When talking to active managers, fund investors can focus on the wrong things – we are heavily biased toward the short-term, and obsess over issues that are recent and salient.  We also drastically overvalue confidence as a characteristic, whilst punishing circumspection, realism and humility.  Given this, it is unsurprising that conversations with active managers are often shaped in a manner that is entirely at odds with the capricious and unpredictable nature of financial markets, and do little to help identify skill.

Active managers inevitably attempt to present themselves in the manner that they believe most appeals to investors and there are, therefore, many things that they should say, but rarely do.  Here are some examples:

“It was a genuine mistake – our analysis was incorrect, but I will make sure I learn from this for future decisions.”

“Whilst I believe in this investment, given that I will get at least 40% of my decisions wrong (assuming I do a very good job), this could be such an occasion.”

“It is important to highlight the pronounced style tailwind that I have enjoyed during this period of outperformance”.

“I can’t confidently predict the outcome of this event and, even if I could, it would be difficult to gauge how markets would react”.

“Although the trade was profitable, the situation did not develop as I had imagined and its success was actually just a dose of good fortune”

“Whilst the event is material and may have significant ramifications for markets I just don’t know what these will be with any certainty, so have decided to do nothing”.

“I appreciate that recent market volatility feels significant, but I don’t want to focus on it because, on a ten year view, it is likely to seem meaningless”.

“I am happy to give my perspective on the macro environment, but I have no particular expertise in the area, certainly relative to the thousands of others opining on the same subject”

“Of course I can review three month performance, but the results are almost entirely random market noise”

“I appreciate that I previously held a high level of confidence in this view, but, after careful analysis of new evidence, I realised that I was wrong”.

“I have absolutely no idea what equity markets will do over the next 12 months, but the odds are in favour of them going up”.

“I am fully aware of our propensity to make behavioural mistakes, and this is how I aim to minimise them…”

“On the balance of probabilities…”

There is persuasive evidence that a select group of risk factors in equity investment provide investors with a return premium – that is they offer a long-term performance advantage relative to the broad market, on a risk-adjusted basis.  The most established and robust are value, momentum and size.  All three of these meet the crucial criteria of being present over an extended time horizon, pervasive across markets and supported by a behavioural / economic foundation.

Based on this, I consider it prudent to have exposure to these factors in a portfolio. However, this acceptance raises an immediate question – if I believe in the efficacy of these factors now, is this decision irrevocable? If I take a view about there being certain structural risk premia in equity markets, is it possible to change my mind? What could the rationale be for such a shift of view?

It is important to make a distinction here – I am not referring to the cyclicality of returns from a factor, I fully acknowledge that the performance of all equity risk factors will wax and wane, often over long cycles.  Rather, my concern is a situation where the long-term expected risk premium for a particular factor evaporates because of some change in the drivers of the anomaly.  I do not worry that the size factor will fail to deliver for sustained periods (for example), but that the premium no longer exists.

Whilst such an occurrence may be considered to hold a low probability, it surely cannot be impossible. Therefore a risk exists, yet one that is difficult to identify and quantify for a variety of reasons:

–  The pillars of all credible equity risk premia are economic and behavioural rationale. Structural excess returns cannot simply be present in the data; there must be a reason for their existence – I have written previously about behavioural drivers for value and momentum.  The problem is that these are only suppositions, in most cases it is impossible to precisely and unequivocally identify the causes of certain risk premia. It therefore follows that we cannot confidently observe when these alter.

–  Long term horizons (large sample sizes) are a prerequisite to build confidence in the robustness of equity risk premia. If we require multiple decades of data (at the very minimum) to support our behavioural / economic hypothesis, we need similar periods of time to ‘disprove’ them.  By the time there is sufficient evidence to support the contention that a risk factor no longer effective, you are likely to be enjoying retirement.

– The problem is exacerbated by the fact that even if a currently sound factor stopped working it would still behave, at times, as if it did.  Let’s assume that from this day on there was no value premium in equity markets – even in such a scenario there would continue to be extended periods when value outperformed.  Expensive stocks can (and do) generate prolonged periods of excess returns, despite there being no evidence of a structural premium.

–  In the event that you are willing to declare the demise of a previously robust equity risk premium, you are likely to be wrong, and at a particularly inopportune time – the sounding of the death knell for value investing will almost inevitably be prelude to resurgent performance from the factor.  It is easy to mistake the cyclical for the structural, and abandon a style of investing when it is depressed and the valuation dispersion wide.

– It is simply not in the interests of the majority of groups working within the burgeoning factor investment sub-industry to state that an prominent risk premium has lost its efficacy – informing clients that the factor they have invested billions in is unlikely to work in the future seems to be an unwise and unlikely business decision.  There are undoubtedly investors who would seek to exploit the change in factor dynamics, but these would be the exception rather than the rule.  It is not an industry renowned for parsimony.

As with all investment judgement, the consideration of factor viability it is about uncertainty and subjective probability. On the weight of evidence, it is likely that established equity risk premia will continue to deliver over the long term, however, there is a low probability that they will not, and it is important to incorporate this possibility into your decision making.  It is also prudent to assess how rich or cheap a particular factor is relative to its own history, which may provide some protection in the event that the presumed structural risk premium is no longer present. Neither of these options directly addresses the central question posed in this article, simply because there are no obvious answers.

One of the many oddities of the investment industry is that whilst it operates in a constant state of uncertainty and flux, its participants talk in the language of certainty.  Confident forecasts and dogmatic opinions are valued far more highly than circumspection and caveats.  This bias stems from the mistaken belief that expertise is related to conviction – that an expert must know the ‘right answer’.  Whilst this might hold in certain situations where the environment is stable and skill dominates outcomes; the reverse is true in random and unpredictable domains, such as financial markets. Here, expertise is more evident in humility, a willingness to revise views and to deal in probabilities.

There is certainly truth to the view that we are poor when it comes to thinking in terms of probabilities, and there are multiple examples of our irrationalities in this area – such as the tendency to neglect probabilities when considering extreme scenarios, and our propensity to overweight or ignore small probabilities.  The notion, however, that we should not talk about probability because we have limitations in this regard is entirely spurious; we cannot make a decision without taking some view on the likelihood of potential outcomes, even if we are not explicit about it.  If we bring our probability assessments into the open; it materially improves our ability to understand our biases, receive feedback on our judgements and learn.

Aside from our general struggle with thinking in such a manner, there are a range of other issues that limit the use of probabilities when making investment decisions and forecasts:

–  Lack of expertise: As soon as probabilities are expressed around a variety of potential outcomes, there is an acknowledgement of uncertainty, which is often erroneously viewed as a lack of expertise and akin to the cardinal sin of stating “I don’t know”.  This issue is exacerbated by the fact that there will be others making bold, singular predictions – surely, they must know better?

– Spurious accuracy: In uncertain environments views on probabilities are necessarily based on subjective judgements. Applying specific probabilities to a range of scenarios can appear overly scientific – what does it mean to believe the likelihood of an event is 17%?  This view, however, misses the value of applying probabilities.  Its use is not as a precise figure but as a measure of confidence and a means to monitor how our views evolve through time.

– Implementation challenges: It is far easier to translate a strident, narrow view into an investment decision, than to attempt to reflect uncertainty and a variety of potential outcomes.

– The forty percent problem:  Probabilities can be misused when making forecasts – the classic case is an individual assigning a 40% probability to an outlier event (a recession, typically). The 40% level means that if the event doesn’t occur their forecast was correct (on balance), but if the scenario does transpire it is of a high enough likelihood for them to be feted for the prediction.  This is an example of probabilities being utilised in a strategic, unhelpful fashion.

– Changing minds:  When we frame outcomes in terms of probabilities, we allow ourselves the freedom to alter our view.  Whilst this should be considered positive and a reflection of realistic pragmatism; it is more often stigmatised as ‘sitting on the fence’ or providing a pre-prepared excuse for ‘being wrong’.

None of these arguments are particularly compelling and they are outweighed by the manifold benefits of thinking explicitly in terms of probabilities when making investment decisions:

– Humility:  Simply by framing potential outcomes in terms of probabilities, we immediately acknowledge the uncertainty and unpredictability of any given judgement. We are divorcing ourselves from hubristic, narrow forecasts from the outset.

– Reduce confirmation and commitment bias: When we espouse high conviction and overly precise views we come to be defined by them. Instead of refining or rejecting our beliefs in light of contrary evidence, we instead seek to preserve our ego by becoming increasingly committed and ignoring countervailing information.  By ascribing probabilities to a range of different scenarios we are more likely to remain open-minded and diminish the influence of being committed to any particular outcome.

– Understand strength of view: It is often difficult to gauge the strength of someone’s view – this is particularly the case for binary situations where a ‘yes’ decision could either represent a marginal call or be a display of resounding confidence.  For example, if we had to predict the result of two coin tosses one, which was biased 55% in favour or tails and the other 95% towards tails – our ultimate view on the most likely outcome should be the same – but the level of confidence wildly different. Given that the investment industry tends to favour those making binary, conviction calls; such nuances are often lost and marked uncertainty can exit beneath a veneer of confidence – employing probabilities can help to reveal this.

– Consider alternative scenarios: The use of probabilities forces us to consider alternative (often negative) scenarios; an individual with a high level of confidence in a specific outcome is still likely to ascribe some probability to other less favourable results.  Even if the chance of these occurring is regarded as minimal, there is an undoubted benefit from considering them, rather than ignoring them entirely and focusing solely on the primary case.  The best example of this would be in assigning a probability of a bullish case for a particular stock – the simple act of not giving the positive scenario 100% likelihood, compels consideration of other potential outcomes, and hopefully encourages debate.

– Incorporate new information: A crucial element of successful decision making is the ability and willingness to revise views in the light of new information. If we make binary decisions (such as buy or sell) we can easily avoid incorporating fresh evidence by claiming our view has not altered (“it is still a buy”); however, by specifying probabilities it becomes increasingly difficult to ignore developments that are likely to impact your level of confidence.

For example, imagine you buy an active mutual fund and hold a 70% confidence that it will outperform its benchmark over three years; after one year the fund has generated significant excess returns – do you revise your view? If it is a simple, vague buy decision you are likely to continue to hold; however, if you have to update your confidence level there is likely to be an impact. Given the evidence of mean reversion in active manager returns, can you really still can you really continue to ascribe the same probability of outperformance over the next three years, or should it be revised lower?  Being explicit with probabilities forces us, and others, to challenge and update our thinking.

– Evaluate past decisions: Given the scourge of hindsight bias it is often impossible to assess the quality of our historic decisions, as we cannot accurately recall our thought processes and feelings at the particular time. If, however, we consistently review and document our decision / forecast confidence level, we are in a far better position to understand how we came to a particular viewpoint and the manner in which we reacted to new information.  This can become a vital tool in learning from past behaviours.

Ascribing likelihoods to potential outcomes is not easy, as with all our behaviours it will be blighted by noise and bias; however, even if we are not openly expressing opinion in probabilistic terms, they are still deeply embedded in the views we hold.  As highlighted in Philip Tetlock’s Superforecasters and Annie Duke’s Thinking in Bets, being explicit about probabilities when making judgements or forecasts allows us to embrace uncertainty, affords us the freedom to revise our opinion as new information arrives and fosters the ability to learn from previous decisions.  In complex and ambiguous financial markets such features are invaluable.