Being an investor in an environment dominated by a highly consequential yet uncertain theme is exhausting. Everyone is searching for answers about the impact of AI and acting as if the next lurch higher or lower in the ‘AI trade’ might be the signal they have been waiting for. I’m afraid these market moves are not providing as much information as we might hope.

The pattern currently established in markets, a familiar one whenever a prominent theme emerges, is extreme sensitivity to the next piece of AI-related information. When it arrives, it is either validation of the bull case (“all that CapEx is more than justified!”) or proof that the bubble has finally been pricked. The result is a series of repeated mini-cycles of euphoria and gloom.

There are two things happening here. First, short-term traders are adjusting their positioning based on how they think other investors will react to new information. Whether that information is genuinely meaningful is often irrelevant. Second, fundamentally-oriented investors are struggling to deal with significant uncertainty, overreacting to each fresh piece of news while inevitably feeling the pressure of sharp market moves.

We have an equity market characterised by extreme levels of dispersion, driven by concentrated thematic trading and accompanied by a torrent of commentary eager to explain every move as a dramatic fundamental shift. This creates an incredibly febrile environment. While there is genuine uncertainty about the consequences of AI, it is undoubtedly being amplified by aggressive positioning and exaggerated narratives.

This presents a difficult backdrop for investors, defined by periods of pronounced, concentrated returns and frequent reversals. To have any chance of navigating it successfully, it is essential that we do not treat every mini-cycle of AI pessimism or optimism as the ultimate resolution of the AI story, however comforting that may seem. We are almost certain to experience many more head fakes and false dawns. Each time they occur, the prominent bulls and bears on either side will begin their victory laps once again. Ignore them.

Over time, markets will adapt to reflect the realities of AI’s economic impact. However, that adjustment probably will not happen tomorrow, and we are unlikely to predict either when it arrives or what it will look like.

The good news is that heroic bets on extraordinarily complex technological and economic developments are not a requirement for most investors. Instead, I would focus on three things:

1. Nobody has the answers on AI

In an industry that prizes loud and high-conviction opinions, it can feel as if you either have to listen to aggressive views on AI or hold one of your own. You absolutely do not. Anyone claiming certainty is either wildly overconfident, selling something, or both.

2. Don’t invest as if you have the answer

It is one thing to talk with confidence about how AI will play out; it is another to invest as if you know the outcome. Trying to position your portfolio around a single vision of the future is extraordinarily difficult and entirely unnecessary. The answer to uncertainty is diversification: building resilience to a range of possible outcomes. High-conviction, concentrated investing looks smart. Diversification is smart.

3. The market’s focus should not be your focus

The biggest behavioural risk in periods when markets become enthralled by a single theme is that we start to believe it deserves our attention too. This is a mistake. The market is focused on what is happening right now; our focus should remain on our long-term goals.

–

The impact of AI on markets, society and the economy is highly uncertain, and it is understandable that we look for clues in short-term market movements and become distracted by the hyperbolic narratives that accompany them. However, these bouts of AI hype and doom are likely to be deeply unhelpful. Not only do they contain little useful information, but they also draw our attention towards short-term noise and away from the factors that truly drive long-term investment returns.

==

–

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.

If you ever visit Stockholm, I would recommend a trip to the Vasa Museum, which is home to a grand warship that sank little more than a kilometre into its maiden voyage in August 1628. Aside from marvelling at its staggering level of preservation, the Vasa disaster is a vivid and ever-relevant example of why big decisions can go terribly wrong.

The Vasa was commissioned by King Gustav II Adolf to project military strength and royal grandeur. It was 69 metres long, with three masts and ten sails. It also carried 64 bronze cannons across two gun decks and close to 700 sculptures and ornaments. Looking at its scale and all it carried, it seems a wonder that it ever floated at all.

The design of the ship was the responsibility of Dutch master shipwright Henrik Hybertsson, but he died a year before the ship’s first voyage, which augured poorly for what was to follow.

Before departure, a test took place in which 30 men ran from one side of the deck to the other. The roll caused by this activity was so severe that the test had to be abandoned. Although Vice Admiral Klas Fleming witnessed this, he did not report it to the King, who was out of the country. According to testimony at the subsequent inquiry, Fleming exclaimed:

“If only His Majesty were at home!”

The ship set sail in front of expectant crowds on 10 August 1628. The Vasa almost immediately struggled for stability as winds gusted. Water began to enter through the open lower gunports, and the ship sank. It is estimated that around 30 people died.

There are several technical explanations for the Vasa’s sinking: its tall, heavy upper structure, the relatively small hull beneath the waterline and the open gunports. But the choice to sail despite the warning is also a failure of decision making, and one that seems eerily modern.

How does such a decision get made?

Power and incentives

Most decisions reflect the power and incentives at play. Decisions get made by those with power, based on their goals and desires, and the Vasa was no different. The King was the autocratic decision maker and he wanted a glorious and prestigious ship. Those working for him had limited power and were incentivised to please him, or at least not disappoint him.

To this day, the best way to predict what decisions will get made in almost any situation is to understand who holds the power and what they want.

The consequences of dissent

The prospect of disappointing King Gustav II Adolf seems to have carried considerable weight: even the failed test was not reported to him. We cannot know exactly how those involved weighed the consequences of calling out problems or jeopardising the project, but the personal risks of speaking up may have felt more immediate and specific than the general danger of going ahead.

There is little credit for disasters prevented

One of the inescapable challenges of raising concerns or highlighting risks that could halt a project is that, if you are successful in putting a stop to a bad idea, nobody ever sees the catastrophe your intervention prevented. There is limited credit available for stopping disasters that never transpired because you took action. In many situations there is more personal risk to speaking out than averting dire consequences.

Accountability sinks

No person or group was officially blamed for the Vasa’s sinking. The builders said they had followed the approved design, the designer was dead and blaming the King was politically unthinkable. This illustrates a type of accountability sink (no pun intended), where nobody takes responsibility or acts because nobody is clearly accountable – it is all lost in the system of control. Environments without clear accountability or agency are acutely susceptible to this problem and it remains a familiar feature of modern corporate life.

Expertise is not enough

Sweden employed expert (Dutch) shipbuilders and the level of craftsmanship on the Vasa meant that it withstood 300 years underwater largely intact – quality was not the issue. Rather the problem was one of organisation and decision making. If you place a group of competent people within an ineffective system, then you should expect the system to win.

—-

Walking around the Vasa is an incredible experience, and its conservation is remarkable. It is also remarkable that many of the decision-making problems that led to the great ship’s demise have also been well-preserved for 400 years.

---

---

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.

When people describe the reason for share price moves or shifts in bond yields, it is almost always in fundamental terms. As if every time a new piece of market-relevant information is released, investors are hurriedly updating their valuation models. This gives a pleasing sense of order to the fluctuations of financial markets, but is a poor explanation for what is really happening. Most market moves are about investors guessing what other investors are going to do.

Let’s say there is a weak employment number in the US, and the S&P 500 drops by 1%. Is that a result of investors reassessing the fair value of US equities due to an increasing risk of slower growth? Maybe. But it is more likely to be investors reacting to how they think other investors will respond to this new information.

Markets – particularly over the short term – are much like what was traditionally called a ‘Keynesian Beauty Contest’ or a guessing game where you win not by guessing the right answer, but what you think others will say the right answer is.

Does this behaviour have anything to do with changes in the fundamental worth of an asset? Yes and no. If investors are predicting how other investors will react to new fundamental information, then they indirectly care about fundamentals. However, they don’t have to. If they are just trying to predict other investors’ actions, they care about whatever signals those investors might respond to at that time. These could be relevant to the asset’s long-term value or not at all.

Also, if most people are involved in the same guessing game, then it is not necessary to predict how other investors will react to new information, but what other people in the game expect other people in the game to be doing. (It can get very circular.)

We can easily end up with a market where nobody is paying any attention to fundamentals; everyone just acts as if everyone else is.

While a lot of market activity has little to do with genuine fundamental changes in the value of an asset and even if it does it is indirect. This type of ‘guessing game’ behaviour can, however, impact fundamentals, if we bring in Soros’ concept of reflexivity.

Here significant movements in price (whatever the cause) can affect fundamentals or ‘reality’. Imagine French government bond yields are being pushed higher by investors guessing that other investors will react to a worsening fiscal situation and higher inflation. This investor-led price move can morph into a profound fundamental problem as these higher yields create higher debt service costs and increasing political pressure.

Although they can often feel entirely distinct, asset prices and fundamentals are not entirely independent of each other.

The Fundamentals Will Out

If most fluctuations in markets are not driven by investors changing their views on the fundamental value of an asset, does that mean they don’t matter? I don’t think so, they are important in a variety of different ways and over different horizons:

• To the extent that investors playing the guessing game care about fundamentals (often they don’t) then fundamentals matter even if indirectly.
  
  
• In certain situations reflexivity can take hold which means non-fundamental price moves create fundamental issues.
  
  
• In extreme situations fundamentals tend to rise to prominence  – for example, when a company is in distress its fundamental worth (or lack of worth) will matter a great deal to the price of its debt and equity.
  
  
• Over the long run, fundamentals will likely win out in defining the return of an asset. Although changes in fundamental value may tell us little about an individual short-term price move, fundamentals should be the most important element over long horizons.

When we read fundamental explanations for why markets have behaved in a certain way, it is rarely an accurate reflection of why prices have moved. Over most short horizons it is not fundamental changes in the worth of an asset that matter, but investors guessing how they think other investors will react to new information they currently deem important. At times this might be related to fundamentals, but very often it will not be.

To be successful taking these types of short-term views we need to somehow be able to predict what issues investors are currently focused on, how these issues will play out and how other investors will react to them. This is a tough ask.

For long-term investors, the fact that short-term market moves are largely the result of investors chasing each other around shouldn’t be a major concern. That is not a game we need to play. We just need to avoid being fooled into thinking that every daily or monthly price move reflects a meaningful change in an asset’s fundamental value.

---

---

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.

One of the most common views expressed in financial markets at present seems to be that bonds (particularly the government variety) are no longer an effective diversifier when held alongside equities in a multi-asset portfolio. These arguments are usually accompanied by a chart displaying rising stock and bond correlations, and perhaps some five-year performance numbers showing how poor fixed income returns have been. I think these perspectives get a lot wrong about the purpose of diversification and how bonds are behaving.

Bonds are doing bond things

If I had been told at the start of 2021 that over the coming years there would be several supply-side inflation shocks, substantial fiscal stimulus, inflation consistently above target and a material rise in interest rates – would I have been bearish on bonds? Even as someone who is reticent to make predictions, I am pretty sure I would have been – particularly starting from such unattractive valuations. The performance of bonds – and their changing relationship with equities – has been just what we would have expected given the starting conditions and subsequent environment.

It is odd that an asset class behaving in a way that is entirely consistent with its structural features is a reason to abandon it, or suggest it is not working. Bonds seem to be working just fine. Unfortunately, all asset classes are vulnerable to a particular set of circumstances, and the precise timing of those circumstances is usually well beyond our capabilities. This is why we diversify.

Starting valuations matter

The valuation of bonds matters a huge amount to their expected future returns, and it is also vital to their diversifying properties. Higher starting yields provide strong insulation from losses incurred due to rising yield levels, offer greater scope for yields to fall during downturns and provide better long-term returns in the unknowable future paths that lie ahead of us.

Valuations are not just about headline yields (inflation matters a lot too), but lots of pessimistic takes on bonds seem wilfully oblivious to the fact that higher starting real and nominal yields are a good thing for investors.

Don’t judge an asset class by its (short-term) performance

The powerful narrative around the ineffectiveness of bonds is classic investor behaviour. We take recent returns, build a story to explain them and then extrapolate. Using the same process to describe bonds as broken now would lead us to be incredibly bullish in 2020 – they had performed remarkably well in prior years and exhibited a negative correlation with equities, what was not to like? (Apart from valuations that is, but who cares about those?)

An approach to diversification that relies on the performance profile of an asset class through a particular period or ‘regime’ is inevitably deeply flawed. Diversification is about building a portfolio for a range of future paths that are at best uncertain and at worst entirely unknowable. Making allocation decisions that assume asset classes will replicate their behaviour from one specific (usually recent) instance leads us in the opposite direction of what diversification should be looking to achieve.

Is it just a macro forecast?

A key question about the pessimism surrounding bonds is whether it is driven by a belief that the merits of high quality fixed income as a strong, diversifying asset no longer exist at all, or is it simply a prediction that the future environment will continue to be difficult for bonds? These are easy to confuse but are very different stances.

The first is the ‘bonds are broken’ argument – which contends that bonds will not behave in the way they have historically. This is a bold call and one best tested by asking – how do you think bonds will perform in a growth shock / recession? If the answer is poorly, then someone genuinely believes that bonds have undergone a profound, fundamental change.

The second perspective is just a macro forecast. A belief that bonds will continue to behave like bonds, but that the backdrop will remain challenging – presumably because of growth and inflation dynamics. It is perfectly reasonable to hold this view, but also important to acknowledge how bad we are at making economic forecasts, and size any position accordingly.

—

It is easy to think of diversification as just being about combining assets to hit some risk (usually volatility) target or to smooth the path of returns over time. While these are valid reasons for why we might diversify, at its heart diversification is really about the future being incredibly uncertain. We don’t know how the years ahead will play out and our portfolio should reflect that ignorance. We want to own assets, such as bonds, that we expect to fare well (and not so well) in a range of different environments.

It is possible that the underlying features of bonds have changed significantly and they no longer offer anything valuable to a diversified investor, but it is difficult to find evidence of this. It seems far more likely that overconfident investors are making assumptions about the future of bonds based on recent performance and overly confident economic predictions.

---

---

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.

Imagine if there were some dramatic developments in the production of nuclear power that made it far easier and less costly to produce. It would provide abundant, cheap energy across the world, but with one small drawback. There was a 10% chance that at some point over the next 50 years it would kill all human life.

I think most of us would assess those trade-offs and suggest we hold off.

Yet claims of existential risks arising from progress in artificial intelligence have become part of normal public debate without provoking anything resembling the reaction we might expect. This tells us a lot about how we think about risk.

In AI safety, the risk of catastrophic outcomes has been a consistent topic – often referred to, in a wonderfully anodyne way, as P(doom) – the probability of an AI-caused existential catastrophe. Recently, Evan Hubinger, a safety researcher at Anthropic, said he believed there was a greater than 10% chance of AI killing all humans within the next decade.

Some people working at the frontier of AI believe their field could have the most disastrous consequences imaginable for humanity, yet development continues at extraordinary speed. This seems odd.

I don’t want to make this post about whether these estimates are in any way reasonable, but rather about why we are prone to underplay some risks and wildly overstate others.

From a behavioural perspective, our sense of risk is heavily influenced by how it makes us feel – the emotions it provokes and the scars it leaves. This is sometimes described as the affect heuristic. We respond strongly to risks that are salient, emotive and easy to recall, and can be remarkably complacent about those that aren’t obvious and do not stir us in any way.

While some people are unconcerned about the cataclysmic risks stemming from AI because they believe the claims are preposterous, there is another issue at work: even high probabilities can fail to elicit much of an emotional response when the risk itself feels abstract and remote.

Now think about the earlier example of nuclear power. Some opposition to nuclear power – in a world where it could help reduce climate risk – is likely shaped by the feelings provoked by the concept of nuclear. The very term brings up images of bombs, devastation and reactor meltdowns. The risk seems both high and consequential because those negative associations are so readily available to us.

By contrast, for many of us AI is benign. For the moment, at least, it can seem like little more than something that helps make our everyday lives a little easier. The most affecting negative marker related to AI might be reserved for those who have watched Terminator 2 recently.

What does this mean?

The use of bland probabilities will likely have relatively little impact on how people evaluate the risk from continued AI development. This might only change if there were a significant negative occurrence related to AI – let’s say a prolonged power outage or material data breach – that affected our lives in a meaningful way. Something like that could radically change how the risk is perceived.

How we feel about AI risk is instructive of where investors often go wrong when dealing with risk. We are constantly responding to whatever is vivid and prominent, while easily losing sight of the things that are more abstract or harder to imagine.

We focus on the things that we see, feel and remember – the pain of the last bear market, severe daily price swings, the latest geopolitical flashpoint. These events either leave deep emotional scars that stay with us or make us overreact to risk in the moment. They shape our behaviour.

Not only can this lead us to make poor choices about risks that are nowhere near as consequential as they seem, but it also means that we ignore or forget those that are not obvious.

This is why a difficult quarter in equity markets can feel far more threatening than, for example, the risk that we fail to stay invested over the long term. One of these is a material risk for investors, and the other is probably not; but our tendency is to get it the wrong way round.

We deal with risk in a very human fashion. We learn from emotive experiences and focus on what is happening right in front of our eyes. We judge risks based on how they make us feel.

—

---

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).

Amidst the “panic”, “fear” and “tumult” in government bond markets, it can be difficult to keep a cool head. Short-term trading is easily conflated with longer-term considerations, and the prevailing narratives can quickly become hyperbolic and often apocalyptic. This is deeply unhelpful for most investors – what’s the best way to navigate such situations?

In spells of real or manufactured market stress, it is far too easy to lose sight of our own investment approach and the things that we consider important. Most typically this means long-term, fundamentally-minded investors being dragged into short-term thinking. 

I have found one of the easiest ways to uncover what an investor thinks is actually important (or to get them to focus on it) is to give use the crystal ball test. Ask: if you had to predict the performance of an asset class over a period of time and could see one market or economic variable in the future to assist you, what would it be?

We can use this approach to cut through a lot of the noise engulfing government bonds at the moment by asking something like:

• If you had to predict where 10 year US Treasury yields would be in five years’ time and could use a crystal ball to see one metric in the future, what would it be?

Would it be growth, inflation, the deficit, debt to GDP, the Fed balance sheet – or something else?

This obviously has nothing to do with actually forecasting the future, but is rather a way to focus on the things that should matter to us about the asset class under scrutiny.

It can also prove insightful to invert the question and ask: if you knew X in advance, would it help you predict the performance of the asset class? This is particularly helpful during times of market stress, where investors can veer dramatically from whatever their process should be and instead become wrapped up in whatever the market is obsessing over. (The next Treasury auction is probably not as critical as we think). 

It is amazing how much time market participants spend talking about issues that probably don’t matter to them given their approach and goals, and, even if they did, they couldn’t predict how they would unfold. This problem becomes particularly acute in stressed environments. 

Fundamentally-focused investors who care about quaint things like cash flow and coupons are incredibly vulnerable to getting caught up in the activity of short-term traders, because this is what drives markets in the moment. Finding ways to draw ourselves back to our own process and principles is vital.

The other piece of information that the crystal ball test can elicit is an investor’s real time horizon. If I were asked to predict Treasury yields over one month and over five years, the variables I would want to see in advance would be very different. Factors that might matter over five years, probably won’t tell us much over the next few weeks. (I am not actually sure what I would want to see in my crystal ball if I had to make weekly predictions).

One of the best way to understand an investor’s genuine time horizon is to ask them what they would most like to know in advance, and work back from there. If they want to see the next inflation print, they are probably not a long-term investor.

—-

While we cannot predict the future or forecast asset class behaviour accurately, asking ourselves or someone else what we would do if we could peek into the future can help to get the focus back to what’s important to us and away from lure of market noise.

—

–

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).

At any given point in time, there is a risk in financial markets that is the focus of everyone’s attention. Recently this has been US Treasuries with talk of a ‘fiscal crisis’ and ‘debt sustainability’ increasingly common. This, of course, is not a new issue. In fact, it seems to rise to prominence whenever there is a gap in the schedule of ‘things to worry about’. Rather than go too far into the weeds on this topic, I would rather focus on the dangers of the language that is often used when this subject is discussed, which is often hyperbolic, ambiguous and difficult to verify.

US Treasuries are one of the largest and most important asset classes in the world. Not only are they a critical holding in most portfolios, but they are also fundamental to the functioning of financial markets and the global economy. Their fortunes matter to investors in a profound way; that means that using words like ‘crisis’ or suggesting debt is ‘unsustainable’ has consequences.

While you may truly believe that there is an impending crisis or that US debt is unsustainable, you cannot stop there. The issue is far too significant to make vague, headline-worthy statements with little substance behind them. You need to give more – such as answering these questions:

– What do you mean by a crisis – specifically – what would it look like?

– Crisis suggests something sudden – is it likely to happen soon?

– What would the implications be across financial markets?

– At what point does debt become unsustainable? Is there a threshold?

– The US cannot run out of money to pay its debt, so do you really mean an inflation problem? If so, what are you forecasting will happen to inflation?

– It sounds pretty bad if US debt is unsustainable. What should I do? Not hold bonds? Not hold equities?

– How can we test whether your views are valid?

There are some effective tactics at play when people talk about US Treasuries in a dramatic and imprecise way. Key is exploiting the fact that people’s standard mental model is to think of US government debt in the same way as a household or company – as if at some point they simply won’t have enough money to pay the next coupon.

For the avoidance of doubt, the US cannot run out of money to service its debt like a corporate (because it issues debt in its own currency) and neither will it suffer a mirror of the Eurozone debt crisis (for the same reason).

None of this means that there are not risks here. There clearly are. But if you are going to talk about fiscal sustainability, it is very important to be clear about exactly what you mean. If the issue is that sustained deficits on top of already high levels of debt, and a lack of willingness to address them, will lead to future inflationary or currency problems, then say so and invest accordingly.

In addition to the often incorrect framing of the ‘credit’ risk faced by the US, there is also a remarkable lack of verifiability to the prognostications offered. When someone talks of fiscal sustainability in the US, it is often not clear whether they think that this means that 10-year yields will move 30bps higher, or the entire market will implode. That ambiguity makes accountability difficult.

It is so easy as an investor to talk in bold terms about the fiscal risk in the US. You can take the occasional victory lap when yields rise a little, but then claim the big risk is still to come; it just hasn’t happened yet.

This is incredibly unhelpful for other investors. Not only is it likely to cause a great deal of worry, but there is no way for them to know what to do about it. They are left with the notion that there is a major risk overhanging markets with hugely uncertain impact and timing.

If your view is that deficit and debt levels mean that the term premium should increase because of greater levels of inflation uncertainty, that is a reasonable, implementable and testable investment thesis. It doesn’t need the language of crisis.

If you genuinely believe that US government debt levels are a far more serious problem, then show your working. How does this play out? And what should investors do about it and when?

Espousing views about market risks that are exaggerated, light on detail and difficult to validate is fantastic for attracting attention, but it doesn’t necessarily make for great investment insight. We should think about how we use our language, because it matters for how investors feel and act. 

—

---

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).

There was a recent article in the FT describing how retail investors in Korea had suffered huge losses after a sharp reversal in the performance of AI-favourites such as Samsung and SK Hynix. The severity of the falls led one investor to ask: “When can I get out of this hell?” That such market moves can have an impact of this magnitude is facilitated by innovations such as single stock and leveraged ETFs. This is another example of where innovation can amplify the cost of our behavioural biases.

It is irrefutable that most of us have a range of behavioural traits that are ill-suited to making sensible investment decisions. We want to make money quickly, we naively extrapolate recent trends, we chase performance, we are overconfident in our own abilities, and we ignore risks that are not obvious to us. The critical question is not whether we are susceptible to such destructive tendencies, but rather how easy it is for us to act upon them.

From the perspective of behavioural mistakes, we should care about two aspects: their frequency and their magnitude. The cost of poor investor behaviour is dictated by how often we might make errors and the impact of those errors.

In a world where technology has made trading easy and frictionless, and activity is vigorously encouraged, we should expect the frequency of behavioural mistakes to increase. This is a problem inevitably exacerbated by the sheer amount of financial market noise we are exposed to.

It is not, however, simply the ease with which we can make imprudent choices; it is how consequential they are when they occur.

As well-demonstrated by recent events in Korea, the ability of investors to risk catastrophic losses – through leveraged vehicles, options or even highly concentrated funds – has never been greater.

Innovation has seemingly created an environment where investors will inevitably make more rash decisions and be more vulnerable to disastrous, irrecoverable outcomes from those choices.

It is possible to frame this situation as a case of technological progress in the investment industry inadvertently promoting poor and consequential investor behaviour. This is often not the case. Rather, the purpose of much innovation is explicitly to benefit from clients’ behavioural biases – they are known and exploitable. Typically, retail investors bear the cost, while other parties benefit.

For any type of investment innovation, there are three questions that need to be asked:

1. Why does an investor need it? (There is a big difference here between need and want; just because you can sell it doesn’t mean you should)
   
2. What behaviours does it encourage?
   
3. Who stands to benefit from it?

If the innovation is not encouraging better investor outcomes, net of the behavioural impact, what purpose does it serve?

---

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).

For a multi-asset investor, being underweight equities is a notoriously painful position. They are typically the highest-returning asset available, and reducing your exposure can hurt both in the short and long run. Does this mean you should always avoid doing so?

Not necessarily, but your answer to this question probably says a lot about your investment approach.

Let’s create a simple example to test this. Assume you have a two-asset portfolio with a 20-year time horizon, a growth objective and a balanced risk profile. You can choose between US equities or medium-maturity US inflation-linked bonds, with a starting 60%/40% split.

Is there a level of relative valuation where you would consider moving money from equities and into linkers?

(The focus here is on valuation rather than any macro or tactical reasons for shifting allocations).

I would imagine that a common answer to this question would be “no” – if you have a growth objective then underweighting equities almost never makes sense. But is that really true? What if real yields on the bonds reached 5%, and based on even optimistic assumptions US equities looked priced to deliver 2–3% ahead of inflation?

Constraints on Behaviour

I think the answer to this depends heavily on what type of portfolio you are managing, and what the objectives and constraints are. There are several important considerations:

Do you have a benchmark objective or a return objective?

A traditional benchmark-based objective (let’s say 60% equities and 40% bonds in this instance) makes moving underweight at any time incredibly difficult. Owning less of your highest-returning asset, even if it is expensive, is likely to prove detrimental over the long term. We also know that, over the short run, valuation differentials do not matter much at all, and equities can perform well in any given quarter, irrespective of how they are priced.

Alternatively, if you have a return-focused objective (cash+ or inflation+), the decision-making focus can be more on hitting that target, and the discomfort of holding reduced equity exposure is far less acute. It does not matter so much if equities perform very well and you are underweight, provided you are still achieving your primary goal.

In this way, portfolios with very similar implicit objectives (long-term growth) can behave very differently based on how they are assessed.

Are you focused on delivering growth or meeting liabilities?

If your aim is to deliver long-term growth, then being underweight the asset most likely to provide that may not prove to be a wise move. If, however, you are looking to meet a set of liabilities and can do so with less risk and greater certainty, then moving away from equities when opportunities arise may be prudent.

What are your risk constraints?

One slightly odd constraint might arise if a portfolio is designed to deliver a certain “risk outcome”, usually defined in terms of volatility (a useful but deeply flawed measure). Even if you felt returns from a typically lower-risk asset (bonds) were likely to be higher than equities, it might be difficult to move assets without appearing to take less risk than you are mandated to. (Cue the debate about what risk actually is.)

The point here is not that our constraints entirely determine the approach you might take to allocating away from equities – there are plenty of other factors that should influence your decision – but that they can be influential.

Valuation Mistakes

Away from these constraints there are two other issues – often misunderstood – about equity valuations and asset-allocation decisions that are critical.

Being expensive is not a strong enough reason to underweight equities.

It seems obvious that if equities are expensive and are set to produce lower returns, then being underweight makes sense, but this is not necessarily the case. To justify an underweight on valuation grounds, you need to believe that equities are so expensive that their prospective return is lower than that of competing assets.

Imagine you believe that when equities are fairly valued they are priced to deliver a real return of 5% per annum, but extreme valuations mean that they are now priced at 3% real. Even if you are right about the lower return, you will still underperform if that 3% is higher than the return available from other asset classes.

Where benchmark-relative returns matter, equities have to be priced to deliver returns lower than the replacement asset – not merely be “expensive”- for an underweight based on valuation grounds to work from a performance perspective.

Valuations are largely irrelevant over the short-run, and their impact also wanes over the very long-run.

The general view is that valuations are close to meaningless over the short term and meaningful over the long term. This is only partially true. I would frame it like this:

Short term: Low. Overwhelmed by sentiment and noise.

Medium term (5–15 years): High. Strong influence from starting yield and potential reversion.

Long term (15+ years): Moderate. Positive influence from starting yield, but mean reversion becomes is likely to be overwhelmed by years of compounding earnings growth.

Whereas over the medium term there is the potential twin benefit of valuation mean reversion and an improved starting yield, when the horizon gets very long the impact of valuation mean reversion (if it happens) is likely to become insignificant relative to the contribution from earnings growth.

In fact, if you are a very long-term equity investor and have identified a cheaper, higher-return market, then you do not actually want valuation mean reversion to happen – or at least you want it to happen as late in your holding period as possible.

Why?

Because if you are investing for 20 years and your preferred market has a starting earnings yield of 7% compared with 5% for the alternative, you want to keep reinvesting into that higher earnings yield for many years. If it reverts to 5% immediately, you receive a one-time performance benefit, but that is likely to be marginal compared with the benefit of the higher yield persisting.

(This assumes the 7% is a genuine anomaly rather than fair compensation for lower growth or higher risk. A persistent, uncompensated gap of that kind should be the exception rather than the rule.)

This gets to the heart of the argument as to why, if you have a very long-run horizon, diversified equity exposure will generally be fine even if starting valuations are rich.

Of course, there are exceptions. In the Japanese equity bubble of the 1980s and 1990s, valuations became so extreme and earnings so cyclically elevated, that the earnings growth needed to outrun the correction was far too high. It took decades to right itself. This was, however, an exceptional period.

The sweet spot for a valuation impact is the medium-term, 5–15-year horizon, which should influence any decisions around how valuations might affect your equity allocations, and any decision to move underweight.

–

The question posed in this piece is a complex and difficult one for multi-asset investors, and one inevitably shaped by the experience of a prolonged and pronounced bull market in equities. How you answer it almost certainly says a great deal about your approach to investing and the environment in which you operate.

—

---

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).

If you had immediately paused the game after England had taken the lead in the 55th minute of their World Cup Semi-Final match against Argentina, and asked the Argentine players and coaches how they would like their opposition to play for the remainder of the match, they would have probably said something like this:

• Give up on offering any attacking threat.
• Have no desire to keep possession.
• Defend incredibly deep and narrow.
• Allow Messi to operate unencumbered on the right, and Fernandez on the edge of the penalty area.

Conveniently, for Argentina, this is exactly what England decided to do, with inevitable consequences.

Why would a high-quality, talented team with a lauded coach opt to play in the exact fashion that suited their opponents, at the worst possible time?

Plenty has been said and written about this, and will continue to be so. I wanted to take a slightly different angle and focus on the psychological drivers. What would make a group behave in this way, when they are on top in a match and on the cusp of a long-awaited World Cup Final appearance?

There were two recognisable behaviours at play – outcome bias and loss aversion.

Outcome bias is our propensity to judge the quality of a process or decision by the results it delivers. If the outcomes are positive, so must have been the reasoning behind it.

England’s decision to play ultra-defensively when taking the lead against Argentina was no doubt driven by the view that it had worked well previously in the tournament – particularly against Mexico – so it made sense to repeat the trick.

There are two major problems with outcome bias, however. The first is the role of luck: sometimes our results are good even when the decisions that led to them were terrible – we were just on the right side of chance. The second is context – just because the outcome was good in one context, it doesn’t mean the same approach will prove a success when the environment is different.

In England’s case, both elements were at play. They were undoubtedly a little fortunate to hang on against Mexico, but crucially the context was entirely different. Against Mexico they were playing with ten men against a solid but limited team. They suffered no such numeric disadvantage against Argentina, and the current World Cup holders have a far greater attacking threat.

If England were going to judge the likelihood of adopting an extremely cautious approach, they would have perhaps been better off looking at their experience in recent major tournament semi-finals and finals, rather than matches in this World Cup alone.*

The other evident psychological phenomenon was loss aversion. We feel the pain of loss far more acutely than the pleasure of equivalent gains, which can have a profound impact on our behaviour. As soon as England took the lead, they went from a team trying to win something to a team aiming not to lose what they had. This was signalled clearly to the players by coach Thomas Tuchel’s defensive substitutions, which seemed to scream at his charges: “whatever you do, do not throw this away”.

When we view something as a potential loss, it can cause fear and anxiety – our responses become emotional rather than thoughtful. It is clearly possible to play in a conservative fashion in an intelligent and considered way, but this is not what England did. Instead, they defended like a junior football team tasked with maintaining a lead – put lots of defenders on the pitch, sit as close to your own goal as possible and boot the ball away when the chance arises.

The lack of evident thought about how to manage a game or hold a lead suggests that choices were driven by an emotional fear of loss, compounded by coaching decisions.

There were many factors that led to England’s depressingly predictable exit, but falling victim to some powerful behavioural biases and being unable to make clear-headed decisions certainly contributed.

—

* Outcome bias also means that if England’s approach against Argentina had worked out, it would have been regarded as a tactical masterclass.

—

===

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 a question for you. If you take all of the hearts from a standard deck of 52 playing cards, and then lay them out one by one, in how many different orders can the 13 cards be dealt?

For example:

J, 7, 5, A, 9, K, 3, 10, 6, 2, Q, 8, 4.

K, 4, 2, 9, Q, 6, A, 8, J, 3, 10, 5, 7.

The answer is…

6,227,020,800. That is over 6 billion different permutations of the 13 cards.

If you did the same with the full deck, the number of possible arrangements is so large that it is not worth even trying to write it down. It is not a number you would ever encounter in daily life. When you shuffle a deck of playing cards and deal them out, it is overwhelmingly likely that the order you reveal has never been seen before and never will be again.*

Trying to predict how the cards will land is as close to impossible as you might wish to get, but it is much easier than making accurate short-term financial market predictions.

Dealing out playing cards has a number of useful features from a prediction perspective:

• The number of cards is fixed.

• The rules of the game are stable and simple.

• You know all possible outcomes.

• When you draw one card, it has a known impact on the next step.

It is a stable, closed and well-ordered system. Financial markets are nothing like this. When investors are trying to forecast how the equity market might perform over the next year, or how a certain geopolitical issue will unfold, they are faced with a complex, chaotic and changeable environment.

It has all the features of a system where accurate predictions are not possible:

• It has an unfathomable number of inputs.

• There is significant path dependency, where each step profoundly influences what occurs next.

• The environment is adaptive – meaning the variables in the system react to what is happening.

• It is impossible to even comprehend the range of potential outcomes.

Despite this, a huge amount of time is spent espousing views and making investment decisions based on precise forecasts of an inherently unknowable future. Even in a very simple system, once the number of steps reaches even a modest level, the chances of making accurate predictions evaporate. Financial markets are anything but simple.

—

* I came across this idea in the excellent More or Less podcast, which you should absolutely be listening to if you enjoy numbers and statistics.

–

–

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).

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).