Suspend your disbelief for a second. Imagine you have been gifted $1m, the only proviso is you must split the amount between an equally weighted 30-stock portfolio of US listed companies selected by Warren Buffett and a 30-stock portfolio of US listed companies selected by…me. You get to keep the amount staked on whichever portfolio produces the highest return.

Where would you put your money?

Of course, it is impossible to take any view on likely outcomes because we are missing a vital piece of information – the time horizon. When considering luck and skill in investing this is the most important thing. It changes everything.

Let’s say the time horizon was just a single day. The odds of my portfolio beating Buffett’s must be 50%. One day’s stock market movement is nothing but random noise. $500,000 each seems a prudent approach.

What if the length of the bet is increased to one year? The chances of my portfolio might be a little less than 50% but only modestly. Nobody can accurately and consistently predict in advance what will happen in equity markets over the next year. Fundamental company attributes are unlikely to matter that much compared to events, narratives and flows. The result would not be far from a coin toss.

How about three years? This is an important timespan because it is often the period over which fund investors hire and fire active managers. We should expect some advantage to arise from Buffett’s acumen and experience here, but the results would still be extremely variable and hugely influenced by sentiment, rather than the aspects of a business Buffett cares about.

We could use base rates to help us size the bet. Between 1988 and 2019 Berkshire Hathaway outperformed the market on c.60% of rolling 3-year periods.[i] A $600,000 stake towards Buffett would seem sensible.

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The tangential point here is that on the time horizon adopted by most fund selectors, Warren Buffett would have been sacked on multiple occasions over his staggeringly successful investing career. Past performance can be a terrible decision-making tool.

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Now, back to the bet. 

Finally, let’s try a 10-year time horizon. We are getting into the realms of long-term investing. Company fundamentals should matter more. Skill should start to exert a material influence. But how much?

Let’s go back to base rates. Over the same period as previously mentioned Berkshire Hathaway outperformed the market on close to 90% of rolling 10-year spells. We might now have more confidence placing $800,000 or $900,000 on Buffett’s side of the table.

Time horizons matter.

When thinking about the bet; don’t worry too much about my limited capabilities in stock picking, just assume that I design my 30-stock portfolio to look as much like the market as possible. Also, it doesn’t have to be Warren Buffett – just a highly skilled stock picking investor. The message will be the same.

So, what is the message?

1) Conversations about luck and skill in investing are irrelevant unless we specify a time horizon. For most styles of investing, the longer the time horizon the more skill will influence outcomes. Whatever the time horizon, however, the results will never be devoid of chance.

2) Investing is a bizarre activity. Over reasonably lengthy time horizons (one year, three years and more) people without any discernible skill will produce better results than the most skilful individuals in the field. There are very few activities that are structured in this way.

We hugely understate the role of luck in investment outcomes. Humility is a pre-requisite for good investing. Sensible decisions will appear mistaken – a lot.

3) Active fund investors have their time horizons all wrong. Attempting to identify skill and then worrying about one and three-year performance is entirely futile. We are doing little more than playing roulette (particularly if we acknowledge that we are unlikely to identify the greatest investor of their generation in advance). A focus on short run horizons will doom us to making persistently bad decisions based on the unpredictable movements of markets.

If there is any chance of success investing in active funds, we must extend our time horizon. If that is not possible, we should not be using them.
 

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[i] Daily: Firing Warren Buffett | UBS Global

In Homer’s Odyssey, Ulysses and his crew must navigate their ship past the sirens. The sirens produce a beguiling and irresistible song, which if heard would lead the men to their deaths. To be the first person to hear their song and live, Ulysses applies some behavioural science. He creates a commitment device in the present to protect his future self. He instructs his crew to fill their ears with wax to avoid temptation and has himself tied to the mast to avoid action. If investors want to enjoy the benefits of long-term investing, we must adopt a similar approach.

Stephen Pinker discusses this type of behaviour management in his new book Rationality. He notes that Ulysses surrendered his ability to act and the sailors their option to know. This is puzzling because wilfully relinquishing information and agency seems deeply irrational. Yet if we are aware of the challenges and impulses that await us, it can be the most rational approach to achieving our goals.

As investors we find ourselves in a similar situation to Ulysses. Most of us have long-term objectives best facilitated by doing less, yet the constant noise and narratives of markets are there to lure us into frequent injudicious decisions.

Being a long-term, low action investor is the easiest approach to adopt in theory, but the hardest in practice. How do we make a commitment like Ulysses to protect us from our future investing selves?

Plugging our ears like the sailors means ignoring the chaotic vacillations of markets and the unpredictable path of the economy. Rarely checking our valuations, cutting off our subscriptions to financial news. Avoiding anything that will entice us away from our plan.  

Tying ourselves to the mast means making action far more difficult than inaction. Cancelling the brokerage account, losing the password for our portfolios, or adding elements of friction to slow an investment decision-making process.

Of course, we don’t do any of these things. It feels absurd to disregard ‘critical’ information and constrain ourselves from making ‘vital’ investment judgements. We also find it difficult to believe that we will make poor choices in the future – surely, we will behave in a perfectly rational manner no matter the environment?

As with so many things in investment, taking the right behavioural steps to achieve good outcomes can seem irrational and imprudent.  Saying ‘I don’t know what markets did yesterday, and I don’t really care’, probably increases the odds that our long-run outcomes will be good, it is just that everybody will think we are incompetent.

Professional investors naturally dislike this type of Ulysses pact.  We are paid to engage with markets and act, irrespective of whether that activity is beneficial.  We must listen to the siren song and probably erroneously believe we can avoid the rocks whilst enjoying the melody.  

Commitment devices do not have to be entirely restrictive, however. They can be designed so that our future self is more likely to exploit opportunities that arise. We might commit to acting only when certain extreme valuation levels are reached. This approach is obviously imperfect compared to an avoidance pact because we will still have to implement the decision when the time arrives (and will no doubt create excuses as to why it is no longer a good idea). Setting a high threshold for action, however, at least protects from the worst ravages of noise and overtrading.  

A critical part of managing our behaviour is understanding the challenges we will face and planning in advance how we will mitigate them. Good investment is primarily about making sensible decisions at the start and avoiding bad decisions on the journey. The problem is that the compulsion to veer off course is likely to be overwhelming.  

Most of us want to be long-term investors, but unless we make the right behavioural commitments at the outset the siren song of financial markets will make that an impossible aspiration.

Asset managers spend a great deal of time cultivating their brand and extolling the virtues of their culture. Although as an investor it is easy (and enjoyable) to be dismissive of these activities, they do matter. Investing in a firm with a toxic work environment and invectives wildly misaligned with our own is unlikely to lead to positive outcomes. If a firm or team’s culture is at odds with its investment philosophy, the culture will win out. Culture is critical but gauging it from the outside is incredibly difficult to do. The only way to better understand it is to ignore the words and instead focus on behaviours.

We should not think about culture without also considering the issue of brand. The two are deeply intertwined and can be considered different sides of the same coin. One external to a company and one internal. A brand is the perceptions held about the behaviours of a company by outsiders. A culture is the expected behaviour of insiders within a firm – what is permitted, enacted, and rewarded. Asset managers are unlikely to sustainably and successfully reset a brand without also addressing the underlying culture.

The cynicism that meets much of the talk around brand and culture within the asset management industry is entirely fair. It is so often vacuous nonsense – a superficial effort to manage perceptions. Establishing or transforming a brand is not about slogans, fonts or colour palettes, it is about changing the beliefs held about a company’s activities. If a company changes its name but its behaviour is consistent with the past, then existing opinions will simply transition to the new name.

If there is an effort to modify the brand and culture of a business, it is critical to ask – “what actions and behaviours are changing and why?” Not – “what is it you are calling yourself now?”

Given the industry’s focus on performance, it is possible that strong brands can exist when the team culture underlying it is poor. Investment returns can be impressive in a bullying, exclusive environment where client outcomes are subordinate to that of the business, but they are unlikely to be sustainable – the culture will lead to a reckoning at some juncture. Even if strong returns do persist against such a backdrop, we should ask ourselves whether it is the type of business with which we are happy to entrust our money.

Situations can also exist where a company has made material strides in improving its culture, but its brand remains tarnished because of past deeds. In such instances, shifting the optics (changing the name or logo) might help to allow the brand to reflect the evolving culture but will be insufficient. There needs to be consistent and meaningful evidence of what is changing. Skoda’s brand image would not have evolved had they not also improved the quality of their cars.

Assessing the culture at an asset management business is not easy. The starting point is to dismiss everything that you are told and anything that appears on a PowerPoint deck, and instead focus on tangible actions. It is easy to extoll the virtues of an inclusive environment in which the many different forms of diversity are paramount, but what is actually being done about it? Have concrete policies been put in place to facilitate this?

If the purported culture is based on putting the long-term interests of the clients first, how is that achieved? What remuneration structures are in-place to incentivise behaviours that are aligned with this mindset? How is the firm overcoming the pressure of meeting short-term financial objectives?

There is often a yawning gulf between what a firm says about its culture and what it actually does.

When assessing the culture of an asset management business, we should start by asking two questions: i) What are the cultural features (expected behaviours) we would expect to see at a high quality investment organisation? ii) What are the cultural elements that would support the application of the specific investment approach we are considering?

As an outsider there are a variety of ways to build a better understanding of culture within a firm or team. Those with privileged access can attend internal meetings and obtain details on incentive structures and historic staff turnover. It doesn’t have to be that difficult, however. Sites such as Glassdoor can be insightful, as can conversations with previous employees. We can also observe how the company engages with different stakeholders. The messages given by management to shareholders may well differ with those offered to potential investors in their funds – shareholders will hear about cost cutting and improving short-term flows, investors will hear of continued investment in the business and the paramount importance of adopting a long-term approach.

What we are seeking to understand is whether a firm’s behaviours and expected behaviours (its real culture) are consistent with what it says and what it is trying to achieve. There is no magic bullet to judging this, but we can easily build a framework or checklist, and reach our own conclusions.

Asset management firms should care about culture not because it sells or helps improve the brand, but because it leads to better outcomes for all stakeholders. Investors should care because our outcomes will be driven by the behaviour of the individuals in the firm with which we are investing.

It is so easy to poor scorn on culture and brand as amorphous and frivolous concepts, particularly when most asset managers play the game of saying the right things to best support and furnish their desired image. Culture is frequently discussed without anyone taking the time to explain it; but this doesn’t mean we should dismiss it. At its heart culture is about behaviour, and there should be few things as important to investors as that.