Investors have never had it so good. We have unprecedented choice, improved transparency and easy access to valuable information. All this with ever-decreasing fees. Yet to believe that these are halcyon days ignores the behavioural reality. Many of the benefits that investors now enjoy come with significant behavioural costs that threaten to turn the best of times into the worst of times.

Let’s begin by looking at the main areas where investors now seem unequivocally better off:

Cost: The cost of investing in simple funds and strategies aligned to our long-term objectives continues to fall.

Control: Improved technology means that we can now select and change our investments at will. No longer are we condemned to persist with unsuitable holdings or thwarted by a quagmire of unfathomable paperwork.

Transparency: We can see exactly what is happening in our portfolios whenever and wherever we wish.

Choice: There is easy access to the full gamut of investment strategies, no matter what our requirements or preferences.

Information: Many high-quality investment insights are freely available.

So far, so good. Yet if we consider the same categories through a behavioural lens, a different picture emerges:

Cost: How can low costs be bad for investors? When they are used as a tool to lure us into activities that we should never engage in. Commission free or low cost trading in individual stocks, FX and even esoteric options comes at a punitively high cost for investors not simply because of the spreads, but the losses we will register with grim inevitability. There are scores of studies looking at the poor results of individual investors trading in such a fashion. Even the adverts for companies providing these services tell us just how bad we are in the small print.

Low costs here are not a benefit, just a hook to turn us into committed, unsuccessful gamblers.

Control: Closely aligned with transparency is the purported benefit of control. We don’t only see our investments each day, we can trade them too. Unfettered control means there is no protection against poor system one or hot state decisions. We make choices that make us feel better in the moment but come with a heavy long-term cost.

From a behavioural perspective, the combination of transparency and control can be toxic.

Transparency: It is difficult to argue that better transparency is a negative for investors, of course it is not. We must, however, be aware of the behavioural implications of improved visibility. The more frequently we observe our investments, the more likely we are to be captured by myopic loss aversion. Where our struggle to cope with short-term losses provokes poor decisions.

It is hard to think of a greater impediment to good long-term outcomes than being able to check our portfolios every day.

Choice: The vast array of choice available to investors is a curse rather than a blessing. Not only will we be confused by the complexity of options, but we will also never be satisfied. The paradox of choice means that we will be constantly frustrated by our failure to select the best option.

Too much choice can easily lead us to feeling confused and unhappy.

Information: We certainly have access to good quality information and guidance, but investors must also suffer a torrent of misinformation and noise.  From financial news channels counting down the seconds to each day’s market to open, to trading experts on Twitter (selectively) highlighting their otherworldly acumen; the weight of unhelpful information vastly outweighs that which is sensible. Brandolini’s law that “the amount of energy needed to refute bullshit is an order of magnitude bigger than is needed to produce it’, certainly applies to the investment information now easily available to us.

The problem of noise and misinformation is exacerbated by the fact that good investment guidance is boring, and the nonsense often far more interesting.  

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I often wonder who is better off. An unengaged investor who owns an underwhelming and unduly expensive active global equity fund in their pension but leaves it untouched over the years; or a fully engaged investor who assiduously checks their portfolio and trades actively. Whilst neither is ideal, the first investor will probably have superior outcomes because their ignorance insulates them from many of the sternest behavioural challenges we face.  

It is far too easy to ignore or understate the true consequences and costs of poor investment behaviour.

So, is now the best or worst time to be an investor?  Probably both. Like never before, investors have the opportunity to make simple and sensible decisions that deliver on their long-term goals. Yet this ignores the stark behavioural realities that we face. From a behavioural perspective it has never been more difficult to make good investment decisions, and unless we attempt to manage this it might really be the worst time to be an investor.

The Russian army’s intimidating presence on the border with Ukraine is the latest macro event that has investors concerned about equity markets. It is also the latest macro event that most investors would do well to ignore*.  We worry about specific, prominent issues because we want to protect against the losses that may occur if our worst fears are realised. The irony is the most sure-fire way for investors to make consistent and substantial losses is by lurching from one high profile risk to the next, making consistently poor decisions along the way. 

We have all seen the charts extolling the virtues of taking a long-term approach to equity investing.  They show how markets have produced strong returns in-spite of wars, recessions, and pandemics. They are a great illustration of the benefits of a long-term approach, but they don’t tell us everything.

What they fail to show is all those critical issues that worried investors but never came to pass. We are always confronting the next great risk to markets; the key to successful investing is finding ways of drowning out this noise.

There are two key reasons why this is incredibly hard to do:

First is how the media and industry serve to stoke rather than quell damaging behavioural impulses by obsessing over the latest macro risk. It’s far more interesting to speculate over the potentially dramatic implications of a given situation, than to repeat some boring lessons about sensible investor behaviour.

Second is that because some events have mattered in the past and some will matter in the future, we feel compelled to act on everything – just in case the current issue really does have an impact. Imagine if disaster strikes after we told everyone to disregard the risk.

Even though we can be certain that there are some events that will cause dramatic (short-term) losses for risky assets; discounting them is absolutely the best course of action for most long-term investors. This is for a host of reasons:

We cannot predict future events: Pre-emptively acting to deal with prominent risks that pose a threat to our portfolios requires us to make accurate forecasts about the future. Something that humans are notoriously terrible at.

We don’t know how markets will respond: We don’t only need to forecast a particular event; we also need to understand how markets will react to it. What is in the price? How will investors in aggregate react? Even if we get lucky on point one, there is no guarantee we will accurately anticipate the financial market consequences.  Take the coronavirus pandemic – if at the start of 2020 we had been able to see into the future and look at the economic data for the year ahead, we would have almost certainly made a host of terrible investment decisions. In investing, even foresight might not be enough to save us from ourselves.

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It is worth pausing to reflect on these first two reasons. Forecasting events and their impact on markets is an unfathomably complex problem to solve. We are incredibly unlikely to succeed in it.

2016 is useful example of this problem. For both the US election and Brexit (two macro risk obsessions at the time) investors were wrong footed by both elements – the forecast of the votes (even though they were binary) and the market reaction to them. Years and months were spent pontificating over positioning for those events, and many very intelligent people got everything wrong.   

When questions are posed such as: “What are you doing in your portfolio about Russia / Ukraine?” It is useful to unpack what is really being asked here, which is: “With limited information and a huge degree of uncertainty and complexity, have you made an accurate assessment of the likely outcome of the tense political / military stand-off between two countries, and then judged the market’s reaction?”

The answer should be no.

If the answer is yes, then we are displaying a huge degree of overconfidence.  

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We are poor at assessing high profile risks: We tend to judge risks not by how likely they are to come to pass, but how salient they are. This a real problem for macro events because the attention they receive makes them inescapable, so we greatly overweight their importance in our thinking and decision making. This is why the media and industry focus on them is so problematic – it makes us believe that risks are both more severe and more likely to come to fruition.  

We need to be consistently right: Even if we strike lucky and are correct in adjusting our portfolio for a particular event, that’s not enough – we need to keep being right. Making a bold and correct investment decision about a single event is one thing, but what about the next one that comes along? We need to make a judgement on that too, we can’t undo all our prior good work. Over the long-run being right about any individual prominent macro event is probably more dangerous than being wrong, because it will embolden us to do it again. 

Most events will not matter to our long-term returns: Daniel Kahneman’s comment that “nothing in life is as important as you think it is, when you are thinking about it” could be used in relation to short-term events and our long-term outcomes. In the moment that we are experiencing them macro events can feel overwhelming and all-encompassing, but on a long-term view they are likely to fade into insignificance.   

It is not that macro events are never significant for markets. There will be incidents in the future that will lead to savage losses in equities; we just won’t be able to predict what will cause them or when they will happen. Trying to anticipate when they will occur, rather than accepting them as an expected feature of long-term investing, will inevitably lead to worse outcomes. 

If we find ourselves consistently worried about the next major risk that threatens markets, there are four steps we should take:

1) Reset our expectations: Investing in risky assets means that we will experience periods of severe drawdown. These are not something we can avoid, they are an inevitability. They are the reason why the returns of higher risk assets should be superior over time. We cannot have the long-term rewards without bearing the short-term costs. We need to have realistic expectations from the start.

2) Check we are holding the right investments: The caveat to ignoring the risks of major macro events is that we are sensibly invested in a manner that is consistent with our long-term objectives. If we have 100% of our portfolio in Russian equities, it might make sense to be a little anxious about recent developments. The more vulnerable our investments are to a single event, the more likely it is we have made some imprudent decisions.    

3) Engage less with financial markets and news: There is no better way to insulate ourselves from short-term market noise and become a better long-term investor than to disengage from financial markets. Stop checking our portfolio so frequently and switch off the financial news. 

4) Educate ourselves about behaviour, not macro and markets: What really matters to investors is not the latest macro event or recent markets moves, but the quality of our behaviour and decision making. We need to shift our focus. The asset management industry can do a lot to help here because at present it does little but promote noise and unnecessary action, inflaming our worst behavioural tendencies.

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Provided we are appropriately diversified, the real investment risk stemming from major macro events is not the issue itself but our behavioural response to it – the injudicious decisions we are likely to make because of the fears we hold.

We need to find a way of worrying less about markets and more about ourselves.

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* As I hope is obvious, this observation is purely from an investment decision making perspective. Macro events will often have profound human consequences, which we should absolutely not disregard.  

I have a suspicion that over recent weeks and months you have become aware of a puzzle called Wordle. A simple, web-based word game that has become staggeringly successful since its October 2021 launch; so much so that the New York Times recently purchased it for a seven-figure sum. Both the structure of the game and its rise to popularity provides timely reminders of some crucial investment lessons:

1) Most activities are a combination of luck and skill: Like investing, Wordle is an activity that combines luck and skill. There are approaches that can be adopted to improve our odds of success (the word we choose to begin with, for example), but they don’t guarantee a good outcome. In any given game a statistically supported and robust approach can be outdone by someone starting with the word ‘toast’ because they were playing whilst eating breakfast. Over time, however, good decision making should win out.

2) How we start matters: Our fortunes in a game of Wordle will be heavily dependent on how we begin. A poor choice at the start, or some bad luck, will have a significant impact on our end results. Investing is about making sensible decisions at the beginning and sticking with them.

3) The usefulness of new information depends on the environment: Wordle is a small, stable game with a limited range of outcomes, where the new information we receive improves our chances. Investing is vast, chaotic and uncertain. We can never be sure what information is relevant, or how to apply it.  How helpful new information is depends on the environment we are in.

4) Going with our gut is probably a bad idea: Once we know some of the letters and their position, we will inevitably get an instinctive reaction as to what the correct word is (we might call this a system 1 response). Following how we feel rather than working to a plan will probably lead to poor choices and inferior outcomes. 

5) We don’t like missing out: We are social animals. We want to do what other people are doing and hate to miss out. This applies to the puzzle game that everyone is playing and the latest investment craze.

6) People enjoy showing off their successes: A key element of Wordle’s popularity is the ability to share our results on social media. Much like investors (selectively) lauding their investment performance on Twitter, we find it hard to resist highlighting our wins.

7) It is difficult to predict fads and fashions: Is Wordle significantly and obviously better than every other word puzzle game available that has not gripped our attention in the same manner? Probably not. Its resounding success is likely a result of a confluence of unpredictable factors such as timing, narrative and social connections. That is not to understate the attractions of the game, but in a parallel universe it may never have captured the public’s attention. We cannot hope to predict what games, stocks or themes will grab our imagination in the future, nor when the enthusiasm will abate.

8) Simplicity is powerful: The beauty of Wordle lies in its simplicity. It is easy to understand, has broad appeal and is quick to play. Achieving this type of simplicity is incredibly difficult. Its realisation was perhaps aided by the fact that its creator initially designed it as a game to play with his partner – it wasn’t intended to be a product to monetize. When we are designing something with the aim of selling it, we often have a bias towards complexity to prove our sophistication, evidence endeavour and ward off the threat of competition. This is certainly the case in investing where simplicity works, but complexity sells.

9) Costs matter: Wordle is (currently) free, it is almost certain that its enormous popularity would not have occurred had there been a charge to play. Costs are a critical factor in success.  

10) Games are meant to be fun; investing isn’t a game: Although there are ‘optimal’ approaches to solve Wordle that improve our probability of a quick win, it is fine to ignore them. Wordle is a game and supposed to be enjoyable. Taking a studious and deliberate approach will suck the joy out it for many players. We should be happy to just go with how we feel. Contrastingly, investing is not a game and if it gets fun or exciting, we should start to worry. Unlike Wordle, taking a boring, evidence-based approach that gets the odds on our side is always the right thing to do.

I am sure I have bored plenty of people in recent years by repeating the mantra ‘process over outcomes’. There is probably no more important frame or model to apply when considering how we make investment decisions. In an environment where skill is often overwhelmed by luck and randomness the more we focus on results alone, the worse our results are likely to be.

Drawing a strong and consistent link between process and outcomes is critical to making good judgements, but it is not everything. There is a third element that is often lost or obscured, but should be the starting point for any investor:

What do we believe about investing?

This seems to be an incredibly simple concept, but a clear sense of the investment beliefs that inform our actions is so often lacking. Without this it is almost impossible to assess the validity of an investment process, or gauge whether it is likely to lead to better outcomes.

The Three Parts of an Investment Decision

We can think about investment decisions as being based on three key parts:

Beliefs / Process / Outcomes:

Beliefs: These are the ideas that we hold to be true about investing. They can be broad, or specific to a problem that we are attempting to solve.  

A passive, index fund investor might believe that there is no reasonable means of consistently improving on the returns of the market. An active fund manager with a quality orientated equity strategy might believe that investors underappreciate the persistently high returns on capital from certain types of companies.

These types of beliefs must be the foundation of any investment decision.

Process: A process is the actions carried out or the steps designed to link beliefs to outcomes. We start by believing something about markets and then create a process that reflects our beliefs to deliver the desired results.

Outcomes: Outcomes have two distinct forms – at the start and end of an investment decision. At the beginning, outcomes relate to the goals or objectives we have – our investment intentions. At the close, they are the end results – a pure consequence of our beliefs and process.

The ultimate outcomes are the one element that we cannot control; although, ironically, it is the one we spend most of our time obsessing over.

Why do beliefs, process, and outcomes matter?

Without considering beliefs, process, and outcomes it is highly unlikely that we will make good investment decisions. 

It is incredibly common to see investment processes (at times quite complex in nature) that are not supported by any clear investment beliefs. This is odd. Presumably to create a process to make an investment decision, there must be an underpinning belief – or what is the point of the process?

There are two major errors investors make in this regard. First is to mistake an optically rigorous process (complex, lots of steps) for a good one. A process doesn’t exist in a vacuum, it can only be as robust as the beliefs that it is attempting to enact or exploit. Second is when investors focus solely on whether a process has delivered in the past, rather than why it should (or shouldn’t) work.

It is difficult to assess the credibility of a process without understanding the beliefs that support it. This is irrespective of how robust it may appear, or how comforted we might be by the historic results it has generated. A process (or decision) must be founded upon an explicit or implicit set of beliefs.

It is perfectly possible to have an investment process and not realise what the underpinning beliefs are, although I would not recommend it. 

The Problem with Beliefs

Having a set of beliefs supporting our investment decisions doesn’t guarantee success, but it at least gives us a fighting chance. There are, however, some obvious pitfalls:

Beliefs are wrong: Although holding investment beliefs is essential, it does not mean that they will be correct. In fact, we all have investment beliefs now that are likely to prove erroneous (I certainly do). Possessing a set of beliefs should not mean that they are immutable – rather things we believe to be true based on our assessment of the available evidence. We should always be willing to change and adapt; although if our beliefs are shifting too frequently, they probably don’t qualify as beliefs. 

Beliefs are too vague: Some investment beliefs are so vague they don’t really mean anything. We should be able to read or hear someone’s investment beliefs and have a clear idea about what that might mean for the design of a process or the decisions that they will make. Too often this is not the case, so the beliefs are rendered worthless. A vague investment belief is akin to someone being asked whether they are religious and they say “No, but I am spiritual”; it tells us something but nothing specific enough to enlighten.

Beliefs are inconsistent with process: There can often be a disconnect between our stated investment beliefs and the process we adopt. Let’s say there is an active fund manager who believes that a long time horizon is essential to delivering excess returns but has a process that is likely to lead to high short-term turnover in underperforming positions. They do so because they think they will be fired if they trail the market for a sustained period. Although this seems like an incentive misalignment issue, it is also a question of beliefs. In this situation the investment process is designed based on what the fund manager believes is required to keep their job. Investment beliefs are subordinate.

A high quality investment decision must always have a thread linking beliefs, process and outcomes.

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Investors can take huge strides towards better decision making by dialing down the incessant noise of headline performance, and instead focusing on the underlying processes that have led to certain results. But that is not enough. We also need to spend more time thinking about what we believe. Every decision we make says something about our investment beliefs, we should be clear about what they are and why we hold them.