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

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

An Unusual Environment for Cautious Funds

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

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

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

A Valuation Windfall

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

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

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

If Not Long Duration Bonds, Then What?

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

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

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

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

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

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

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

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

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

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

Deteriorating Performance and Improving Valuations

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

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

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

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

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

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

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

Investment Bubbles and Frauds Have a Lot in Common

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

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

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

Let’s take each element in turn:

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

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

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

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

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

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

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

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

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

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

For investors this is the worst of all worlds.

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

The Power of Not Having a View

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

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

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

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

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

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

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

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

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

When Should Investors Take a View?

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

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

Let’s take an example.

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

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

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

Wilful Ignorance

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

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

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

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

ESG Investing is About Values, Value and Valuation

It has been a bruising spell for ESG investing. Not only has the war in Ukraine brought into sharp contrast some of the potential trade-offs involved (fairly and unfairly), but it has faced numerous stinging criticisms. Tariq Fancy – formerly CIO of Sustainable Investing at BlackRock – labelled it a ‘dangerous placebo’, Stuart Kirk made his now infamous ‘Miami underwater’ speech and Aswath Damodaran – probably the pre-eminent scholar of business valuation – suggested people working in ESG were either ‘useful idiots’ or ‘feckless knaves’. As is symptomatic of the world today, ESG investing has become another polarised debate. It is either unimpeachable and essential, or little more than an asset management confidence trick. This lack of nuance is incredibly unhelpful and makes a complex topic even more problematic. How can investors successfully navigate these issues?

Why Has Criticism of ESG Investing Increased?

There are two central factors that have driven the increasing level of criticism faced by ESG investing. First is some of the unsubstantiated claims that arose from the asset management industry. When companies in the ESG sweet spot were enjoying prodigious performance tailwinds, it was easy to make naïve yet compelling assertions about how we can ‘do good’ and outperform. This was a potent marketing cocktail – not backed by robust evidence – that created entirely fanciful expectations. It was just a matter of time before the backlash arrived.

The second catalyst was the pronounced style rotation in markets, which has seen high-growth companies (including many ESG darlings) fall back down to earth, whilst much-maligned resource stocks have surged. In financial markets it is performance that creates narratives (not the other way round). When something is underperforming it becomes open season for disapproval.

And much of the opprobrium has been warranted. Greenwashing is rife, trades-offs and difficult questions about fiduciary duty are roundly ignored and the industry is in danger of measuring everything and achieving nothing. Yet valid criticisms do not render the entire endeavour meaningless or defunct. It just means we need to step back from the noise and think clearly about what ESG investing is and why it matters.

How Should We Think about ESG Investing?

One of the central problems with ESG investing is its sheer complexity. Investors of all guises are inevitably discombobulated by a seemingly endless array of measures, metrics, initiatives, regulations, acronyms, initiatives, bodies, reporting requirements, pathways, targets and even genuine issues.  Amidst all this, it is easy to lose sight of its underlying purpose.

At its core, ESG investing is about three elements – values, value and valuations. Any ESG-based decision we make should consider these aspects:

Values: These are issues that we care about. What matters to us outside of pure financial considerations?

Value: These are factors that we believe impact the worth of a company. Do they create or destroy long-term business value? *

Valuation: This is how an ESG related factor or business is priced. Is it expensive or cheap?

With any ESG based judgment or decision, an investor should be asking – is this about values, value or valuation?

Let’s take each element in turn:


Values are the ESG-related choices that we make because of our beliefs on the issues or subjects we care about. The most obvious example of a values-based ESG decision is a portfolio exclusion. For example, we decide that we do not wish to invest in tobacco stocks because of the harmful and addictive nature of the product.

The flip side of exclusions is investing in thematic ‘impact’ strategies – here we might wish to invest in companies that are engaged in activities that we believe are positive for society or the environment. Investing in such a way makes us feel good or at least better.

The distinguishing feature of a values-based choice is that we are agnostic about the return effect of such decisions. We are willing to accept a financial cost. Green bonds are a good example of where there is some evidence of investors accepting inferior returns (in the form of a lower spread / yield) to ‘directly’ fund certain types of activity with an expected positive environmental impact. Investing due to our personal values will not always result in a loss but we have to accept the possibility that it might.

The problems arise when investors are unclear about what is driving a decision. Most investors in heavily thematically tilted sustainable or ESG funds are not doing so under the apprehension that performance will be poor (despite the historic evidence of thematic fund performance). Asset managers also frequently muddy the water by applying minor exclusions at the margins of a fund (such as controversial weapons), but without being transparent about whether this is an investment view or values-based choice.

This is a messy and highly subjective area. Not only because of the personal and somewhat opaque nature of values, but also the different ways we might be willing to express them. Two investors with a similar set of values might behave in an entirely different way – one might exclude a certain industry; another might believe that engagement is a far more effective approach.

There are few right answers when it comes to values, but if we are making a values-based decision it is critical that we admit we are doing so and understand the potential implications.

The question that investors need to ask to ascertain whether an ESG-related decision is values based is – am I willing to accept a financial cost to make a decision that is consistent with my values?

If the answer is no, then we need to provide a coherent, evidence-based explanation as to why the decision is instead about value or valuation.


Value is about the ESG issues that impact the value of a business. These will be specific to companies and industries, and should be considered alongside other relevant factors that impact the long-term worth of a business.**

The crucial point here – as Alex Edmans’ highlights in his excellent recent paper – is that if there are ESG issues that are vital to the value of a company then it should be a focus of all investors, not simply those running ESG or sustainability orientated strategies.[i] ESG factors and risks that are central to a business and will impact shareholder returns should be considered alongside a host of other aspects. The job of any fund manager or analyst is to understand the factors within a business that are likely to create or impair long-term shareholder value.

The logical extension to this idea is that there is no need for sustainable or ESG-orientated funds because all competent investors should be doing it anyway. There is some truth to this, and this is hopefully the direction in which the industry moves. There are, however, two caveats:

First, ESG funds may cater to certain investor values (as previously covered), but if this is the case then we should be willing to incur a potential cost. Second, ESG funds are likely to believe that these issues are more material than others and therefore weight them more highly in their analysis of a company’s worth. In such a scenario we need to be transparent that this is a stark investment view that will have meaningful implications – we are stating that most mainstream funds are neglecting the importance of ESG factors and underweighting them in their investment decisions. There is nothing wrong with holding this perspective – although it would be helpful to understand the evidence supporting it – but we need to be clear that it is a position that will have performance implications.

Even if we correctly identify the ESG issues that are relevant to a company and can assess their materiality, there is one other aspect to consider – valuation.


Identifying the long-term drivers of value within a business is imperative for making sound investment decisions, but we cannot ignore how that business is priced. What we pay for a security or asset matters greatly to the returns that we receive.

Let’s assume we have identified an ESG factor that has a material impact on the creation of shareholder value and a company that scores particularly well on this metric (amongst many other non-ESG characteristics). Is it a good investment? It depends on the price. Positive ESG or non-ESG characteristics do not result in good investment outcomes if they are more than reflected in the price that we must pay for it. ***

There will almost inevitably be times when stocks with a particular set of ESG credentials become very expensive. What do we do in that situation? 1) Hold them for so long that the price paid pales into insignificance relative to cash flows and growth (few people have a time horizon of this length). 2) Become a values-based investor and say that we are willing to endure a lower return because of the positive ESG traits. 3) Not hold the companies because they are not attractively or even fairly priced. The third option seems the obvious one but becomes problematic if we had made commitments about the ESG metrics of our fund, which limits our flexibility. If we hold expensive assets to maintain some score or meet an ESG threshold – we become implicit values-based investors.

In the future we may see strategies that are explicitly willing to sacrifice potential returns by investing in companies with positive ESG characteristics irrespective of the price. But for most existing funds this creates question marks around fiduciary duty – this is a discussion that not many people want to have but will have to happen at some juncture.

For any ESG orientated investment decision we should be able to ask whether it is driven by values or value.  If the latter, there should be a significant evidence base supporting why it impacts the long-term value of the business. We can then consider how that company is priced relative to those attributes and all the many other facets that feed into an assessment of its valuation.

What about externalities?

If we think about ESG investing through a values, value and valuation lens, where does that leave negative externalities? Where and how do we incorporate a cost created by a company that is not fully borne by them? Let’s take an example.

Imagine there is a large social media company that we believe creates a profound societal cost due to its negative impact on the mental health of teenagers. How do we integrate that into a values, value and valuation framework?

If we believe that costs of this are not currently incurred by the company but may be in the future, we can absorb this into our valuation. Even though it is currently an externality we can price for its future internalisation. It is in such situations that engagement is likely to prove particularly powerful and can combine values and value effectively. (I care about the issue deeply and think the company value will increase if it alters its behaviour).

If we believe that either costs are unlikely to ever be fairly levied on the company, or that we simply find the activity of the company unpalatable then our decision (perhaps to exclude the company from our portfolio) will be a values-based choice.

The major difficulty with externalities is when we think from a portfolio perspective rather than how they impact an individual business. We may suffer the cost of the negative externalities of a company we hold because it has broader consequences on, for example, economic growth or asset class performance. A polluting company we own may benefit financially (particularly in the near term) from avoiding the full internalisation of external costs, but it could still be to the detriment of our overall, long-run returns (amongst other things).

If we make decisions based on the potential ‘universal’ impact on our investment returns it can still be considered value-led, just through a different lens. The critical aspect is to be open about how we arrive at such judgements.    

Trying to simplify how we think about ESG by using a values, value and valuation framework doesn’t make a complex and subjective area easy. Being clear about the drivers of our ESG-influenced decisions will, however, help in both setting realistic expectations and allow for reasoned debate about the quality of our choices.   


* This could also apply at a portfolio or market level.

** This is obviously messier and more complicated than it sounds. There will be (many) scenarios where company executives are incentivised based on short-term profitability / share price performance and rational behaviour for them may be to maximise this, perhaps at the expense of long-term shareholder value. Engagement should play a crucial role in such situations.

*** The reverse of this situation is a company that scores poorly on the ESG metrics that are relevant to it but is incredibly cheap. Here we can decide not to invest (which becomes a values-based decision) or look to invest and engage.

[i] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4221990

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

The Survival Game

Imagine a young active fund manager is presented with a choice; over a twenty-year investing career the fund they manage can take one of two paths. In path A it delivers annualised outperformance of 3%, but it is a bumpy ride – there will be numerous years of sustained and substantial underperformance. In path B their fund underperforms the market by only 0.3% a year, but it is a far smoother journey – in some years returns are a little better than the benchmark, in some slightly worse, but never too far away. Which path would they choose?

For a client investing with the fund manager the choice seems relatively straightforward – path A leaves them with substantially more wealth and justifies their use of an active fund. Yet for the fund manager it is not an obvious decision at all, in fact it is probably rational for them to choose path B, even though it would leave their clients worse off over the long run. Why? Because in path A there is a high probability that they will be fired and never be able to deliver the long-run results promised; contrastingly, path B is more likely to lead to a lucrative career.

There is a major incentive problem at the heart of the asset management industry, where the interests of clients and the professional investors who run money for them are often poorly aligned.

The key to a ‘successful’ career as a fund manager is not long-term outperformance, it is survival. Making sure from quarter to quarter that your results are adequate so that you don’t find yourself in the firing line. If you can survive long enough then you might get promoted to head of team or another executive role, so you are no longer even directly responsible for investment decisions. The most lucrative choices you can make are those that help you to stay in the game.

The power of the incentive to keep your job and progress your career increases through time. As you earn more money, you adapt your lifestyle, take on a bigger mortgage and send your children to private school. This means the risk of short-term failure becomes even more acute.

The development of this type of incentive structure means that the active fund management industry has evolved to a point where making high conviction, long-term decisions is irrational behaviour for many participants. Even though it should be one of its primary purposes.  

This is not the fault of fund managers. The entire industry is complicit in the game of enabling their own short-term survival. Asset management companies trying to meet quarterly inflow targets, board and committee members worried about the reputational impact of something going wrong, consultants concerned about losing disgruntled clients. Even regulators are now enforcing judgements on “value” based on performance time horizons over which every strategy (no matter how capable) will fail at some juncture. Nobody is incentivised to make long-term investment decisions because doing so exposes you to profound personal and corporate risks. 

Most people are left spending their time engaging with largely meaningless short-term market noise and ensuring that they are safely ensconced within the pack.

What does this cultural backdrop mean for the structure of the active asset management industry? We are left with an unnecessarily large and amorphous blob of uninspiring funds stuck in the middle and doing enough to survive. Strategies taking higher conviction, longer-term decisions frequently succumb to the endemic short-termism that defines the industry (irrespective of whether they are skillful or lucky).

For the active management sector to successfully evolve not only does it have to become smaller and cheaper, but it must ensure that it creates an incentive structure and clear purpose that is properly aligned with the long-term interests of its clients.

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

The Behavioural Lessons of Gilt Market Turmoil

Much of the focus on the dramatic and unprecedented sell-off in gilt markets this week has been centred on the technical factors that led to an intervention from the Bank of England, potentially worth £65bn. Whilst the tribulations of the Liability Driven Investment strategies used by pension schemes are both fascinating and concerning, these periods of extreme stress are not just about the technicalities – they also provide acute behavioural lessons:

Small sparks can lead to great damage in complex systems:

The catalyst for the dramatic rise in gilt yields was the new leadership’s ‘mini-budget’. Which precise part of Kwarteng’s proposal led investors in UK assets to panic? The removal of the highest rate of tax, the unfunded nature of the proposals or the lack of independent oversight from the Office for Budgetary Responsibility? Everything and nothing. It doesn’t matter. In deeply complex, interconnected systems small sparks can precipitate dramatic and destructive feedback loops.

Markets are about the behaviour of other investors:

Financial markets are about the decisions made by other people. Most investors do not assess new information about an asset based on how it impacts its cash flows and valuation, but how we believe other investors will respond to that same information. This creates vicious and virtuous circles. In periods of severe turbulence this feature of markets is taken to the extreme. Our decisions become driven by the fear and cost of being the wrong side of momentum shifts. We want to be in the herd during the stampede, not underneath it.

Predicting when things will happen is close to impossible:

The fact that complex systems can be compromised by small events doesn’t simply make them riskier than we might normally perceive. It makes them even more difficult to forecast than we realise. Even if a system has inherent fragilities, anticipating when these will be exposed (if ever) is an incredibly difficult, perhaps impossible, task. Investors should never try to predict when things will happen.

Both financial and mental models can break under stress:

It is inevitable that the scale and speed of the rise in gilt yields would have torn asunder many ‘worst case’ assumptions that have been made in financial models. Whether it be the stress tests or scenarios used to judge the appropriate collateral buffers in an LDI strategy or the predicted drawdown in cautious (but duration heavy) portfolios, some models will have been found wanting. This is to be expected – models are an abstraction, a simplified version of something too chaotic to replicate. Not only that, but the output of financial models is inexorably shaped by what has happened before. In a complex system, things tend to break in the future in a different way to how they broke in the past.

It is not just the limitations of financial models that leave us vulnerable, but the mental models that investors use. Inescapably, the mental models we apply to inform our investment decision making are framed by what we have experienced. For most that means years of tranquil market conditions, moribund inflation, and interest rates at close to zero. When the environment shifts it can leave us incredibly exposed.  

Short-term performance chasing sows the seeds of future pain:

One of the major casualties of the remarkable increase in yields has been defensive or cautious funds, some of which are nursing losses of more than 20% across the year. Many of these strategies have used a heavy allocation to long duration bonds to provide a ‘low volatility’ return stream and diversification alongside the growth assets held in a portfolio.

It is easy to now be critical of the unappealing ‘return free risk’ of owning long duration bonds with very low return prospects, but it is important to remember the context. Holding such assets had worked well for years (decades). Investors who came to find the combination of close to zero returns and (potentially) severe volatility unappealing likely found themselves underperforming their peers and benchmark. The more pressure investors feel about poor short-term performance – ‘being underweight duration led to underperformance again this quarter’ – the greater the temptation is to fold. Unfortunately, there is often a choice between keeping to our long-term investment principles or keeping our job and assets. We cannot always do both.

Market shocks leave scars:

The type of market shock we have witnessed in the past week will undoubtedly leave scars. Not simply in terms of unrealised and realised losses, but future behaviour. What will the consequences be? Changes to collateral buffer requirements for LDI strategies seems obvious (we have a new scenario to use in the risk model). What about cautious and defensive portfolios – are long duration assets now less palatable? (Ironically, they are far more attractive now than they have been in recent years). Will it now be more acceptable to hold high cash levels in a portfolio? The trend towards global bond and equity exposure at the expense of a domestic (UK) bias will almost certainly gain even further momentum.

The memories and consequences of stressful events unavoidably shape our future behaviour. Some changes will be an irrational reaction to an idiosyncratic occurrence, others might be more sensible. Some behaviour shifts will fade, others will prove long lasting.  

Our model for how things work has changed, and it will change again.

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

Something Has to Hurt

In his new book on decision making, Ed Smith, who was responsible for the selection of the England Men’s cricket team between 2018 and 2021, discusses the challenges of innovative thinking.[i] He quotes poker player Caspar Berry:

“Whenever someone innovates in business or in life, they almost inevitably do so by accepting a negative metric that other people are unwilling to accept”.

Smith cites the dramatic increase in the number of 3-point shot attempts in the NBA in recent years – a revolution led by the then Houston Rockets General Manager Daryl Morey – as an example of pre-existing norms being broken because of a willingness to accept a negative metric (the increased failure rate when attempting the higher value shot).

It is not just in sport where this concept prevails. It matters for investors too. Whenever we attempt to make decisions with the aim of improving returns, we must also be willing to experience unpalatable negative metrics.

The simplest investing analogy that encapsulates the requirement to accept a negative metric is in active investing. Growth investors deviate from their benchmark because they have willingness to accept higher valuations; whilst (traditional) value investors may suffer from a portfolio with lower sales growth, weaker profitability, and potentially higher levels of debt.

Yet these simple figures miss the point. The critical aspect of a readiness to assume a negative metric is not the number itself, but the experience and consequences of deviating from what is expected. The cost to Daryl Morey of his team’s increasing propensity to take 3-point shots was not the lower successful shot percentage. It was the reputational risk, the anxiety of being the outlier, the threat of failure – all the stresses and pressures that come from diverging from the norm.

We can observe these trade-offs right across the investment landscape. Let’s take the equity risk premium, one compelling explanation for the long-run return advantage to equities is myopic loss aversion – higher returns are the compensation required for the pain of short-term losses. If we want to enjoy the benefits of long-term equity investing, we need to accept the behavioural pain and embrace the negative metrics.

On a more granular level, this is exactly the situation faced by active investors. Prolonged bouts of underperformance are inevitable – even if we happen to possess the ability to deliver long-run outperformance. It is pointless even having conversations about investor skill if we do not have the appetite or wherewithal to withstand the uncomfortable behavioural realities of active investing.

To make matters worse, negative metrics are not something that only appear on the road to success, it is also a feature of the path to failure. When we diverge from the crowd or consensus, we might accept negative metrics and still be wrong.

The most damaging situation for investors is where we take decisions with the intention of enhancing our performance, but don’t acknowledge or accept the negative aspects that we will have to endure to achieve it. If we invest in equities but don’t understand that gut wrenching bear markets are the price of admission, we will sell at the most inopportune time. If we invest in active funds and expect consistent outperformance over months, quarters and years we will pay the exorbitant tax of incessantly switching from near-term losers to yesterday’s winners.

Any investment decision comes with pain points and costs, failing to recognise and accept these will lead to consistently poor decisions.

[i] Smith Ed (2022). Making Decisions: Putting the human back in the machine. William Collins

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

Learning to Be a Good Investor is Hard

Learning the skills required to become a good investor should be easy. There is plenty of information, decades of evidence and many willing teachers. Despite this it is anything but – we only need to look at the consistent and costly mistakes that we all make to acknowledge how tough it is. But what makes it quite so difficult? Terrible feedback loops. Effective feedback is critical to good learning, but in investing these feedback loops are as unhelpful as they could possibly be. Long, noisy and erratic.

The first time we put our hand on a hot stove, we quickly learn that it is a bad idea. Why is this? Because the feedback loop is short and direct. The immediate heat and pain provide an incredibly salient lesson in what not to do in the future. Unfortunately, not all feedback loops are this efficient.

If we break down the critical features of a useful learning feedback loop, we can see why investing is so problematic:

FeedbackEasier LearningHarder Learning

Response: Rapid responses are vital in being able to understand immediately what a sensible course of action looks like. If we only felt pain in our hand two years after we put it on the stove, then the lesson really isn’t that valuable. If we want to make good decisions in the future, we need to receive good quality feedback as quickly as possible.

This is a real problem for investing. A long-term approach is critical for most successful investors, but – by definition – we only reap the rewards of this over time. We don’t get helpful instant feedback. We must wait and trust that we will get the right outcomes from the choices we make.

Results: Feedback is most useful when the link between our actions and results is clear. We have no doubt that the consequence of touching the stove is the burn on our hand. Things become much trickier when there is blurring between our choices and their outcomes.

Measured, sensible and evidence-backed investment decisions will often appear the opposite. They will frequently be outshone by investors engaging in ill-informed, wild speculation. This is particularly problematic over short time horizons, where meaningless noise dominates outcomes.

Imagine we are taking an exam. We know that nobody else in our class has studied, they barely even turned up to lessons. We have worked diligently and prepared to the best of our abilities. When the results come out, however, we find out that we are bottom of the class. We inevitably question why we bothered to work so hard and wonder whether we should follow the more relaxed approach of our classmates.

This is the situation faced by an investor trying to learn the craft. Good decisions will often receive feedback (in terms of short-term performance) that looks poor. So how can we be confident that we are doing the right thing?

Impact: Learning from short feedback loops only works if the impact from negative feedback is minor. Discovering that jumping from a tall building is a bad idea is excellent feedback, but the consequence is so severe that it is not that useful in the future.

Investors might receive valuable feedback on the dangers of concentration, the risk of leverage or the warning signs of investment fraud. These lessons are not so valuable if they come only after catastrophic losses.

The learning feedback loop for investment decisions is long, wildly erratic, and often too consequential.

How Do Investors Learn?

Investors learn in two ways. From our own experience and from the experience of others. It is often assumed that the most valuable form of learning is personal experience and whilst there is some truth to this – I have certainly learnt a great deal from my investing mistakes – it is not entirely accurate.

Our own personal sample size is simply too small. We will only have a narrow and particular set of experiences – and that just isn’t enough. It is far too easy to learn the wrong lessons. Imagine we are fortunate enough to begin investing in the early days of an investment bubble. We might go through years of learning about how valuations don’t matter, stories are everything and prices only go up. That is what our feedback has told us.

So, we must rely on others to learn how to make good investment decisions. Whilst this is better – it gives us a far more robust body of evidence – it is still challenging. Now we have so many samples to choose from we are easily confused – who and what should we pay attention to?

How to Learn Without Good Feedback Loops

Noisy and long feedback loops makes learning to make good investment decisions incredibly difficult. It means there will be times when we are likely to doubt even the most unimpeachable principles – such as the prudence of diversification. There are, however, several steps we can take to help address the problem:

Ignore near term feedback as much as possible: Unless we are short-term trading (good luck), then we need to ignore the random fluctuations of markets – even if there is a compelling story attached. It rarely tells us anything useful.

Decide what type of feedback is useful: Although disregarding short-term performance is vital for most investors, it is not reasonable to wait 40 years to judge whether you have made a sound decision. Instead, we need to consider what type of information would be helpful in assessing the quality of the decisions we have taken. For example, if the performance of our investments is wildly more volatile than we were expecting – this is probably helpful feedback. We should set some reasonable expectations to compare our results against.

Understand that our own experience is a very small and biased sample: We can learn from it, but it can also be deeply misleading.

Learn the right things from the right people: Learning from the experience of others is essential for investors, but it also leaves us vulnerable. From day traders posting their successes on Twitter to an outright snake oil salesman selling get rich quick trading schemes (to make themselves rich), there are more bad lessons out there for us than good ones – and, to make matters worse, the bad ones are more exciting.  Unlike school, in investing the best lessons are the boring ones. We should learn from those who have the right alignment of interests, similar objectives and plenty of experience.

Weigh evidence correctly: Not all evidence is created equal. The vast amount of information and noise around financial markets means that good learning involves being able to filter evidence that is robust (broad, long-time horizons, sound principles) from that which is flimsy (narrow, transitory and biased).

Focus on general principles rather than specific stories: Understanding principles that are likely to hold through time (the importance of valuation, the power of compounding or the benefits of diversification) is likely to be far more worthwhile than learning specific ideas about markets, assets or trading techniques, which will often prove fleeting. These principles can become models that we can apply across all types of investment decisions.

The feedback problem makes learning to become a good investor incredibly difficult, at times it can feel like learning to play the piano but where each time we hit the correct key the wrong note sounds. It is easy to become disenchanted.

Any useful feedback we receive will often be too late, either because something has gone badly wrong or because meaningful results only emerge over time. There is no easy solution to this. Investing is an exercise in dealing with short-term noise, deep uncertainty and profound behavioural challenges.  The best we can do is base our decisions on sound principles, always be willing to learn and understand that most short-term feedback can be happily ignored.

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

Why is Active Fund Selection So Difficult?

Selecting an active fund that will outperform its market capitalisation benchmark through time is an exacting challenge. We have all seen the bleak data regarding just how few funds deliver long-term excess returns in most (but not all) asset classes. It is, therefore, easy to make the argument that markets are simply too efficient and there are not sufficient opportunities for active investors to exploit, but this doesn’t hold water. Even if markets were efficient, we would expect a reasonably even distribution of outperformance and underperformance from active investors around this. Results would be random, but the probability of success would be somewhere near 50%. * In most cases, however, the odds of a positive outcome are far worse than this. But why?

There are three major issues that shift the probability of successful active fund selection from a 50 / 50 shot to something that can be close to zero: Fees, constraints, and behaviour. Any investor in active funds must manage these deliberately and well to give themselves a fighting chance:


Fees are the immutable, overwhelming impediment to successful active fund investing. They are a minor problem over any given year, but compound into a major, often insurmountable hurdle through time. The higher the fee level, the closer the probability of outperformance gets to zero.

People often misattribute the struggles of active management with efficient markets or incompetent professional investors, but this is generally not the case. The trouble is fees. Active funds are too expensive in aggregate, and this shifts our starting odds of success far lower than the 50% they would be before costs are considered.

In recent times there has been a conflation of two arguments: that low fees are incredibly beneficial to investors and that a market cap allocation approach is inherently superior to other methodologies. The first contention is true, the second is not. This mistaken thinking has arisen because most low-cost funds adopt a market cap indexing approach, and this methodology has enjoyed a prolonged period in the sun in many markets (the US in particular). There have been decades in the past where a market cap allocation has been inferior to other techniques (such as equal or fundamentally weighted).

The point is not that a market cap allocation is a poor strategy to adopt (it is perfectly sensible for most investors) but rather that the travails of active funds are more to do with the structural problem of high fees, rather than the cyclical issues of mega cap US companies making market cap indices hard to beat.

Staunch advocates of active fund investing often tend towards complacency on fees on the basis that certain managers are so skilful and will generate such a high level of alpha that the fee level isn’t a major concern. This is a dangerous mindset.

It is inconsistent to compare a certain cost with an uncertain benefit. If fees for an active fund are 1% and expected alpha is 2%, we need to haircut that forecasted outperformance for our own fallibility. We might be wrong that a manager has skill, or invest at an inopportune time (following a spell of stellar performance, for example). Active fund investors often talk about the hit rate required to be a successful fund manager (not much more than 50%), is it that different for fund investors? **

For active investors, reducing fees paid is the easiest lever to pull to improve the odds of success.


Active fund investors must also seriously consider the constraints they encounter in their investment approach; these will substantially reduce their chances of delivering the desired outcomes.

The most obvious impediment is likely to be size. The larger the level of assets, the narrower the opportunity set and the more difficult it becomes to generate outperformance. Although (for obvious reasons) asset management companies do not like to acknowledge it, it is an inescapable fact that above a certain minimum viability threshold a rising level of assets impairs future returns. The extent of this hindrance will vary depending on the asset class involved but in almost all instances it is a major drawback.

It is not only size that serves to constrain active fund investors, but there is also a host of other implicit and explicit limitations that will impair returns and reduce the likelihood of success. ESG restrictions are an obvious area in the current climate, as are controls on variables such as tracking error or manager tenure. A requirement to recommend or own too many funds is also highly problematic (investment skill, if it exists, is scarce not abundant).

Some fund investors must even deal with disastrous constraints such as only holding funds that have delivered outperformance over certain historic periods (such as the last three years). This is the type of constraint that immediately puts the chances of long-run success at zero.

Anything that restricts the investable universe or limits the agency of the investor reduces the probability of successful active fund investing. It is critical that we know what these are before we start.


Even if we have skill in selecting active funds, manage fees prudently and face limited constraints, there is one thing that can make it all redundant – our behaviour. Active fund investors must be acutely aware of behavioural challenges (and be able to deal with them) if we are to have any hope of prolonged success.

The most significant behavioural challenge is related to time horizons. To invest in active funds there must be a willingness to not only hold for the long-term (we should be thinking ten years) but withstand the inescapable bouts of prolonged underperformance that will occur during these periods. Let’s be clear, on the time horizons and incentive structures of most fund investors, Warren Buffett would have been fired on numerous occasions.

An obsession with noise-laden short-term numbers – such as poring over quarterly results – or a bizarre fascination with the spurious idea of consistent calendar year outperformance are the type of traits that will eviscerate our chances of long-run success.

When owning an active fund for the long-term we will be regularly provided with reasons to sell. If an active fund manager has underperformed for three years, we will always be able to identify ‘process issues’ that have caused the underwhelming returns, and will not resist the urge of asking them “what are they doing?” to address their poor results (in most cases, hopefully nothing).

The added problem is that there will, of course, be times when selling is the correct course of action. Nobody said it was easy.

It is vital not to underestimate the harsh behavioural realities of active fund investing, but unless we are able to discard the rampant myopia and find ways to manage our preoccupation with short-run outcomes, we should be investing in index funds.

Improving the Odds of Success

This post has been somewhat negative as it has focused on those factors that make successful active fund investing so difficult, rather than address the positive steps that can be taken to improve the odds of success. Although I will cover this in another post in more detail, there are ways in which this can be done. Tilting towards empirically sound factors at a low cost (such as value, momentum and quality) should enhance long-term outcomes, identifying investors with skill is difficult but possible (it has little to do with past performance) and making counter-cyclical decisions (investing when valuations are cheap and performance is poor, rather than the reverse) is a painful but productive approach.

The problem is that the proactive measures we might take to improve our odds are irrelevant unless we first deal with high fees, burdensome constraints, and poor behaviour. These will conspire to overwhelm any other positive actions we might take. If we want to invest in active funds, we need to be clear about how we are going to address these three key issues. If we cannot then we really should not be doing it.

*This is a deliberate simplification, which assumes no skew (lots of small funds outperform and a few large funds underperform, for example) and that active investors invest only in their defined market.

** It is, of course, not just a hit rate that matters but the win/loss ratio too.

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

Most of Us Are Secret Momentum Investors

Momentum investing has something of an image problem. It is not particularly sophisticated to say that we are buying a security because its price is going up or selling it because it is going down. It appears far superior to make investment decisions based on the elaborate fundamental analysis of a company or forensic due diligence of an actively managed fund. Despite a somewhat unattractive reputation, however, most of us are momentum investors. We just don’t want to admit it.   

What are the attractions of momentum investing?

In its most simple terms momentum investing is buying assets that are performing well, whilst abandoning the laggards. There are a range of reasons why investors find this secretly appealing:

1) It’s easy: Doing momentum investing badly is incredibly easy. It takes barely any effort to know which asset classes and securities are in-vogue. (Conversely, good momentum investing is difficult, particularly behaviourally).

2) It’s comfortable: Investing in things that are working right now and selling those that aren’t is incredibly comforting. It makes us feel good and worry less.

3) We extrapolate: We cannot help but think that what has happened recently will persist into the future.

4) We build stories around performance: When an asset is performing well, we create stories to justify it. Positive performance momentum leads us to form a compelling and persuasive investment narrative. A virtuous / vicious circle which increases our conviction.

5) We are comfortable in the crowd: Chasing momentum means following the crowd. Not only do we think that crowd behaviour provides us with information; taking a contrarian stance against it carries a host of unpleasant risks.  

6) Our career might depend on it: Momentum investing can be a useful survival strategy in the asset management industry, even if it destroys value over the long-term. Always telling clients how we are invested in the latest flavour of the month areas might just keep us from getting fired.  

Why don’t we admit to being momentum investors?

Despite the appeal of momentum investing, few of us admit to being profoundly influenced by it (excluding those who are running explicit momentum strategies). It is just too simple.

Although the majority of active fund investors chase performance, they rarely acknowledge it as the major influence on their decision making. Even when using a dreaded performance screen to filter a universe of funds (which ingrains momentum into the selection) this will be framed as a minor part of the process, before the more detailed research begins.

It is just not feasible to say to colleagues or clients: “we invested in this fund primarily because it was performing well”, even if this is the case. (We will also inevitably persuade ourselves that positive performance momentum wasn’t the significant driver of our decision).

Why doesn’t being an implicit momentum investor work?

There is a major problem with momentum being our implicit investment strategy – it doesn’t work. We are likely to be wildly inconsistent in our behaviour. Erratic, driven by noise, emotion and perverse incentives. We will be frequently whipsawed and often under-diversified.

Each time we make investment decisions that are implicitly driven by momentum it makes us feel better for a time; but what will feel like short-term wins, almost inevitably compound into painful, long-term losses.  

But momentum investing does work!

Why am I claiming that momentum investing doesn’t work, when it is one of the most empirically sound investment approaches to adopt? Momentum is everywhere.[i] It is because there are two types of momentum investing: implicit (the one we don’t like to admit) and explicit (which we find in academic literature and employed by various quant firms). Explicit momentum strategies are the polar opposite of their implicit counterpart. They are systematic, rules-based, unemotional, persistent and diversified. Everything implicit momentum strategies are not.

People often question why there is a premium for systematic momentum strategies. Perhaps because their profits are the other side of the losses made by ill-judged and widespread implicit momentum strategies. Bad momentum strategies feed good momentum strategies

Implicit momentum, or what we might call performance chasing, is endemic and entirely understandable. Not only are we hardwired to invest in assets that are performing well and sell those that are struggling, but the asset management industry also compels it – all our short-run incentives are aligned to behave in this way.  

There is nothing wrong with momentum investing, but there is plenty wrong with adopting an investment strategy that we won’t acknowledge to ourselves or anyone else.  

[i] https://pages.stern.nyu.edu/~lpederse/papers/ValMomEverywhere.pdf

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