Betting Against Warren Buffett

Suspend your disbelief for a second. Imagine you have been gifted $1m, the only proviso is you must split the amount between an equally weighted 30-stock portfolio of US listed companies selected by Warren Buffett and a 30-stock portfolio of US listed companies selected by…me. You get to keep the amount staked on whichever portfolio produces the highest return.

Where would you put your money?

Of course, it is impossible to take any view on likely outcomes because we are missing a vital piece of information – the time horizon. When considering luck and skill in investing this is the most important thing. It changes everything.

Let’s say the time horizon was just a single day. The odds of my portfolio beating Buffett’s must be 50%. One day’s stock market movement is nothing but random noise. $500,000 each seems a prudent approach.

What if the length of the bet is increased to one year? The chances of my portfolio might be a little less than 50% but only modestly. Nobody can accurately and consistently predict in advance what will happen in equity markets over the next year. Fundamental company attributes are unlikely to matter that much compared to events, narratives and flows. The result would not be far from a coin toss.

How about three years? This is an important timespan because it is often the period over which fund investors hire and fire active managers. We should expect some advantage to arise from Buffett’s acumen and experience here, but the results would still be extremely variable and hugely influenced by sentiment, rather than the aspects of a business Buffett cares about.

We could use base rates to help us size the bet. Between 1988 and 2019 Berkshire Hathaway outperformed the market on c.60% of rolling 3-year periods.[i] A $600,000 stake towards Buffett would seem sensible.



The tangential point here is that on the time horizon adopted by most fund selectors, Warren Buffett would have been sacked on multiple occasions over his staggeringly successful investing career. Past performance can be a terrible decision-making tool.



Now, back to the bet. 

Finally, let’s try a 10-year time horizon. We are getting into the realms of long-term investing. Company fundamentals should matter more. Skill should start to exert a material influence. But how much?

Let’s go back to base rates. Over the same period as previously mentioned Berkshire Hathaway outperformed the market on close to 90% of rolling 10-year spells. We might now have more confidence placing $800,000 or $900,000 on Buffett’s side of the table.

Time horizons matter.

When thinking about the bet; don’t worry too much about my limited capabilities in stock picking, just assume that I design my 30-stock portfolio to look as much like the market as possible. Also, it doesn’t have to be Warren Buffett – just a highly skilled stock picking investor. The message will be the same.

So, what is the message?

1) Conversations about luck and skill in investing are irrelevant unless we specify a time horizon. For most styles of investing, the longer the time horizon the more skill will influence outcomes. Whatever the time horizon, however, the results will never be devoid of chance.

2) Investing is a bizarre activity. Over reasonably lengthy time horizons (one year, three years and more) people without any discernible skill will produce better results than the most skilful individuals in the field. There are very few activities that are structured in this way.

We hugely understate the role of luck in investment outcomes. Humility is a pre-requisite for good investing. Sensible decisions will appear mistaken – a lot.

3) Active fund investors have their time horizons all wrong. Attempting to identify skill and then worrying about one and three-year performance is entirely futile. We are doing little more than playing roulette (particularly if we acknowledge that we are unlikely to identify the greatest investor of their generation in advance). A focus on short run horizons will doom us to making persistently bad decisions based on the unpredictable movements of markets.

If there is any chance of success investing in active funds, we must extend our time horizon. If that is not possible, we should not be using them.
 


[i] Daily: Firing Warren Buffett | UBS Global

Long-Term Investors Must Make a Ulysses Pact

In Homer’s Odyssey, Ulysses and his crew must navigate their ship past the sirens. The sirens produce a beguiling and irresistible song, which if heard would lead the men to their deaths. To be the first person to hear their song and live, Ulysses applies some behavioural science. He creates a commitment device in the present to protect his future self. He instructs his crew to fill their ears with wax to avoid temptation and has himself tied to the mast to avoid action. If investors want to enjoy the benefits of long-term investing, we must adopt a similar approach.

Stephen Pinker discusses this type of behaviour management in his new book Rationality. He notes that Ulysses surrendered his ability to act and the sailors their option to know. This is puzzling because wilfully relinquishing information and agency seems deeply irrational. Yet if we are aware of the challenges and impulses that await us, it can be the most rational approach to achieving our goals.

As investors we find ourselves in a similar situation to Ulysses. Most of us have long-term objectives best facilitated by doing less, yet the constant noise and narratives of markets are there to lure us into frequent injudicious decisions.

Being a long-term, low action investor is the easiest approach to adopt in theory, but the hardest in practice. How do we make a commitment like Ulysses to protect us from our future investing selves?

Plugging our ears like the sailors means ignoring the chaotic vacillations of markets and the unpredictable path of the economy. Rarely checking our valuations, cutting off our subscriptions to financial news. Avoiding anything that will entice us away from our plan.  

Tying ourselves to the mast means making action far more difficult than inaction. Cancelling the brokerage account, losing the password for our portfolios, or adding elements of friction to slow an investment decision-making process.

Of course, we don’t do any of these things. It feels absurd to disregard ‘critical’ information and constrain ourselves from making ‘vital’ investment judgements. We also find it difficult to believe that we will make poor choices in the future – surely, we will behave in a perfectly rational manner no matter the environment?

As with so many things in investment, taking the right behavioural steps to achieve good outcomes can seem irrational and imprudent.  Saying ‘I don’t know what markets did yesterday, and I don’t really care’, probably increases the odds that our long-run outcomes will be good, it is just that everybody will think we are incompetent.

Professional investors naturally dislike this type of Ulysses pact.  We are paid to engage with markets and act, irrespective of whether that activity is beneficial.  We must listen to the siren song and probably erroneously believe we can avoid the rocks whilst enjoying the melody.  

Commitment devices do not have to be entirely restrictive, however. They can be designed so that our future self is more likely to exploit opportunities that arise. We might commit to acting only when certain extreme valuation levels are reached. This approach is obviously imperfect compared to an avoidance pact because we will still have to implement the decision when the time arrives (and will no doubt create excuses as to why it is no longer a good idea). Setting a high threshold for action, however, at least protects from the worst ravages of noise and overtrading.  

A critical part of managing our behaviour is understanding the challenges we will face and planning in advance how we will mitigate them. Good investment is primarily about making sensible decisions at the start and avoiding bad decisions on the journey. The problem is that the compulsion to veer off course is likely to be overwhelming.  

Most of us want to be long-term investors, but unless we make the right behavioural commitments at the outset the siren song of financial markets will make that an impossible aspiration.

Should Investors Care about an Asset Manager’s Culture and Brand?

Asset managers spend a great deal of time cultivating their brand and extolling the virtues of their culture. Although as an investor it is easy (and enjoyable) to be dismissive of these activities, they do matter. Investing in a firm with a toxic work environment and invectives wildly misaligned with our own is unlikely to lead to positive outcomes. If a firm or team’s culture is at odds with its investment philosophy, the culture will win out. Culture is critical but gauging it from the outside is incredibly difficult to do. The only way to better understand it is to ignore the words and instead focus on behaviours.

We should not think about culture without also considering the issue of brand. The two are deeply intertwined and can be considered different sides of the same coin. One external to a company and one internal. A brand is the perceptions held about the behaviours of a company by outsiders. A culture is the expected behaviour of insiders within a firm – what is permitted, enacted, and rewarded. Asset managers are unlikely to sustainably and successfully reset a brand without also addressing the underlying culture.

The cynicism that meets much of the talk around brand and culture within the asset management industry is entirely fair. It is so often vacuous nonsense – a superficial effort to manage perceptions. Establishing or transforming a brand is not about slogans, fonts or colour palettes, it is about changing the beliefs held about a company’s activities. If a company changes its name but its behaviour is consistent with the past, then existing opinions will simply transition to the new name.

If there is an effort to modify the brand and culture of a business, it is critical to ask – “what actions and behaviours are changing and why?” Not – “what is it you are calling yourself now?”

Given the industry’s focus on performance, it is possible that strong brands can exist when the team culture underlying it is poor. Investment returns can be impressive in a bullying, exclusive environment where client outcomes are subordinate to that of the business, but they are unlikely to be sustainable – the culture will lead to a reckoning at some juncture. Even if strong returns do persist against such a backdrop, we should ask ourselves whether it is the type of business with which we are happy to entrust our money.

Situations can also exist where a company has made material strides in improving its culture, but its brand remains tarnished because of past deeds. In such instances, shifting the optics (changing the name or logo) might help to allow the brand to reflect the evolving culture but will be insufficient. There needs to be consistent and meaningful evidence of what is changing. Skoda’s brand image would not have evolved had they not also improved the quality of their cars.

Assessing the culture at an asset management business is not easy. The starting point is to dismiss everything that you are told and anything that appears on a PowerPoint deck, and instead focus on tangible actions. It is easy to extoll the virtues of an inclusive environment in which the many different forms of diversity are paramount, but what is actually being done about it? Have concrete policies been put in place to facilitate this?

If the purported culture is based on putting the long-term interests of the clients first, how is that achieved? What remuneration structures are in-place to incentivise behaviours that are aligned with this mindset? How is the firm overcoming the pressure of meeting short-term financial objectives?

There is often a yawning gulf between what a firm says about its culture and what it actually does.

When assessing the culture of an asset management business, we should start by asking two questions: i) What are the cultural features (expected behaviours) we would expect to see at a high quality investment organisation? ii) What are the cultural elements that would support the application of the specific investment approach we are considering?

As an outsider there are a variety of ways to build a better understanding of culture within a firm or team. Those with privileged access can attend internal meetings and obtain details on incentive structures and historic staff turnover. It doesn’t have to be that difficult, however. Sites such as Glassdoor can be insightful, as can conversations with previous employees. We can also observe how the company engages with different stakeholders. The messages given by management to shareholders may well differ with those offered to potential investors in their funds – shareholders will hear about cost cutting and improving short-term flows, investors will hear of continued investment in the business and the paramount importance of adopting a long-term approach.

What we are seeking to understand is whether a firm’s behaviours and expected behaviours (its real culture) are consistent with what it says and what it is trying to achieve. There is no magic bullet to judging this, but we can easily build a framework or checklist, and reach our own conclusions.

Asset management firms should care about culture not because it sells or helps improve the brand, but because it leads to better outcomes for all stakeholders. Investors should care because our outcomes will be driven by the behaviour of the individuals in the firm with which we are investing.

It is so easy to poor scorn on culture and brand as amorphous and frivolous concepts, particularly when most asset managers play the game of saying the right things to best support and furnish their desired image. Culture is frequently discussed without anyone taking the time to explain it; but this doesn’t mean we should dismiss it. At its heart culture is about behaviour, and there should be few things as important to investors as that.

Investors Should Prefer Camels to Horses

There is a common decision-making adage that states: ‘a camel is a horse designed by a committee.’  Although there is some doubt over its origin it is thought to have been first uttered by Sir Alec Issigonis, designer of the iconic Mini car. The ungainly camel represents the flaws of committee-led design, which is often defined by indecision, competing interests and compromise. The sleek horse is the result of individuals or small teams operating with focus and a distinct purpose. Although it is a wonderfully salient maxim, it is deeply flawed. Camels are a design / adaption marvel and in areas such as investing they provide invaluable lessons about how best to deal with uncertainty.

The idea that a camel is a poorly conceived horse does a huge disservice to a fantastically versatile creature. Adapted for desert living, camels must deal with dramatic temperature extremes from +50°c to -40°c. This means that they cannot use fat as insulation (as many animals living in cold climates do), but instead store fat in humps and have insulating fur. The energy stored in their humps mean they can go for sustained periods without food; whilst their technique for processing water allows them to survive for days in the severest droughts.

Although not as rapid as the fastest horse they are no slouches with certain species able to run up to 40mph. They are also ideally suited to long distance toil. Bactrian camels can carry 200kg (440lbs) for 50km (31 miles) per day. Camels have a range of other adaptions that allow them to survive and function in hostile environments such as wide padded feet, an extra-long intestine (to aid water absorption) and a fluctuating body temperature. They are creatures built for variability and uncertainty.

We are drawn to horses because of their appearance and speed, but their design is only superior to a camel if we are certain about the distance, environment and terrain. The less we know about our future path and the conditions we will encounter, the more valuable the resilience of the camel becomes.

The preference for the alluring features of a horse over the unwieldy camel is also suffered by investors. Most of us have long-term objectives requiring a portfolio that can withstand extreme variability in the environment and cope with material uncertainty. We are, however, so often tempted by options that have proved themselves ideally designed for the recent past and assume those conditions will persist. This leaves us sharply exposed to the realities of a complex and dynamic system.

Even when we acknowledge that the investment landscape will be changeable our tendency is to believe that we can foresee this and adapt our positioning accordingly. When we attempt to time markets or invest in funds that do, we are declaring that we can forecast the undulating path ahead and identify the investment ideally designed to navigate it. Although the promise of holding the perfectly tailored investment vehicle at the appropriate moment is an appealing aspiration, it is also an exercise in profound and costly overconfidence.

A prudently diversified portfolio is akin to a camel; it is not the most attractive choice and at any given time there will always be a superior option to deal with the current circumstances. It feels like we are always making concessions and carrying unnecessary burdens. Those fat storing humps on a camel seem superfluous when food is abundant, but much like the drag of holding anything but the most in-vogue asset class or fund, they are essential tools for an uncertain future.

If we are asked to undertake a long journey along an unpredictable path we should take lessons from the design of a camel, not a horse.

What is Your Investment Edge?

The idea of an investment edge is a simple one. It means that there are some features of an investment behaviour that improves the odds of better outcomes. Although the concept is straightforward, locating edges and creating an environment that fosters them is incredibly challenging. This is primarily due to the difficulty in specifying and evidencing them. Many established active fund managers – who are selling edges – struggle to articulate their own supposed advantages. Edges are, however, not the sole domain of active managers; whenever anyone is making an active investment decision they should understand the edge they have in doing so, otherwise they should not be doing it. 

Types of Investment Edge

The starting point for overcoming the problems of identifying an investment edge is defining the different types that might exist. I consider there to be three broad groups, which each include a range of more granular sub-groupings, these are: Analysis, Behaviour and Implementation:

Analysis – What information is used and how it is used

Informational
– Investors access more / unique information (insider trading is an edge, albeit an illegal one), or use different / new types of information.

TechnicalInvestors have specific technical skills that provide them with an advantage in assessing securities and markets. For example, a complex MBS strategy.

CriticalInvestors use information in a distinct fashion, which provide differentiated insights.

Behaviour – How an investor makes decisions

Decision Making I – Investors structure a decision-making process that mitigates the impact of our behavioural limitations.

Decision Making II – Investors structure a decision-making process that exploits the impact of our behavioural limitations. Most factor-based strategies are founded upon such an edge.

Emotional – Investors manage and control their emotions, so that their decisions are not overwhelmed by how they feel.

Environment Investors work in an environment that supports the objectives of their investment approach. The obvious example here being a high conviction active manager who is incentivised based on the long-term results of their strategy and supported through prolonged periods of underperformance.

Temporal – Investors make long-term investment decisions absent pressures of short-term performance or noise. This is the incredibly powerful edge that private investors hold over professionals.

Implementation – How an investor implements ideas

Trading Investors can skilfully trade in and out of positions.

Portfolio Shape
Investors have an advantage in how they construct their portfolio or how they weight conviction in certain ideas.

Not all edges are created equal. Given the abundance of information the potential for a credible analytical edge now seems far lower than has historically been the case. Edges are also not mutually exclusive, often they are dependent upon one another. For example, a temporal edge can only be credible within a supportive environment.

Although there are simple investment edges most (particularly those that are not easily commoditised) are a complex web of complementary or (sometimes) conflicting elements.

Key Questions About Investment Edge

The categories of investment edge are by no means exhaustive, but I would expect most to fall within these groupings. Critically, defining edges in these terms is only a starting point for more detailed analysis. There are three critical questions to ask about any purported investment edge:

1) What type of edge is it? It is not sufficient to state that an investor has an edge that sits within a certain category, we need to be clear about precisely what it is, otherwise it becomes close to impossible to evidence. Edges can be very general – buying companies that are cheaper than the market. They can also be specific – complex country models to assess the credit quality of an emerging market.    

2) Why does the edge improve the chances of better returns? It is important not to accept an investment edge at face value. We need to create a hypothesis as to why it might improve our results. We can never be certain, but unless we can make a plausible claim as to why an edge should lead to excess returns, then it probably isn’t an edge.

3) Can we evidence the edge?  Now comes the tricky part. If we have identified an edge and have created an argument as to why it may lead to better outcomes, we need some means of evidencing it. Obtaining confidence in edge (or skill) is all about drawing a consistent link between process and outcome. The typical and flawed approach to this is to discover an investor who has outperformed and then assume that their edge must therefore be effective. Markets are far too random and noisy to make such inferences. There are many investors with no credible edge that will appear as if they do when we focus on performance in isolation.  Instead, we need to ask what type of behaviours are likely to result from the edge and identify whether that is apparent in the decision making of the investor.

There are inevitably challenges with this approach. Sample sizes are often small and the evidence base lacking. Also, the more nuanced and intricate the edge, the more difficult it is to draw a causal link between it and outcomes. This means we must adjust our confidence in the existence of any supposed edge and should correct our investment conviction accordingly. Any view on an edge is a probabilistic judgement informed by the evidence available.

If we don’t attempt to evidence an edge then we cannot develop a reasonable level of confidence that it exists or observe when it has been compromised or competed away.

How to Identify an Investment Edge  

Generating convincing evidence about the existence of an investment edge is undoubtedly a challenge, but there is an even more fundamental problem. It is often difficult to decipher what the actual edge is. Even investors who should have one (because they charge for it) struggle to convey what precisely they believe their advantage to be. Fortunately, for most traditional, qualitative investment approaches there is a simple resolution. We just need to ask the fund manager one question:

“Could you effectively systematise your investment approach?”

Inevitably most active fund managers would baulk at the notion that their nuanced investment process can be transformed into an algorithm; for a start it does not augur well for their career prospects if the answer is yes. More importantly, if the answer is no the reasons they give as to why it cannot be made systematic should provide a clear view of their purported investment edge. By definition, they must believe that there are distinct elements of their investment process that cannot be easily or consistently replicated. Whatever is supposedly lost through systematisation, is likely to be some form of supposed edge.

Identifying a possible edge does not mean that an investor possesses a genuine one – most of the time it will not be – but it gives us a clearer sight of what that edge might be. We can then test it.

Most active investment strategies will feature two levels of potential edge – a base level ‘risk premia’ that can be easily systematised and then a more nuanced secondary level which reflects the specific features of their approach.  For example, the manager of a value equity strategy will have a base level edge of buying cheaper companies than the market (easy to replicate, but still with historic efficacy) and the second level that is the distinct elements of their process that allows them to produce better outcomes than the cheap, simple version of the base level edge. The second level is what investors are paying for, but it is much harder to evidence credibly, and we should have less belief in it.



This post might read as if it is solely about how we perceive the investment edges of other investors, but it is not. We must always view ourselves through the same lens that we judge other investors.

When we make an investment decision, do we know what our edge is?

Nobody Really Thinks About Behaviour 

It is easy to think of investing as a technical endeavour, where we can develop specialist knowledge and insights to improve our results. We expend a huge amount of time and energy on enhancing models or refining processes to gain some edge or advantage. It is difficult to argue against this drive for progress.  Yet, in investment, what feels right can often lead to worse outcomes. The desire for more information, more precision and more complexity almost inevitably impairs the quality of our decision making. 

Despite its rise to prominence in recent years, investors are still not thinking about behaviour nearly enough.

The arms race to improve technical sophistication is understandable, but a major failure in prioritisation. Do we really believe that our analysis is going to be better than the next person? Is it worth allocating inordinate resource to the slim chance that it might be? Are our research and analytics going to be superior to the house with 100x the capabilities that I / we have?

There is nothing wrong with enhancing our technical proficiency, but it should be subordinate to considering our behaviour. The potential to improve our results by understanding and managing our behaviour outstrips any other changes we could make that might enhance our investment fortunes.

The first question any investor should ask is – how can I create an environment that minimises the behavioural challenges I will face?

So, why don’t we do it? In part, it is because we still don’t believe it. We can pay lip service to behaviour, but at heart we still see ourselves as rational decision makers.

Most importantly, making behaviour the critical part of an investment approach doesn’t feel or look right. Creating strong behavioural frameworks is often about doing less. Less activity, less information and fewer decision points. Good luck trying to pitch that.

To be successful long-term investors, particularly if we have short-term accountability, is staggeringly difficult. The very minimum we should be doing is acknowledging that the potential to make poor short-term decisions based on noise, emotion and incentives is exceedingly high.

Our default expectation should be that over the long-run we will make a lot of bad investment decisions driven by our behavioural limitations.

We should be trying to fix that first, rather than worrying about extracting some uncertain analytical edge.

The question that is never asked

The problem with treating behaviour like a distracting but ultimately meaningless sideshow is not only evident in the lack of priority attached to it, but how rarely it seems to be considered across the industry. All the way from asset managers to technology providers and regulators.

The obvious example is about the access all investors now have to their portfolios / investment accounts. An optically wonderful development but what are the behavioural consequences? (They seem obvious to me).

Whenever anyone is making a change to an investment process the first question that should be asked is:

“How will this impact behaviour?”

I am not sure it is ever asked.

Every change we make to our approach to investment will alter our behaviour. Even slight, seemingly inconsequential adjustments can have a profound influence on our judgements.

So often alterations are made which have good intentions but spell behavioural disaster. It is difficult to think of many developments in the investment industry in recent years that are not likely to make us more short-term and trade more frequently.

But if behaviour is so important, why don’t we care about it enough?

1) Many things that are likely to aid our behaviour appear regressive and unsophisticated (less interaction with markets / fewer decisions). Constraining choice, reducing information and adding friction rarely seems like a winning ticket.

2) As we struggle to see behavioural weakness in ourselves, we find it difficult to understand how it will likely impact other investors.

3) Many behavioural issues seem so minor that they are easy to disregard. We should never underestimate how small changes will have dramatic consequences for choices and outcomes. 

4) The requirements to be a good behavioural investor run counter to the structure of the industry and its incentives. The management of career and business risk are far more powerful than many realise. Short-term incentives always trump aspirations of good long-term behaviour.

5) The benefits of good behaviour are not always easy to see. There is no obvious counter-factual and they accrue over the long-term. We much prefer quick wins or approaches that feel like quick wins (but create long-term losses).

6) Good behaviour that gets the odds on our side can feel very painful in the short-term and is easy to abandon. It is not comfortable spending time doing less, when everyone else is doing more.

Every development to an investment process, platform or piece of regulation should be viewed through a behavioural lens. Ideally, each change should be designed to improve investor behaviour, as nothing will provide a greater net benefit. When changes are implemented that have the potential for negative behavioural consequences then specific steps should be taken to ameliorate these. This is the least we can do.

There is plenty of talk about behaviour, but unfortunately not much action.

What is More Difficult, Asset Allocation or Security Selection?

I was speaking with a friend recently and, as they also worked in the industry, our conversation inevitably turned to investment. We were discussing the difficulty of different aspects of the job, in particular the contrast between asset allocation and security selection. They were of the view that asset allocation was inherently more challenging, whilst I held the opposite position. As I reflected upon this discussion, I realised how important this issue was. If investors are undertaking an activity to improve outcomes it is critical to understand how difficult the task is and why. If we can answer this, we can judge whether it is worthwhile and what is required to carry it out successfully.

So, what is more difficult, asset allocation or security selection?

Before considering the specifics of the question, it is important to define some terms. If we are asking what aspects of investment are more difficult, we need to understand what we mean by it. We can do this by framing it as a simple problem:   

How easy is it to adopt and maintain a process that can improve the odds of better outcomes?

The issue of difficulty is really about skill – the capacity to consistently link process and outcomes in an intentional and positive fashion.  

And that brings us to the first question we should consider when considering the difficulty inherent of a given task:

Is it an activity where skill can influence the results?

Before even beginning to worry about the relative difficulty of anything, it is critical to understand whether we can consistently and positively impact results at all. Some activities are just too hard, and the results of our endeavours will be dominated by randomness. We can apply two tests to identify such situations:

Reasonableness test: Is it reasonable to believe that skill can influence an activity and offer some advantage? This is a simple sense check to avoid the pitfall of seeing patterns in random outcomes. If we get enough people flipping coins some will get five heads in a row, that does not mean it is reasonable to believe it is a task where skill can exert an influence.

In a field as complex as financial markets it is easy to get immediately lost in the weeds. It can save a great deal of time to start with first principles: define what the essence of the task is and the core assumptions that must hold to believe that skill can be a factor.

Evidence test: Is there evidence that the potential to influence outcomes with skill exists?  If we believe that an activity passes a reasonableness test, we need to validate this by looking at the data. Do historical outcomes support the idea?

We will have an example of an investment activity that may fail both of these tests later.

Once we have made a judgement on whether the results of an activity are likely to beholden to randomness, we can move to the next question:

What is the nature of the skill?

We can often fall into the trap of believing that investment difficulty is just an issue of technical complexity. It is simple to assume that the more technically challenging a skill is, the more reward we might enjoy from performing it well. This is a misnomer. Technical factors are one aspect, but equally important are the behavioural facets.

Technical skill is where there is inherent complexity in the task and expert knowledge is a necessary but not sufficient condition. Behavioural skill is where the task itself might be simple, but our ability to make the rational decisions required to improve outcomes is compromised. Both are types of processes that can lead to better outcomes, but the requirements to execute them successfully are entirely distinct.  

If we know what type of skill is required, we can attempt to judge how difficult it is to perform. Which brings us to the final question: 

How difficult is it to undertake the skill to improve results?

It is not sufficient to know whether skill can exert an influence on performance, we need to know how hard it is to successfully perform it.  Mowing the lawn and flying a 747 are both tasks where skill influences outcomes, but one is far more challenging to master than the other.

Difficulty matters for investors. Just because the application of skill might improve our results, it doesn’t mean it is a good idea to try. Not only because something might be so challenging that it is a waste of our time to even attempt it, but because our attempts might lead to worse outcomes than if we had not even tried.

The difficulty of any investment activity is also context dependent. For professional investors, the working environment is critical. If technical expertise is required, then the abilities of colleagues and quality of systems may greatly influence the feasibility in exercising a skill. If the skill is behavioural then steps must be taken to neutralise problematic biases. It is impossible to capture a behavioural premium from adopting a long-run approach (for example), if everyone is obsessing over quarterly results. Simple skills can quickly become impossible to perform.

Having created a framework for assessing difficulty and feasibility, we can consider the question posed in the title of this post. To muddy the waters slightly, I will address strategic asset allocation (long-term) and tactical asset allocation (short-term) separately, as they are markedly different endeavours.

Tactical Asset Allocation

Tactical asset allocation – adjusting portfolio exposures over short time horizons based on market conditions to improve returns or reduce risk – is undoubtedly the most difficult activity of those that we will discuss. It falls at the first hurdle. It doesn’t even pass a reasonableness test.

Is it reasonable to expect any person or team to confidently and consistently predict the near-term movements of a system as staggeringly complex and adaptive as financial markets? It is hard to contend that it is.  

Not only is it an unreasonable expectation. I am yet to see any compelling evidence that investors can add value by calling market directionality or asset class performance in the near term on a reliable basis.

If tactical asset allocation is so difficult and there is so little evidence of it working, why is it commonplace? It is likely a behavioural phenomenon. It is the very fact that financial markets are so chaotic and unpredictable that makes the idea of tactical asset allocation so alluring; because markets are turbulent and changeable there is an overwhelming urge to act. Something is happening – do something about it!

In an absurd fashion, it is often easy to be viewed as a negligent investor by do nothing even when it is overwhelmingly the most sensible course of action.

Tactical asset allocation is really about creating narratives, stories to talk to investors and clients about. The main advantage that stems from tactical asset allocation is the comfort clients may receive from seeing activity in their portfolio through difficult market conditions. This might help them stay the course. Despite this potential benefit, my sense is that money would be better spent educating investors on how boring and long-term investment should be, rather than using the indirect and uncertain behavioural benefit of tactical asset allocation.

In a ‘traditional’ multi-asset portfolio, tactical asset allocation is usually applied relative to a neutral allocation within some form of risk tolerance. For example, a portfolio can move underweight or overweight equities based on an assessment of market conditions. Attempting to adjust such exposures seems a futile task. Provided the time horizons / objectives of the portfolio are sufficiently long, the rational, evidence-based approach would simply be to permanently overweight equities within the portfolio’s risk tolerance and capture the long-run premium. This would get the probabilities of good outcomes on our side far more than attempting to time markets.

There are two problems with such a simple approach: 1) We cannot charge for it in the way we might for tactical asset allocation. 2) We will need to endure the difficult spells of equity performance to capture the probable return advantage. Neither seems like a compelling reason to persist with tactical asset allocation.

If short-term asset class timing is so difficult, what about if we adopt a longer-term approach?

Strategic Asset Allocation

Compared to tactical asset allocation, adding value through strategic asset allocation – the long-term (ideally 10 years+) mix of assets in a portfolio – is easy. If you don’t believe me, answer this question:

Maintaining prudent risk tolerances (say +5/-5% allocation changes or 1% tracking error budget) how confident would you be in outperforming a 60/40 portfolio over the next ten years by making strategic adjustments to the allocation?

I am not confident about many aspects of investments but my answer to this question would be somewhere around 80%. Why so high? Because I would simply overweight equities and underweight bonds. As the time horizon extends, I become more confident in receiving an additional return for the additional volatility. Risk-adjusted returns might be a little worse, but that is acceptable if you remain within the mandated risk tolerances and of course: ‘you can’t eat risk-adjusted returns’.

There are inevitably challenging scenarios where long-run equity returns from here are inferior to bonds, but that is captured in the 20%. If markets take one of those paths my modest overweight to equities is probably going to be the least of my worries.

Even if we take a more intricate approach, there is still evidence to suggest that over the long-run the returns from cheaper assets will outstrip more expensive assets. Over ten years I think that emerging market equities outperform US equities, but my confidence would be nowhere near 80%, probably closer to 65%. It is still, however, an evidence-based edge. It is also one that passes a reasonableness test – is it reasonable to expect cheaper major asset classes to outperform more expensive ones on average over the long-run? I think so. There is solid evidence supporting this type of strategic asset allocation behaviour and it is not technically difficulty, but there is a major problem – behaviour.

Although most investors time horizons are more than ten years, really none of them are. We care far too much about short-run outcomes, so our ability to capture improved returns from simple strategic asset allocation adjustments is incredibly limited. Whilst we can have a high confidence in a structural overweight to equities, can we maintain it through the inevitable bear markets – can we keep our job? Imagine attempting to hold an overweight to emerging market equities and an underweight to US equities position through years of thumping US outperformance. Although the odds may be on our side, nobody will believe they are.

It is not technically difficult to make prudent, long-run asset allocation decisions that get the probabilities in our favour, but few of us operate in an environment where we are able to exploit that advantage.

How do the behavioural challenges of top-down, strategic asset allocation compare to the bottom-up complexities of security selection?

Security Selection

We can consider security selection to encompass picking a collection of individual stocks or funds to improve upon the returns of a default, market cap index. As with SAA and TAA, we can split the activity into two elements: identifying companies that will improve on the returns of the market (stock picking) or structuring a combination of stocks to have attributes or biases that are distinct from a market cap approach (factor tilts). These are not mutually exclusive, but for the purposes of assessing difficulty it is helpful to treat them separately.

Stock picking is incredibly difficult – the evidence clearly attests to this – only the minority achieve exceptional long-term results. Unlike tactical asset allocation, however, it does not fail the reasonableness test. Is it reasonable to believe that it is possible to pick a collection of companies with better attributes than a selection based purely on their size?  Yes, it probably is. It is just very hard. Technically and behaviourally. Even if we have a technical edge that can add value, there will be arduous periods when it will appear that we don’t.

By contrast, factor tilts are not technically difficult to achieve. They are simple and commoditised. It can be accomplished by deviating from a market cap weighting methodology with virtually any other approach. There is also ample evidence that – over a long enough horizon – established factors provide some form of return advantage. It is also reasonable to assume that buying cheaper, higher quality, smaller sized etc… companies, on average, leads to better results.

The challenge of factor tilts in security selection is not technical, it is behavioural. Even factor tilts with vast amounts of empirical evidence as to their efficacy will underperform for prolonged and painful periods. This is a requirement rather than a bug, if there wasn’t some discomfort in holding a factor-tilted approach, there likely would not be a return advantage.

What’s the answer?

The answer as to what is more difficult: asset allocation or security selection is – it depends. We need to understand the specific details of the skill we are attempting to perform before making such a judgement. Strategic asset allocation may be a more worthwhile endeavour than tactical asset allocation but comes with its own profound challenges. Whereas factor-based stock investing is theoretically easy, but practically tough. 

The question is also inherently subjective. Reasonable people may disagree and the difficulty of any investment activity will be highly dependent on our environment. All investors, however, should be explicitly considering the likelihood that they can deliver positive results from the task they are undertaking.

We must remember that most activities that offer the potential to deliver improved returns will either be complicated (technically) or painful (behaviourally), sometimes they will be both. Whatever the cause of the difficulty we need to understand it if we are to have any hope of achieving better outcomes.

What Happens if the 60/40 Portfolio Underperforms for a Decade?

The success of the simple 60/40 portfolio has been one of the defining features of the investment landscape over the past decade. A combination of persistently declining bond yields and exceptional performance from US equities has meant that it has trounced most alternative allocation approaches. Doing anything but hold a 60/40 portfolio (or a derivation of it) has almost inevitably come at a cost. It is now considered to be the natural, default option by many investors. It is not clear, however, whether this status is because of something innate in the 60/40 structure that makes it the neutral choice, or whether investor opinions would change if it endured a prolonged spell of disappointing returns.   

This piece is not another critique of the 60/40 approach (most of which are attempting to sell another product), nor an assertion that investors must do something else (aside from lower their expectations for future returns). It is about how investors treat evidence. What evidence we choose to use, what we choose to discard and the importance we place on certain elements.

A ‘passive’ allocation to a 60/40-type portfolio is often framed as the obvious, evidence-based investment decision, and there is certainly compelling support for it. The returns have been stellar, particularly since the secular decline in yields began, and it has inevitably been boosted by the low costs typically attached to this approach to investment. Yet in assuming this is now the only approach to adopt in the future, we are inescapably ignoring other pieces of evidence.

Investors in 60/40 portfolios hold significant allocations to the US equity market (which has been a particular boon for non-US investors) and long duration sovereign / quasi-sovereign bonds. Holding a US equity focus in a portfolio now is to choose to ignore the evidence that over the long-run expensive markets tend to produce lower returns than those which are more attractively valued. Furthermore, owning long duration, low yield assets is a recipe for higher volatility and underwhelming returns.

If we suspend our disbelief and imagine that over the next ten years US equities have been trounced by other developed and emerging markets, what would our reaction be? Would the 60/40 still be the in-vogue, evidence-based default, or would something else now be in its place? Given how sensitive our investment perspectives and purported beliefs are to historic performance, it is almost certain that investment industry would be awash with obituaries for a 60/40 approach, probably at the precise time it becomes a more compelling option.

When an investment strategy has been successful, particularly for a sustained period, it is incredibly difficult to envisage this changing. Yet we only have to look at the performance of the value factor over the last ten-years (plus) to understand how this can occur. Having exposure to value is well-supported by the evidence but has failed to deliver meaningfully for a sustained period. Even investment approaches that work will go through arduous period when they don’t. No strategy is immune to this.

In the scenario where a 60/40 portfolio has struggled relative to other options, investors have endured a cost because they have focused on a certain piece of evidence (the long run success of this approach) and ignored other relevant information (the long run poor results of expensive assets). This is perfectly reasonable. All investors are faced with a plethora of evidence, and it is upon us to filter this and focus on that which we believe to be most robust and material.

The danger is to assume that any view we take is neutral. It is not. We are always making judgements and trade-offs. It is easy now to state that a 60/40 approach is simply following the evidence because it has performed so well, for so long. Yet we frame and weigh evidence through the window of recency. If something is working now, then the evidence we have supporting it seems more important and more obvious. It is easy to disregard or underweight evidence to the contrary.

We can see how past performance informs our use of evidence by looking at the typical home equity bias held by investors. From an investment philosophy standpoint there is limited compelling evidence for holding a heavy bias towards our domestic market, but how any given investor perceives the home bias is likely to be dictated by where they are located. In the UK, there is an ongoing clamour to remove this home skew. Not because everyone has suddenly alighted upon the evidence, but because returns from the UK equity market have been wretched (on a relative basis) for years. By contrast, is it unlikely that US investors are desperate to increase their exposure to underperforming international markets.

If anything, in this scenario, it is UK investors that should be more circumspect about the speed of such a shift in allocation given the evidence of strong long-run performance from undervalued markets, but this is far from the case. Recent performance is not only used as the most important piece of evidence, but it also frames how we perceive all other information.  

Our time horizons are also a major defining factor in the evidence we choose to follow and that which we choose to ignore. Investment approaches supported by the most robust evidence only play out over of the long-run (if at all) and patience is required to see it come to fruition. One thing the investment industry has little of is patience. That is why the evidence of what is performing well right now is so compelling. We are not asking people to wait, to believe something different to what they are currently witnessing or bear uncomfortable risks.

Even if we consider something to be the neutral investment option it is imperative to consider the evidence we are using to support that view and also justify why we have chosen to ignore other pieces of evidence. We also need to envisage a future where the default disappoints and understand how we would react in such a scenario. The 60/40 has been a great option for many investors, but we cannot forget that it is an investment view and should treat it as such.  

Only Invest in Active Managers If You Can Withstand Prolonged Periods of Underperformance

The argument against the use of active management is often focused on the difficulty of identifying a fund manager with the requisite skill to outperform the market. This perspective, however, ignores a critical element of employing active fund managers. It is not simply about finding the right ones, it is about being able to stick with them over the long-term. An elegant study recently released by Vanguard put this into sharp contrast. It showed that even successful active funds endured protracted, multi-year spells of underperformance. The message is simple: if we are not able to withstand years of under-par returns, we should not be using active managers at all.

The Vanguard study, which looks at the performance of open-ended actively managed equity funds with US domicile, covers over 2,500 funds across a 25-year period. The entire piece is worth reading but there are some critical observations:

– “Close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one, three and five year evaluation periods”.

– “Eight out of ten outperforming funds had at least one five year period when they were in the bottom quartile relative to their peers”.

Underperformance is an inevitable and expected part of the return profile of all active managers, even those with skill who manage outperform over the long-term. Hopefully, the study lays to rest the spurious but pervasive notion that years of consistent outperformance is either a reasonable expectation or anything more than random patterns being weaved.

Identifying a skilful active manager is incredibly difficult; but even if we can do it, it will not matter if we are unable to cope with the barren periods. The first question we ask before considering investing in an active manager should not be – do we have the ability to find one? Rather, are we in a position where we could hold them for the uncomfortable and volatile long-term? If the answer is no, we should not even begin the search.

It is easy looking at historic underperformance on a screen before we invest; living through it is an entirely different proposition. The doubts about the quality of an underperforming manager or their suitability for the prevailing market environment are relentless. Fund investors spend most of their time worrying about the managers who are underperforming. It is difficult to overstate how behaviourally taxing it is. The easy option is always to switch from the bothersome laggard and into a flavour of the month leader to make the questions and concerns disappear, at least for a time.  

Persisting with an underperforming active fund as an individual is extremely challenging, but even if we have the personal wherewithal, the problem does not vanish.  It is not just us that has to endure it – it is the other stakeholders too.

The underperforming fund manager and the firm they work for must also retain conviction. It is of little use if we stand firm only to see the manager change their approach or their employer fire them.  The incentive of the fund manager is to keep their job and for the asset management company to preserve assets; keeping faith with an under-scrutiny investment strategy which has delivered years of poor results is not aligned with either of those. Unfortunately, for a fund manager, possessing investment skill might not be enough.

For professional fund investors, the final hurdle is the people we are accountable to. Do we work in an environment that is supportive of adopting a long-term approach and willing to endorse investment decisions that will look wrong, often for sustained periods?  There is no point investing in active funds if we will repeatedly be forced out of them (due to pressure from others) after three years of underperformance. As a pattern of investment behaviour, it is hard to think of a more pernicious strategy.  

There are no easy solutions to the problem of persevering with a struggling but skilful active fund manager. The temptation to sell will often be overwhelming. There are two ways of giving ourselves a fighting chance. The first is setting the correct expectations at the outset – we need to be abundantly clear about the prospects for a fund or manager with all interested parties. Even if we are right, multiple difficult years are inevitable.

The other potential ameliorative is manager blending. Combining active fund managers of different styles should not only smooth returns and provide diversification benefits; if done well it is an effective behavioural tool. When one manager is experiencing a fallow period, another is likely to be enjoying a tailwind and delivering superior results. The whole concept of blending is built on the notion that not everything will work, all the time. Even attempting it helps in setting the correct expectations. Furthermore, the pain of the underperformance from one fund will be offset (somewhat) by its more productive counterpart.

Blending is no panacea. It is far from a precise science and if it is done too well, we will end up owning an expensive version of the market. It will also not stop us and others worrying about the straggler. The pain felt about the underperformer is likely to be more acute. These issues notwithstanding, it is the best option available to investors in active funds.

Unfortunately, even if we can hold active funds through tumultuous periods of performance it is not enough to guarantee positive outcomes. The manager we invest in might actually be underperforming because something has gone wrong, and the right course of action is indeed to sell.

Nobody said it was easy.



Vanguard Study: Patience with Active Performance Cyclicality

How Should We Judge The Quality of a Sell Decision?

Determining whether a decision to sell an investment was correct seems like one of the simpler judgements that we make. If it continues to perform well after we have sold it then it was a mistake; whereas if it goes on to struggle it was a wise choice. Unfortunately, it is not always that easy. Focusing on the outcome of a decision alone can often be deceptive and lead us to draw entirely erroneous conclusions.

To explore why this is often the case, it is useful to offer some examples. The main issues we face when assessing the quality of a sell decision is dealing with known costs, hindsight bias, and tail risks:

Known Costs

The manager of a value fund sells a stock once it returns to its fair value. Following its sale, the stock continues to perform well and reaches a historically expensive price.

This can easily be viewed as a fund manager making the error of selling too soon or failing to run their winners. But is it? The manager has a philosophy and process built on buying undervalued securities, should we really expect them to continue to own a position when it becomes expensive?  This would invalidate the process. In such situations following the process is the correct decision even if it appears to be a mistake from a pure outcome perspective.  

If a manager persistently encounters situations where they are selling stocks that go on to outperform, they could adjust their process to capture this momentum. The alternative route is simply to state that missing out on these returns is a known and accepted cost of their approach.

Hindsight Bias

We are investing in an actively managed fund that undergoes significant changes; the asset management company is acquired, and the fund manager departs. An individual with minimal experience is appointed to run the fund. We decide to sell our position in the fund. It performs incredibly well over the next five years and is amongst the strongest in its peer group.

When we review a sale, we will inevitably incorporate information that was not available at the time the decision was made. The potent combination of hindsight and outcome bias means that not only we will think it was a mistake to sell the fund, but that it was obvious that we should not have done so.

In this instance, the new manager may simply have been lucky. Even if they do possess skill, we did not have sufficient knowledge at the time to make such a judgement. The choice to sell the fund was unequivocally the correct one. It will appear, however, as if we sold a talented fund manager at precisely the wrong time.

Tail Risks

We are investing in a fund which has a stellar track record but are becoming concerned about certain developments, particularly around the behaviour of the fund manager. We are not sure how serious these are but estimate that there is a 5% chance of the fund ‘blowing up’. Given this, we decide to sell the position. The fund continues to deliver outstanding returns in the years that follow.

This is a simplified example designed to portray the most difficult type of sell situation faced by an investor. Despite the decision being correct, we will likely be considered foolish for making it. As if we were worrying about nothing and have needlessly forgone performance.

When we judge the success of decisions solely on outcomes, we are likely to consistently penalise those choices that seek to avoid the cost of low probability, high impact failures. As, by definition, they do not often come to pass. Prudent, risk conscious choices will frequently appear unnecessarily cautious.



It is not that results are unimportant when assessing the quality of sell decisions. They can tell us a significant amount about our investment behaviour, particularly if we can build a large enough sample size. They do not, however, tell us everything. Successful investment is about creating a process that gets the odds on our side. In a system where randomness and chance can exert an overwhelming influence, we need to think less about the result of a given decision and more about whether it was consistent with a robust process.