes.

7) Predicting macro and market developments is close to impossible, diversify instead.

It doesn’t matter how much evidence builds up that market forecasting is a destructive use of time; it will remain one of the most prominent parts of the investment industry. We can, however, benefit by simply not doing it – it gives us a head start over those that are. Forecasting and market timing is an attempt to deal with the ingrained uncertainty investors face, but it is the wrong answer. The correct response is diversification. The entire point of sensible diversification is to create a mix of assets that reflects the inherent uncertainty of the future.

8) If you want to understand anything in financial markets, think about incentives first and second.

As someone who has spent so much time applying behavioural science concepts, it always feels a little dispiriting to acknowledge that incentives drive most behaviour, but it is undoubtedly true. If we are ever in doubt about why something is being sold to us, why a group of investors are behaving in a certain way or how a geopolitical event is unfolding – the answer will almost always be found by following the incentives.

9) Most investment activity is some form of performance chasing.

Although nobody likes to admit it, and it gets camouflaged in many elaborate ways, the vast majority of investment activity across financial markets is performance chasing (it is amazing how many detailed investment processes and projects result in the recommendation of an asset class or fund that has performed very well in recent years). Everyone wants to own more of the things that are going up and less of the things that are going down. This is, of course, rational behaviour; not only does it appeal to our outcome-orientated psychology, but it is easier to raise assets / attract clients / not lose your job when you own the stuff that has been doing well.

Although there is some merit to momentum investing, performance chasing is not the same thing. It lacks all of its structure, discipline and explicit intent. All investors would be better off acknowledging their performance chasing tendencies, and trying to do less of it.

10) Our behaviour will define our outcomes; if we don’t think explicitly how to manage it, we are doomed to fail.

Humans are an exceptionally successful species, but most of our highly effective adaptations are incredibly ill-suited to making sound long-term investment decisions. It is not that we are irrational or stupid, just that we are applying our characteristic traits to an entirely different task – survival / reproduction has different requirements to making sensible investment decisions. Unless we think very deliberately and carefully about our investment behaviour, we don’t have much hope of good outcomes.

———

This set of beliefs has evolved through my career, which raises the question – how committed to our investment beliefs should we be? The answer is firmly enough that we don’t capitulate at the first moment of significant doubt, but with sufficient give that if enough pressure is applied, we might be inclined to change our mind. The tightness of grip on our own beliefs should also undoubtedly be related to our experience. The more that we have seen, heard, read and lived through should impact the confidence we may hold in our beliefs (though they should never be unimpeachable).

Ultimately, what we believe about how financial markets work will have an overwhelming influence on our investment results. We should all think a little more about what we believe and why.

—

---

My first book has 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 (UK) or here (US).

Last week saw a heavy and rapid sell-off in a swathe of software-related companies, a dramatic move that was linked to Anthropic’s launch of an AI-driven workplace assistant. These share price falls were characteristic of an environment that has moved from AI optimism to AI uncertainty. This is not simply uncertainty about the efficacy of vast capital expenditure, but the jeopardy surrounding which businesses might suffer material disruption from the next leg of AI development. This doesn’t just mean nervous times for some growth investors, but maybe changes how all investors think about risk.

Ain’t Nothing Like The Real Thing

Although it may sound counter-intuitive, one potential impact of the quick and unpredictable progress of AI is a return to favour of old economy stocks. Much of the past 15 years has been dominated by new economy stocks – best symbolised by US technology companies – at the expense of more traditional industries, such as resources, financials and utilities. The market has favoured companies with high price to book ratios often supported by intangible assets.*

In a world where there is increasing uncertainty over which areas will be most at risk from AI disruption, maybe this phenomenon will change; investors might start to prefer companies where the chance of the business being upended seems significantly lower. It feels easier for AI to do significant damage to the model of a software company than it does to a miner, for example.

AI progression means that certain types of business now hold a wider range of outcomes. Almost certainly some investors will find that the intangible assets of their favoured company were intangible for a reason – they didn’t exist. **

The risk attached to businesses vulnerable to AI with intangible assets and once seemingly impervious moats is likely to be a little higher, as will the return required for holding them. It is tough to be an investor if you are living in fear of the next release from Anthropic or OpenAI.

We may enter an environment where (certainly compared to recent years) investors start to value real things a little more and ephemeral things a little less.

The Best and Worst Time for Active Investors

Every consequential investment theme gets turned into an argument for or against active management – depending on our prior – and AI disruption is no different.

Advocates of active investing will assess the current environment and say something along the lines of:

“AI will create a huge gulf between companies that win and companies that lose. Investors who truly understand businesses and the industries they operate in will thrive.”

Conversely, index fund supporters will say:

“There is no reasonable way of knowing which companies will be the beneficiaries of AI and which will be the victims, this makes concentrated stock picking more dangerous than ever. The cost of being wrong has never been higher. It is far better to own everything, and make sure you hold the winners.”

Who is right? Take your pick. What seems incontrovertible is that certain business models will be negatively impacted – perhaps drastically so – while others will benefit. This will create dispersion and volatility.

—-

The sharp decline in the shares of software companies was not fundamental (yet), it was a case of investors predicting how other investors might react to the latest AI developments. We don’t know how genuine these concerns are – and that is the problem. AI is causing huge uncertainty and it is impossible to know what the consequences will be. There will be continued bouts of volatility and only time will tell what is speculation borne of temporary doubts, and what represents genuine and profound change.

—

* It is certainly fair to say that outside of the US, value as a style has been finding more favour in recent years, but the dominance of the US and the Magnificent 7 sometimes makes this a little hard to notice.

** Over a longer horizon there are clearly broader (and more important) questions about how AI will impact society and economies.

—

---

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Until recently I was seemingly one of the few people who hadn’t seen the TV show ‘The Traitors’.  It became popular so quickly that my stubborn, contrarian streak prevented me from indulging. After some persistent persuasion from my children, however, I succumbed and have been watching the latest UK ‘celebrity’ version. Not only do I have to reluctantly admit to enjoying it, but I have found the contestants’ – often baffling – approach to the game starkly reminiscent of some of the most destructive investor behaviours.

For the uninitiated, the game is very simple. A group of (20 or so) people are put together and a small subset (usually 3) of them are secretly selected to be ‘traitors’. Each day the traitors covertly select one of the ‘faithfuls’ to ‘murder’ (remove from the game). Also, each day, the entire group have to discuss and vote to banish a member of the group who they suspect of being a traitor. For the faithfuls the aim is to rid the group of traitors, while for the traitors it is to remain undetected until the end and claim a prize for themselves. (Party game fans may recognise this structure from Mafia / Werewolf).

A distinctive feature of the game is the almost complete absence of useful evidence the players can use to guess who might be a traitor in the group. The traitors are selected by the producers prior to the show, and players must make judgements based on their interactions with each other during the game. 

The way players decide on who to banish for being a suspected traitor follows a consistent blueprint:

– There is virtually no meaningful evidence about who is a traitor.

– All players significantly overstate their skill in ‘reading’ people and hugely overweight meaningless information. 

– Players construct persuasive, compelling and entirely spurious reasons about why another participant is a traitor.

– The players who put together the most elaborate arguments are considered smart even though they are consistently wrong.

– The player identified as a traitor is banished and it transpires that they were a faithful.

– Players lament their approach and consider whether a different strategy might be worth considering next time.

– In the following round they do precisely the same thing, seemingly forgetting it didn’t work before.

These are all very human behaviours and almost identical to those that we see from investors attempting to predict the short-term movements of financial markets.

The hallmarks of which are:

– An environment defined by noise and very few signals.

– Massive levels of individual overconfidence in the skill to make predictions about asset class performance.

– A wonderful ability to create impressive and coherent stories about market conditions.

– Credibility and airtime given to investors who sound smart.  

– Those investors frequently being wrong.

– Everyone carrying on doing the same thing anyway without acknowledging it didn’t work before.

—

Whether we are trying to guess who the traitor is in a party game or predict the performance of US equities over the next 6 months, the patterns will be familiar. We will inevitably see evidence where there is none, be wildly overoptimistic about our own capabilities, and create stories to alleviate the discomfort of randomness and uncertainty.

Human behaviour doesn’t change much, just the context. 

—

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Although it could have easily escaped your attention, as it has received such little fanfare, the price of gold has been rising sharply – recently surpassing $4,000 per ounce. Significant moves in the gold price are fascinating from a behavioural perspective because gold is probably the perfect belief asset – that is an asset which is impossible to value in any reasonable way so it’s worth is entirely dependent on what we think other people believe it to be. This has significant implications for how gold might behave, and how people both talk about it and trade it. 

We are currently in the stage of the cycle where many people conjure up reasons for why gold is so attractive because they cannot admit that they mainly like it because its price has gone up a lot. That is not to say that there are not valid reasons why an investor might hold the asset but, as usual, near term performance must bear much of the responsibility.

How should investors think about gold?

Gold is not a better form of money: One of the most common and vociferous arguments from investors who are bullish on the prospects for gold is that it is far superior to standard fiat currencies because it holds its value, whereas the like of the US dollar or sterling lose their purchasing power through time. This view makes very little sense. In a well-functioning and growing economy, a positive level of inflation is desired – it encourages spending and investment – this means currencies should lose value through time. It is a feature not a bug. Yes, a dollar today may buy you less than it did 30 years ago, but I am pretty sure that salaries have changed over that time also, and I am confident people do things with their money – like spend it and invest it.

The merits of owning gold change depend on what question you ask. Is holding gold over the long-term better than putting cash under the mattress? Quite possibly. Is holding gold over the long-term a better option than owning productive, real economic assets (such as company shares)? I am not so sure.

Gold has excellent Lindy properties: Although the ‘debasement’ argument often made about gold is an exceptionally dubious one, gold does benefit from the Lindy effect. This is the idea that the expected life of something that is non-perishable is proportional to its current age. In simple terms this means that the longer something has existed, the longer we assume it will last. (The expected future life of Great Expectations is significantly longer than anything published last week). The concept is named after Lindy’s deli in New York City where it was speculated that a show running for a month on Broadway could be expected to last for another month.

Gold has been used as a store of value for thousands of years. People have believed in it for an extremely long time, which should give us some confidence that people will keep believing in it. This feels somewhat amorphous – but when you don’t have much else to go on it matters.

Belief assets can be extremely volatile: The more assets are based on belief than anything tangible the riskier they are likely to be. Why is this? If an asset is driven by strong fundamental features – let’s say a high-quality bond with a contractual return and fixed maturity – the range of potential outcomes is very narrow. The more speculative the asset, the more it is based on indefinable beliefs, the wider the range of outcomes and the greater the uncertainty.*

Assets that have long-term, fundamental value drivers experience a (sometimes light) gravitational pull towards some form of fair value. As belief assets have no fair value the price can vary widely – this can be both incredibly lucrative and, at times, painful. (Belief assets are perfect for bubble formation – there is nothing to hold them back).

Prices for belief assets change because perceptions change. If the gold price were to drop to $2,000 is it more or less attractive than it is now? Nothing will have changed about the yellow metal, just what people believe other people believe about it.  

Price moves in gold create stories about gold: As we are being bombarded with stories around the reasons for the rise in gold price – debasement, fiscal largesse, central bank purchases, political uncertainty – it pays to remember the causality here. Price moves come first and then the narratives to justify it second. It is not that the stories have no validity, it is just that they become more persuasive the higher the price rises, creating a self-reinforcing loop – for a time at least.   

Do you like the asset or its trend?  Momentum investing has a long and storied history of delivering positive returns – but only if carried out in a deliberate and measured fashion. One of the problems with strongly trending belief assets is that rather than acknowledge that they want to participate in the price momentum, investors need to offer a compelling fundamental rationale. Although this might make them sound smarter, all it means is that they are a closet momentum investor without the discipline required to do it well.

Know why you own it: Perhaps the key for any investor owning gold is to be very clear about why you hold it, otherwise you risk being whipsawed around as price trends (and beliefs) fluctuate. If you purchase it tactically be specific about the precise factors that are informing your view (even if it is just trend following). If it is a structural portfolio holding you should be willing to bear periods of significant losses with equanimity and understand the exact role it is playing.  

—

There is nothing inherently wrong with holding gold, but it is important to accept the type of asset it is and the investment behaviour it may encourage. If Ben Graham had been asked about gold, he may have said something like:

In the short-run, the market (for gold) is a voting machine, and in the long-run it is also a voting machine.

—

* Whether an asset is a belief asset or a fundamental asset can also depend on time horizon. An equity investor trading on a three-month view is turning stocks into a belief asset because they are worried only about sentiment (belief) changes – the fundamentals are largely irrelevant.

–

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

It seems a fair bet that in a few years’ time we will come to see the two most dangerous words in investing as “democratisation” and “innovation”. Although one might feel like something of a luddite when criticising progress, it is difficult to escape the notion that too many ‘solutions’ in investing are designed to solve the problems faced by the industry, rather than the clients it serves.

New markets, new instruments, new platforms and new structures. It is wonderful to see such a bewildering array of choice available to all. Who doesn’t want to trade single stock options at three o’clock in the morning?

The idea that providing everyone access to everything will provide clear client benefits is a dubious conceit. In most cases all it is doing is creating greater confusion, temptation and cost, while making it increasingly difficult for investors to manage their behaviour.

It is frustrating that minimal thought seems to go into answering the question: how is this development likely to impact client outcomes once we account for the behavioural impact?

There is a seemingly accepted view that opening access to ‘institutional’ assets and instruments previously unavailable to the retail market an undoubted positive. As if most private investors are being shut out from exclusive areas of the market that could transform their fortunes. This exact argument was made about hedge funds years ago, and I am not sure that it worked out too well.

For an industry perspective there are certain things that are critical from a revenue perspective – activity, complexity and differentiation. Unfortunately, these things are all too often a drag on client returns – not many investors who trade a lot, own complex products and struggle to deal with too much choice ever come out well from it.  

There is certainly nothing wrong with innovation, but we must accept that there can be an acute friction between what might be good for industry outcomes and what might be good for client outcomes.

Of course, it is possible to have industry developments that are beneficial for both clients and companies, but the more something egregiously benefits the seller, the more scrutiny we should place on the question – which client problem is this solving?

When shiny new things are brought to market (particularly the retail market) far too little effort is given to making the case as to why clients will benefit. In a world of rapid technological change and declining industry margins, investors will need to be on guard that what is presented as progress, isn’t actually likely to make them worse off.

—

My first book has 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 (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

I have no idea what happened in financial markets in the second quarter of 2019. I think it is safe to assume that not many people do. The problem is that when we were living through it, it would have felt like the most important thing. As if the ‘information’ we were engaging with would have a profound impact on our investment outcomes. Yet now we cannot even remember it. Our obsession with dealing with what is right in front of us may well be an effective evolutionary adaption, but it is a terrible affliction for most investors with long-term goals.  

Human attention tends to be drawn towards two things – salience and availability. Salience is where something is particularly noticeable (often due to some emotional resonance), and availability is how easily something comes to mind (typically because it is recent). The lure of the day-to-day gyrations of financial markets is strong.

Unfortunately, it is not only an issue of attention, but importance. We are prone to hugely overweight the relevance of what is happening in the moment, as Daniel Kahneman noted:

“Nothing in life is as important as you think it is, while you are thinking about it.”

In the general sense this is not irrational human behaviour. If something is happening or changing in the current instant, then it can make absolute sense to focus on it and deal with it immediately. Taking the time to accurately calculate the probability of whether that movement you spotted on the savannah is actually the head of a lion is probably not a smart strategy. The issue is that rationality is context dependent. What is good for human survival is often terrible for long-term investing.

The problems that stem from this behavioural wiring are twofold. First, we are likely to neglect information that is genuinely important in favour of what we are currently experiencing. Second, we are almost certain to trade too much as we get stuck in the cycle of continually reacting to the next set of salient and available information, or what we might instead call the prevailing market narrative.

That most investors are caught in this behaviourally satisfying but return-eroding loop is reflected in the lack of introspection or reflection around past decisions and opinions. Nobody looks back at all the predictions that were made in our market outlooks for 2019 because it would be embarrassing to acknowledge how wrong we were and how attentively we focused on matters that were either irrelevant or unpredictable. It is better for everyone if we all just keep looking forward.

Escaping this damaging obsession with the present is not simply about overcoming our own behavioural limitations but acting in a manner that is contrary to expectations. It is not just us who feels that we must do something about what is happening right now. Everyone does. Even if we don’t think it is important it makes sense to act as if it is. In this instance taking action is still about survival, but not from the lion, in our job.

There are inevitably periods in time when there are market developments that matter for our long-term prospects. These might be fundamental (such as some significant change in valuations or expected returns) or behavioural (dealing with these challenges of bear markets and bubbles), but will be dramatically outweighed by things that are either unimportant or unforecastable. 

When we are living with markets in each moment it is almost impossible to separate signal from noise because of the undue status we place on the present. Aside from entirely ignoring the vacillations of markets (which for many is impossible), the only conceivable way to deal with this is to define in advance what aspects are important and then attempt to ignore the rest. This is the price of admission for the advantages provided by a long-term investing approach. Nobody said it was easy.

Attempting to be a long-term investor while obsessing over the short-term fluctuations of financial markets is like starting a diet but filling your kitchen with chocolates and cakes; you might still achieve your goals but you are really making it hard for yourself. 

—

My first book has 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 (UK) or here (US).

Although we may not like to admit it, the past performance of an asset class or fund is likely to have an overwhelming influence on our decision making.  We may try and mask the hold it has on us, but we are inescapably drawn towards investments with strong recent returns. The more pronounced and persistent the outperformance, the greater the pull. There is probably no more prevalent nor puzzling paradox in investing – in order to enhance our returns we make decisions based on a measure that is likely to reduce them.

The past performance of an asset are returns that we are not going to enjoy. They have been (at best) drawn forward from the future – the better the performance before we invest, the worse they will be after. Unusually strong returns are typically the result of unsustainable tailwinds, random doses of good luck and the inescapable swings of market sentiment.

Periods of abnormally strong performance mean that an investment has become more expensive and that it has earned higher returns than it is reasonable to expect on average. Both factors acting as a gravitational pull towards future disappointment.

This type of behaviour is most pronounced in active fund selection. Here it is not even an implicit driver of decision making, but rather an explicit feature of most processes. The popularity of star fund managers is (at least in part) forged on the notion that exceptional returns in the past are a prelude to exceptional returns in the future. We ignore the realities of valuations, the spectre of mean reversion, and fickle hand of fortune, and instead assume that some form of idiosyncratic skill will overcome all of these factors. This is an assumption with terrible odds of success.

The pull of past performance is not unique to fund manager selection, it is pervasive across the industry. We only need to look at the clamour for US equities following a decade (or more) of stellar performance. Investors seem to behave as if the market’s outsized returns in the recent past increase the probability of a continuation of this pattern, when in all likelihood the reverse should be true.

Why do we have such a strong tendency to read the wrong signal from past performance?

Extrapolation: We seemingly cannot avoid believing that trends of the recent past will persist, even when this view seems to be contrary to any rational analysis. A critical part of this anomalous behaviour is the power of storytelling. When assets or funds deliver exceptionally strong (or weak) performance, narratives are weaved to explain them. These compelling stories that justify unusual returns also bolster our belief that they will endure.  

Outcome Bias: Aside from our inescapable short-termism (more on that later), outcome bias is probably the most damaging behavioural foible suffered by investors. Whether it be for a stock, fund or asset class, when we witness strong performance we imbue that thing with some inherent goodness (and vice-versa). High past returns give us increasing confidence in the credentials of an investment. It must be good, haven’t you seen the returns?

Career Risk: For many, being in thrall to past performance is a survival strategy. Most professional investors make decisions to survive over the short-term. Although performance chasing might objectively appear to be an odd strategy at an aggregate level, for an individual it might be the best way to keep our job or avoid another difficult meeting. Investing in the in-vogue areas of the market can be both irrational and rational at the same time – it depends on our objective / incentive.

Instant / Delayed Gratification: Inherent in the paradoxical impact that past performance has on our decision making is the trade-off between instant and delayed gratification. We have an ingrained preference for doing things that make us feel better in the moment over waiting for rewards that may occur at some uncertain future point. Performance chasing gives us an instantaneous, positive hit – we are investing in areas of the market that are working right now, the stories supporting it are captivating and everyone thinks we are making a sensible call. The alternative approach gives us pain now with any benefit someway off in the distance.

One clear signal of the dangers innate in performance chasing is that there is no behavioural cost. It is easy to do and feels good when we do it. Almost all positive investment approaches come with behavioural pain – something has to hurt.

—

There is one important exception about the perils of making decisions based on past performance. The success of trend-following strategies, which are explicitly past performance focused. If there is evidence of this working, why is performance chasing such a problem? There is a critical distinction. The success of systematic trend-following strategies is about the consistent application of discipline and rules. Conversely, most investors engage in erratic trend-based investing (we invest in things because they have ‘gone up’) and rationalise the decision based on some post-hoc fundamental analysis.

We are largely secret trend-following investors not admitting how much past performance matters to ourselves or others, and absent the aspects that makes capturing such trends work. 

The paradox inherent in investors’ unhealthy focus on past performance does not mean that we should scour the market for the most egregious laggards, but rather be wary of the influence of high historic returns on our decisions and realistic about its likely consequences. Unusually strong past performance should make us concerned not confident. 

–

My first book has 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 (UK) or here (US).