Two years ago value investing was dead, now it is the obvious approach to adopt in the current environment. What has changed? Short-term performance. There are more captivating rationales but underlying it all is shifting performance patterns. These random and unpredictable movements in financial markets drive our behaviour and are the lifeblood of the asset management industry; but they are also a poison for investors, destroying long-term returns.

Narratives + extrapolation

The damage wrought by our fascination with short-term performance is a toxic combination of two behavioural impulses– narrative fallacy and extrapolation. Narrative fallacy is our propensity to create stories and seemingly coherent explanations for random events; a means of forging order from noise. Extrapolation is our tendency to believe that recent trends will persist.

Short-term performance in financial markets is chaotic and meaningless (insofar as we can profitably trade based on it); but we don’t see this; instead, we construct stories of cause and effect.  Not only this, but the tales we weave are so persuasive we convince ourselves that they will continue.  

This is why when performance is strong absolutely anything goes. Stratospheric valuations, unsustainably high returns, made up currencies and JPEGs of monkeys cannot be questioned – haven’t you seen the performance, surely that’s telling you something?

Of course, it is telling us very little of use. It is just that we struggle to accept or acknowledge it. There must always be a justification.  

Performance is not process

In the years before the stark rotation in markets, I noticed a fund manager frequently posting on social media about the stellar returns that they had generated. Their approach was in the sweet spot of the time – companies with strong growth and quality characteristics, often with a technology element – but this was never cited as a cause of the success. Instead, the focus was on how their process and sheer hard work had directly resulted in consistent outperformance over short time periods. They were simply doing it better than other people.

This was palpable nonsense. Financial markets do not provide short-term rewards for endeavour. Nor can any investment approach consistently outperform the market except by chance (unless someone can predict the near future, which if they could, they wouldn’t be running money for us).

Many investors, however, seemed to accept this. Why did they laud such a bizarre notion? Because performance was strong. If performance is good a fund manager can say almost anything and it will be accepted as credible (that must be right, haven’t you seen their performance?) If performance is bad then everything said will be disregarded (don’t listen to them, haven’t you seen their performance?)

The problem with extolling short-term performance as evidence of skill (rather than fortunate exposure to a prevailing trend) is what happens when conditions change. If we say that our process leads to consistently good short-term outcomes, what do we say when short-term outcomes are consistently bad?

When performance is strong it is because of ‘process’, when it’s weak it is because of ‘markets’.

Sustaining the industry

Although the fascination with short-term market noise is a major impediment for investors, it serves to sustain the scale of the asset management industry. There is an incessant stream of stories to tell, fund managers to eulogise or dismiss, and themes to exploit. If financial markets were boring and predictable the industry would be a very different place.

Not only do the vacillations of markets give us something to talk about, but they also give us something to sell. The sheer number of funds and indices available to investors is a direct result of the randomness of short-term performance. There will always be a new story or trend to exploit tomorrow.

The impact of the reams of ever-changing narratives is compounded by our inclination to mistake positive short-run performance for skill. If investors struggle to disentangle luck and skill it means unskilled fund managers are rarely ‘competed out’ of the industry. It also incentivises new entrants – I have no skill in picking stocks, but if I selected a random portfolio there would be a decent chance of me outperforming over one year or three years, maybe even longer. It is a pretty lucrative business, so I might as well give it a go.

If we make judgements based on short-term performance everyone will look skilful some of the time.

ESG scrutiny

We have recently been witnessing an emerging backlash against ESG investing and, as the obverse of the resurgence of the value factor, this has undoubtedly been fuelled by weak short-term performance. Returns from ESG leaders, in-vogue companies and aligned industries have lagged and therefore the narrative has changed – outcomes are bad, maybe everything about it is bad.

The underlying problem is that any benefits of ESG investing were consistently obscured by unsubstantiated and unrealistic claims about its return potential. ESG investing was never (and should never have been) about the performance of any given fund or area of the market over arbitrary time horizons. As soon as we base the credibility of something on its potential to deliver short-run performance we are simply waiting for the reversal.

The desire to link every aspect of investing to the vagaries of short-term performance does nothing but scupper long-term thinking.

Misaligned incentives

The obsession with short-term performance is a vicious circle. Everyone must care about it because everyone cares about it. We can be the odd one out, but also out of a job. 

This creates a pernicious misalignment problem where professional investors aren’t incentivised to make prudent long-term decisions; they are incentivised to survive a succession of short-time periods. Irrespective of whether this leads to good long-term results.

The best way to preserve a career is to think short-term.

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The more we are gripped by short-term performance, the worse our long-term returns will be.

Any investor with the ability to adopt a long-term approach has a profound and sustainable advantage, there are just very few of us able to exploit it.  

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.