When discussing the behavioural foibles that impact our investment decision making, it is often stressed that these issues also affect professional investors – seemingly in an effort to allay any notion that expertise insulates them from such issues. Whilst it is certainly true to state that professionals are not invulnerable, this does not go far enough. If we think about some of the main challenges encountered by investors around issues such as time horizons, over-trading, overconfidence, misaligned incentives and benchmark obsession, these problems are often exacerbated when investing in a professional context. Amateur investors* therefore have a number of behavioural advantages:
- There is no need to check your portfolio on a daily basis: Access and control are optically wonderful developments for investors, but almost certainly come with significant behavioural costs. They allow us to react to the random, noisy movements of our investments and exhibit our most destructive behavioural tendencies. However, amateur investors don’t have to engage as frequently as professionals – they can make some sensible long-term decisions at the outset and review their portfolio sparingly; avoiding the emotionally exacting experience of living through your long-term investments on a day to day basis. Professional investors possess no such edge – they are compelled to constantly monitor their portfolios and must deal with the behavioural issues that stem from this.
- You can make decisions consistent with your own time horizon: Most people have a reasonable idea of the time horizon for their investments – saving for an expected thirty years to retirement, for example. Whilst all types of investors struggle to make long-term decisions, this can be particularly pointed for professionals. In addition to the notion of a reasonable time horizon being somewhat vague, professional investors often have to work to multiple (often implicit) time horizons some of which might seem contrary to sensible investment decision making. For example: three months for performance reviews, annual for performance fee targets, or three years as the typical minimum assessment period for professional fund investors / consultants. These types of pressures can foster an ingrained myopia for any professional investor. Of course, all investors suffer from short-termism, but it is easier for amateur investors to avoid it.
- Your incentives are perfectly aligned: Allied closely with the aforementioned time horizon concept, incentives are also problematic. For amateur investors, the incentive for investing is clear – to meet their specified long-term objective. For professionals, the incentives can be complicated and often contradict the goals of the strategy that they are responsible for – such as excess rewards for generating abnormal short-term returns (often driven by performance fee structure) or raising assets to levels which maximise revenues, but impair return potential.
- You can do nothing: Professional investors have an activity problem – there is too much of it. There are two major pressures that cause needless and often destructive overtrading for professionals: i) They have constant exposure to incessant newsflow and random market fluctuations, which often compels them to act, ii) It is difficult to justify fees and show expertise by doing less, so the tendency is to do more. Although not immune to these issues; amateur investors have the wonderful, liberating ability to make sensible, long-term investment decisions and then leave well alone.
- There is no need to chase performance: Professional investors are under consistent and significant performance pressure with failure to deliver over short time horizons creating pointed career risk. This leads to decision making which can often be dominated by the short-term performance imperative at the expense of philosophy and process considerations. It is often viewed as unacceptable for a professional to state that they are doing the same thing after three years of poor performance – even if such a period says remarkably little about the long-term validity of a particular approach.
- There is no need to window dress your portfolio: Why is it that professional fund investors are prone to sell their active fund positions after three years of poor performance and replace it with a strategy with a stellar three year track record, despite evidence that, on average, this is poor behaviour? At least part of the reason is that their portfolios look better (and are more saleable) if they hold long-term winners, even if they have not been holding them for much of the period where they have been successful. Conversely, it is difficult for them to own notable laggard strategies from a perception perspective, even if there has been no fundamental change in the view.
- You don’t need to make bold forecasts on the economy or market: If you work as a professional investor there is an implicit (sometimes explicit) assumption that you should have strong views on the near term direction of capital markets and the global economy. Given that this is a skillset few people possess this is a highly problematic situation which results in virtually every professional investor opining and many trading on such views, despite there being scant evidence that they have any particular capability in this area. For professional investors this situation is difficult to avoid because answering ‘I don’t know’ or ‘that is entirely unpredictable’ is not a route to a successful career in the industry. Better to have a bold, well-articulated view and be wrong.
- There is no requirement to be constrained by arbitrary benchmarks: Benchmarks are seen as the gold standard in assessing the value for money delivered by professional investors, but they are a behavioural disaster. They foster short-termism and create a situation where outcomes dominate process (this is particularly problematic because it is an environment where randomness and uncertainty are pronounced). Most pointedly they overwhelm behaviour – rather than focus on the consistent application of a philosophy or long-term client outcomes, the spectre of short-term benchmark comparisons looms large and inevitably drives decision making.
- You don’t have to strive to be exceptional: The investment industry is over-populated and highly competitive, which means to be successful many professional investors believe that they have to generate results that are exceptional. The problem with this is that it leads them toward making decisions that are injudicious on average. If you believe that you are exceptional then you can (over)confidently ignore base rates because they don’t apply to you. Amateur investors suffer no such competitive threat – they can simply follow sensible investment principles and make decisions that are proven to be good on average (which, ironically, will probably lead to exceptional results relative to what other people are trying to achieve).
- You don’t need to worry about what other people are doing: Given the incentive structure, professional investors face they are often focused on what is working / performing and what is selling (often one and the same thing) – and can often be diverted from their core competencies. Whilst amateur investors can easily be swayed by what other people are doing (it can be tough when your neighbour tells you about their biotechnology punt that is up 500%) they don’t need to be.
Of course, amateur investors are not immune from the plethora of behavioural issues that lead to poor investment decision making. It is, however, important to acknowledge that the investment industry has certain structural features that serve to generate or inflame a particular set of behavioural shortcomings. In a world of few edges, investors who can avoid them should be sure to do just that.
NB: When I was writing this post I came across an article from Barry Ritholtz that covered similar ground, hopefully the behavioural slant of this article makes it sufficiently distinctive to be interesting. His article is here.
* The term amateur sounds pejorative but this is not meant to be the case – it is simply a reference to those people who hold investments but do not manage them for a living i.e. the majority of individuals who aren’t professional investors.