We tend to judge the outcomes of our investments in binary terms.  We make money or lose money. We outperform or underperform. Our judgement was good or it was bad.  This type of thinking is flawed because of the role of luck in financial markets.  If I make a decision when the odds and evidence are heavily in my favour and it doesn’t work out; that doesn’t make it a poor decision. A small dose of randomness can heavily dilute the information provided by outcomes alone. But there is something else. A prudent investment approach means making certain decisions that you expect and hope to disappoint.

The need for investors to diversify is often framed as a means of smoothing investment performance or tailoring a portfolio to a specific appetite for risk.  Whilst this is true, it is not enough. Diversifying across a range of assets or securities is an acceptance that we cannot predict the future and that we will be wrong about many things. 

The more confident we are, the more concentrated our investments.  With perfect foresight we would only invest in one security.  If we want to understand an investor’s confidence, check their portfolio concentration.

Appropriate diversification means always holding some assets and securities that appear to be laggards. This is the intended result.  We can think of such positions as failures or costs. Alternatively, we can consider them to be holdings that would have fared better in a different scenario to the one which transpired*.

As investors we all have opinions on markets, stocks and funds.  Diversifying our risks appropriately is challenging because it forces us to make decisions not only that we think are likely to be wrong and costly, but that we want to be wrong and costly. This is difficult to justify to ourselves, let alone others.  It is tough to tell a confident story about our view of the world, and then make investments that seem contrary to it. 

“So, you have just told us there might be an inflationary problem around the corner, why are you holding nominal government bonds?”

“Well, I might be wrong and there could be a deflationary problem around the corner”.

That’s a hard sell.

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Let’s make a bet. There is $100,000 on offer. You have to decide what will produce the highest return over the next decade. Emerging market equities or US equities. You have to allocate the $100k between the two options. You will receive the amount you stake on the strongest market.  If you are supremely confident, you can put it on a single outcome and risk losing the entire amount. If you are ambivalent you can split it equally and guarantee $50k.

Most investors will have a view on this choice. Some more forthright than others.  If you had a strong disposition towards US equities, how aggressive would your stake be?  Given the huge uncertainty surrounding the result it makes little sense to go all in.  You need to diversify and put money on both. This means allocating money to something that you think is wrong and want to be wrong.  It is sensible and prudent, but uncomfortable.

If you wager $70k on US equities and they outstrip emerging market equities, how do you feel? You are likely to curse your conservatism, rather than think about the other possible paths taken. You were right, why didn’t you back yourself more?

After the event, diversification only feels gratifying if we were wrong.  If we were right it feels like a cost. If I bet each-way on a horse that wins a race, I will rue the fact that I didn’t bet solely on a victory.

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As always, the most challenging aspects of these types of decisions are when it involves changing our mind.  Let’s expand on the emerging market versus US equities bet. Five years in and the returns from both markets are identical.  You are asked if you want to adjust your stakes.  As you have some new information, you still favour US equities but now have less confidence in your view. So you alter your bet to $60k US equities / $40k emerging markets.

You have made a decision that you explicitly want to be incorrect.  At the end of the ten year period, it is in your interests if you were to look back and regret making this choice.  The level of cognitive dissonance here is pronounced.  I prefer US equities but I am reducing my bet. I am making a decision and I want it to cost me money. 

The central problem here is that when we are making an investment decision there are a huge range of potential, unknowable paths. After the event, only one route has been taken and a binary judgement will be made – were you right, or wrong?  To make matters worse,  everyone now feels that the result was obvious at the time you made your decision. 

Sensible investment is not about predicting a single path and trying to maximise your returns if it comes to pass.  It is about ensuring that you are appropriately positioned for a reasonable range of outcomes.  By all means have a view, but it needs to be heavily tempered with an acknowledgement that the future is inherently unpredictable.  

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How often do you hear this phrase?

“Based on the information you had at the time, that seemed a sensible decision – even if it didn’t work out”.

In life? Rarely, In financial markets? Never. 

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The best investors are those that are well-calibrated. They understand what they don’t and cannot know. Their decisions reflect this.  In simpler language they are comfortable making choices that they feel are wrong and that they hope come with a cost.

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*This doesn’t absolve us from investing mistakes.

One of the most effective methods for changing our behaviour is to alter the level of friction we face when making a decision. If we want to encourage an action, make it simple. If we want to restrict it, put up obstacles. We use this method intuitively in our everyday life – when we are trying to eat healthily we know it’s best not to have chocolate readily accessible in the fridge – but we tend to understate how the introduction of small amounts of friction can have profound consequences for the choices we make.

Take the case of paracetamol.  It is estimated that after the UK introduced limits on the number of tablets contained in a single packet, overdose deaths fell by 43%^[i]*.  It seems absurd to believe that the implementation of a seemingly slight change could materially influence a decision of unparalleled consequence, but it can.  When behaviours are driven by emotion and moments, even minor amounts of friction can exhibit incredible leverage. This is a concept that matters a great deal for investors.

Technological developments have profoundly changed the decision-making experience of both professional and private investors in recent decades.  We are awash with information (noise) and stimulus; and have the freedom to transact at any given moment. Technology has made investing seamless.  It has removed the friction.

The greater transparency and control investors enjoy is regularly lauded, and it has brought us a wave of benefits; but it also comes with a major shortcoming.  The absence of friction allows us to easily take decisions based on how we feel at a given point in time.  It makes the most pernicious investing behaviours – performance chasing / market timing / panic selling – easy, and the most important – adopting a long-term approach – more difficult.

Friction in investment has a bad image.  We tend to think of it slowing our decision making.  Rendering us unable to access opportunities as they arise and suppressing our best instincts.  This view is illogical.  For most investors, the ability to exploit near-term opportunities or react rapidly to changing market dynamics is a danger not an advantage.  Whilst a very select group will attempt such activity for most of us it is a damaging distraction or at best an irrelevance.  We tend to perceive friction as a hindrance, but it can quell some of our worst dispositions and promote long-term investing.

It is important to differentiate friction in decision making from outright prohibition.  Friction does not prevent us from taking a particular path entirely, it simply slows the process.  It introduces time and reflection.  Although there may be some investing activities where a complete block might be prudent; in most cases the simple introduction of some level of difficulty or delay is likely to have significant ramifications for our decision making.

For private investors, the notion of friction is often allied to being trapped in poorly performing, expensive funds where extricating yourself from them is seen as too painful, costly or complicated to be worthwhile.  This is an undoubted negative friction. Freedom and ease of movement here is essential.  Yet a consequence of removing such friction is the ability it gives us to lurch between in-vogue investments and make judgements based on ever-dwindling time horizons.   

To counter this, we can introduce our own inhibitors.  Part of our long-term investment plan should be specifying limits on how frequently we check our investments (the most effective way to reduce volatility is to review your portfolio less) or put restrictions on the amounts of trades we place.  Setting the password for your account to something you are unlikely to remember might have an even greater impact.

It would also be helpful if the investment platforms that we use allowed us to apply our own restrictions when setting-up an account – creating frictions in a cold state that will prevent us making poor decisions in a hot one.  For example, there could be a feature where your ability to place trades online is switched off, unless you make a request (which might take 7 days to be approved).  Not removing the choice, but introducing a pause.

Even for professional investors, the use of friction can be beneficial.  It is typical to pour scorn on ‘committee-led’ decision making and any element of an investment process that seems to undermine the unadulterated views of a fund manager.  But they are not immune to short-term thinking or the pressure to react to the prevailing market narrative.  Frictions in the process can allow them to be more faithful to their investment objectives, rather than act as an impediment. 

Long-term investing has never been more difficult. The freedom, transparency and choice now available to investors which has brought many benefits, also increases the opportunity to make poor decisions.  Doing less and enjoying the power of compounding sounds simple but it is far from easy.  The more we engage with markets, the greater the temptation is to make choices that feel good now, that we later come to regret.

Taking a long-term approach takes effort and requires assistance.  A little bit of friction can go a long way.

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* Not all of these will be suicides, and there are several confounding variables that mean that there is significant uncertainty around the 43% figure.  There is general agreement, however, that there has been a meaningful impact.

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^[i] https://www.nhs.uk/news/medication/smaller-paracetamol-packs-may-have-reduced-deaths/