As fund investors we spend a great deal of time deliberating the positive steps we can take to achieve better investment results. This is undoubtedly an important endeavour, yet there is something easier and more effective that should come first – deciding what we should not be doing.
Nassim Nicholas Taleb highlighted the benefits of a focus on eliminating errors in his book Anti-Fragile where he describes the theological idea of via negativa, which is a means of explaining God by virtue of what it is not, rather than what it is. Taleb broadened this concept to contend that it is easier and more beneficial to stop negative activities than to attempt to identify new, constructive behaviours:
“You know what is wrong with more certainty than you know anything else.” [i]
We can eliminate the mistakes that we know are damaging and costly far more easily than discovering positive behaviours that might improve our fortunes. The more complex and unpredictable the environment, the more likely this is to be true.
This is an approach that should be adopted by fund investors, who face an unfathomable array of choices and decision points. Rather than obsessing over how to define the precise allocation to the right funds at the right time – an incredibly difficult task – it would be more productive to first concentrate on the actions we should avoid. Prioritise omission over commission.
So, what is it that fund investors should not do?
1) Don’t buy into a fund after extreme positive performance: Abnormally strong performance on the upside is highly unlikely to persist, investing after a spell of stellar returns is a horribly asymmetric bet.
2) Don’t be concentrated by fund, manager, style or asset manager: Concentration is the surest path to severe losses, it implies we know far more about the future than we actually do.
3) Don’t predict short-term market movements: We cannot predict the short-term behaviour of markets or funds that invest in them. We should not make decisions that suggest that we do.
4) Don’t check short-term fund performance: Short-term fund performance is typically nothing more than random noise, checking it frequently encourages poor decisions.
5) Don’t use performance screens: Given that strong fund performance tends to mean revert, it is hard to think of a worse way of filtering a universe of candidate funds than by ranking on the strength of historic returns.
6) Don’t keep selling underperforming funds to buy outperforming funds: A common behavioural trait which feels good at the time we do it, but compounds into a pernicious tax.
7) Don’t buy thematic funds based on strong backtests: If a fund is being launched based on an in-vogue theme with a stellar backtest the chances are we are already too late.
8) Don’t invest in active managers if we cannot bear long spells of poor performance: Even skilful active managers will underperform for long periods, if that is unpalatable invest in index funds.
9) Don’t invest in funds if you don’t understand how they make money: Investing in things we don’t understand is a recipe for disaster.
10) Don’t persist with an active manager when they start doing something different: A circle of competence for a manager is usually incredibly narrow, if they are venturing outside of this we should avoid them.
Each of these prohibitions is attempting to do the same thing – establish a simple heuristic that is generally effective in a highly uncertain environment. Although most investors prefer to embrace positive actions, putting a stop to poor behaviour is a much easier win.
[i] Taleb, N. N. (2012). Antifragile: Things that gain from disorder (Vol. 3). Random House.