Much of the focus on the dramatic and unprecedented sell-off in gilt markets this week has been centred on the technical factors that led to an intervention from the Bank of England, potentially worth £65bn. Whilst the tribulations of the Liability Driven Investment strategies used by pension schemes are both fascinating and concerning, these periods of extreme stress are not just about the technicalities – they also provide acute behavioural lessons:

Small sparks can lead to great damage in complex systems:

The catalyst for the dramatic rise in gilt yields was the new leadership’s ‘mini-budget’. Which precise part of Kwarteng’s proposal led investors in UK assets to panic? The removal of the highest rate of tax, the unfunded nature of the proposals or the lack of independent oversight from the Office for Budgetary Responsibility? Everything and nothing. It doesn’t matter. In deeply complex, interconnected systems small sparks can precipitate dramatic and destructive feedback loops.

Markets are about the behaviour of other investors:

Financial markets are about the decisions made by other people. Most investors do not assess new information about an asset based on how it impacts its cash flows and valuation, but how we believe other investors will respond to that same information. This creates vicious and virtuous circles. In periods of severe turbulence this feature of markets is taken to the extreme. Our decisions become driven by the fear and cost of being the wrong side of momentum shifts. We want to be in the herd during the stampede, not underneath it.

Predicting when things will happen is close to impossible:

The fact that complex systems can be compromised by small events doesn’t simply make them riskier than we might normally perceive. It makes them even more difficult to forecast than we realise. Even if a system has inherent fragilities, anticipating when these will be exposed (if ever) is an incredibly difficult, perhaps impossible, task. Investors should never try to predict when things will happen.

Both financial and mental models can break under stress:

It is inevitable that the scale and speed of the rise in gilt yields would have torn asunder many ‘worst case’ assumptions that have been made in financial models. Whether it be the stress tests or scenarios used to judge the appropriate collateral buffers in an LDI strategy or the predicted drawdown in cautious (but duration heavy) portfolios, some models will have been found wanting. This is to be expected – models are an abstraction, a simplified version of something too chaotic to replicate. Not only that, but the output of financial models is inexorably shaped by what has happened before. In a complex system, things tend to break in the future in a different way to how they broke in the past.

It is not just the limitations of financial models that leave us vulnerable, but the mental models that investors use. Inescapably, the mental models we apply to inform our investment decision making are framed by what we have experienced. For most that means years of tranquil market conditions, moribund inflation, and interest rates at close to zero. When the environment shifts it can leave us incredibly exposed.  

Short-term performance chasing sows the seeds of future pain:

One of the major casualties of the remarkable increase in yields has been defensive or cautious funds, some of which are nursing losses of more than 20% across the year. Many of these strategies have used a heavy allocation to long duration bonds to provide a ‘low volatility’ return stream and diversification alongside the growth assets held in a portfolio.

It is easy to now be critical of the unappealing ‘return free risk’ of owning long duration bonds with very low return prospects, but it is important to remember the context. Holding such assets had worked well for years (decades). Investors who came to find the combination of close to zero returns and (potentially) severe volatility unappealing likely found themselves underperforming their peers and benchmark. The more pressure investors feel about poor short-term performance – ‘being underweight duration led to underperformance again this quarter’ – the greater the temptation is to fold. Unfortunately, there is often a choice between keeping to our long-term investment principles or keeping our job and assets. We cannot always do both.

Market shocks leave scars:

The type of market shock we have witnessed in the past week will undoubtedly leave scars. Not simply in terms of unrealised and realised losses, but future behaviour. What will the consequences be? Changes to collateral buffer requirements for LDI strategies seems obvious (we have a new scenario to use in the risk model). What about cautious and defensive portfolios – are long duration assets now less palatable? (Ironically, they are far more attractive now than they have been in recent years). Will it now be more acceptable to hold high cash levels in a portfolio? The trend towards global bond and equity exposure at the expense of a domestic (UK) bias will almost certainly gain even further momentum.

The memories and consequences of stressful events unavoidably shape our future behaviour. Some changes will be an irrational reaction to an idiosyncratic occurrence, others might be more sensible. Some behaviour shifts will fade, others will prove long lasting.  

Our model for how things work has changed, and it will change again.

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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.

In his new book on decision making, Ed Smith, who was responsible for the selection of the England Men’s cricket team between 2018 and 2021, discusses the challenges of innovative thinking.[i] He quotes poker player Caspar Berry:

“Whenever someone innovates in business or in life, they almost inevitably do so by accepting a negative metric that other people are unwilling to accept”.

Smith cites the dramatic increase in the number of 3-point shot attempts in the NBA in recent years – a revolution led by the then Houston Rockets General Manager Daryl Morey – as an example of pre-existing norms being broken because of a willingness to accept a negative metric (the increased failure rate when attempting the higher value shot).

It is not just in sport where this concept prevails. It matters for investors too. Whenever we attempt to make decisions with the aim of improving returns, we must also be willing to experience unpalatable negative metrics.

The simplest investing analogy that encapsulates the requirement to accept a negative metric is in active investing. Growth investors deviate from their benchmark because they have willingness to accept higher valuations; whilst (traditional) value investors may suffer from a portfolio with lower sales growth, weaker profitability, and potentially higher levels of debt.

Yet these simple figures miss the point. The critical aspect of a readiness to assume a negative metric is not the number itself, but the experience and consequences of deviating from what is expected. The cost to Daryl Morey of his team’s increasing propensity to take 3-point shots was not the lower successful shot percentage. It was the reputational risk, the anxiety of being the outlier, the threat of failure – all the stresses and pressures that come from diverging from the norm.

We can observe these trade-offs right across the investment landscape. Let’s take the equity risk premium, one compelling explanation for the long-run return advantage to equities is myopic loss aversion – higher returns are the compensation required for the pain of short-term losses. If we want to enjoy the benefits of long-term equity investing, we need to accept the behavioural pain and embrace the negative metrics.

On a more granular level, this is exactly the situation faced by active investors. Prolonged bouts of underperformance are inevitable – even if we happen to possess the ability to deliver long-run outperformance. It is pointless even having conversations about investor skill if we do not have the appetite or wherewithal to withstand the uncomfortable behavioural realities of active investing.

To make matters worse, negative metrics are not something that only appear on the road to success, it is also a feature of the path to failure. When we diverge from the crowd or consensus, we might accept negative metrics and still be wrong.

The most damaging situation for investors is where we take decisions with the intention of enhancing our performance, but don’t acknowledge or accept the negative aspects that we will have to endure to achieve it. If we invest in equities but don’t understand that gut wrenching bear markets are the price of admission, we will sell at the most inopportune time. If we invest in active funds and expect consistent outperformance over months, quarters and years we will pay the exorbitant tax of incessantly switching from near-term losers to yesterday’s winners.

Any investment decision comes with pain points and costs, failing to recognise and accept these will lead to consistently poor decisions.

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[i] Smith Ed (2022). Making Decisions: Putting the human back in the machine. William Collins

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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.

Learning the skills required to become a good investor should be easy. There is plenty of information, decades of evidence and many willing teachers. Despite this it is anything but – we only need to look at the consistent and costly mistakes that we all make to acknowledge how tough it is. But what makes it quite so difficult? Terrible feedback loops. Effective feedback is critical to good learning, but in investing these feedback loops are as unhelpful as they could possibly be. Long, noisy and erratic.

The first time we put our hand on a hot stove, we quickly learn that it is a bad idea. Why is this? Because the feedback loop is short and direct. The immediate heat and pain provide an incredibly salient lesson in what not to do in the future. Unfortunately, not all feedback loops are this efficient.

If we break down the critical features of a useful learning feedback loop, we can see why investing is so problematic:

Feedback	Easier Learning	Harder Learning
Response	Short	Long
Results	Clear	Unclear
Impact	Minor	Major

Response: Rapid responses are vital in being able to understand immediately what a sensible course of action looks like. If we only felt pain in our hand two years after we put it on the stove, then the lesson really isn’t that valuable. If we want to make good decisions in the future, we need to receive good quality feedback as quickly as possible.

This is a real problem for investing. A long-term approach is critical for most successful investors, but – by definition – we only reap the rewards of this over time. We don’t get helpful instant feedback. We must wait and trust that we will get the right outcomes from the choices we make.

Results: Feedback is most useful when the link between our actions and results is clear. We have no doubt that the consequence of touching the stove is the burn on our hand. Things become much trickier when there is blurring between our choices and their outcomes.

Measured, sensible and evidence-backed investment decisions will often appear the opposite. They will frequently be outshone by investors engaging in ill-informed, wild speculation. This is particularly problematic over short time horizons, where meaningless noise dominates outcomes.

Imagine we are taking an exam. We know that nobody else in our class has studied, they barely even turned up to lessons. We have worked diligently and prepared to the best of our abilities. When the results come out, however, we find out that we are bottom of the class. We inevitably question why we bothered to work so hard and wonder whether we should follow the more relaxed approach of our classmates.

This is the situation faced by an investor trying to learn the craft. Good decisions will often receive feedback (in terms of short-term performance) that looks poor. So how can we be confident that we are doing the right thing?

Impact: Learning from short feedback loops only works if the impact from negative feedback is minor. Discovering that jumping from a tall building is a bad idea is excellent feedback, but the consequence is so severe that it is not that useful in the future.

Investors might receive valuable feedback on the dangers of concentration, the risk of leverage or the warning signs of investment fraud. These lessons are not so valuable if they come only after catastrophic losses.

The learning feedback loop for investment decisions is long, wildly erratic, and often too consequential.

How Do Investors Learn?

Investors learn in two ways. From our own experience and from the experience of others. It is often assumed that the most valuable form of learning is personal experience and whilst there is some truth to this – I have certainly learnt a great deal from my investing mistakes – it is not entirely accurate.

Our own personal sample size is simply too small. We will only have a narrow and particular set of experiences – and that just isn’t enough. It is far too easy to learn the wrong lessons. Imagine we are fortunate enough to begin investing in the early days of an investment bubble. We might go through years of learning about how valuations don’t matter, stories are everything and prices only go up. That is what our feedback has told us.

So, we must rely on others to learn how to make good investment decisions. Whilst this is better – it gives us a far more robust body of evidence – it is still challenging. Now we have so many samples to choose from we are easily confused – who and what should we pay attention to?

How to Learn Without Good Feedback Loops

Noisy and long feedback loops makes learning to make good investment decisions incredibly difficult. It means there will be times when we are likely to doubt even the most unimpeachable principles – such as the prudence of diversification. There are, however, several steps we can take to help address the problem:

Ignore near term feedback as much as possible: Unless we are short-term trading (good luck), then we need to ignore the random fluctuations of markets – even if there is a compelling story attached. It rarely tells us anything useful.

Decide what type of feedback is useful: Although disregarding short-term performance is vital for most investors, it is not reasonable to wait 40 years to judge whether you have made a sound decision. Instead, we need to consider what type of information would be helpful in assessing the quality of the decisions we have taken. For example, if the performance of our investments is wildly more volatile than we were expecting – this is probably helpful feedback. We should set some reasonable expectations to compare our results against.

Understand that our own experience is a very small and biased sample: We can learn from it, but it can also be deeply misleading.

Learn the right things from the right people: Learning from the experience of others is essential for investors, but it also leaves us vulnerable. From day traders posting their successes on Twitter to an outright snake oil salesman selling get rich quick trading schemes (to make themselves rich), there are more bad lessons out there for us than good ones – and, to make matters worse, the bad ones are more exciting.  Unlike school, in investing the best lessons are the boring ones. We should learn from those who have the right alignment of interests, similar objectives and plenty of experience.

Weigh evidence correctly: Not all evidence is created equal. The vast amount of information and noise around financial markets means that good learning involves being able to filter evidence that is robust (broad, long-time horizons, sound principles) from that which is flimsy (narrow, transitory and biased).

Focus on general principles rather than specific stories: Understanding principles that are likely to hold through time (the importance of valuation, the power of compounding or the benefits of diversification) is likely to be far more worthwhile than learning specific ideas about markets, assets or trading techniques, which will often prove fleeting. These principles can become models that we can apply across all types of investment decisions.

The feedback problem makes learning to become a good investor incredibly difficult, at times it can feel like learning to play the piano but where each time we hit the correct key the wrong note sounds. It is easy to become disenchanted.

Any useful feedback we receive will often be too late, either because something has gone badly wrong or because meaningful results only emerge over time. There is no easy solution to this. Investing is an exercise in dealing with short-term noise, deep uncertainty and profound behavioural challenges.  The best we can do is base our decisions on sound principles, always be willing to learn and understand that most short-term feedback can be happily ignored.

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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.

Selecting an active fund that will outperform its market capitalisation benchmark through time is an exacting challenge. We have all seen the bleak data regarding just how few funds deliver long-term excess returns in most (but not all) asset classes. It is, therefore, easy to make the argument that markets are simply too efficient and there are not sufficient opportunities for active investors to exploit, but this doesn’t hold water. Even if markets were efficient, we would expect a reasonably even distribution of outperformance and underperformance from active investors around this. Results would be random, but the probability of success would be somewhere near 50%. * In most cases, however, the odds of a positive outcome are far worse than this. But why?

There are three major issues that shift the probability of successful active fund selection from a 50 / 50 shot to something that can be close to zero: Fees, constraints, and behaviour. Any investor in active funds must manage these deliberately and well to give themselves a fighting chance:

Fees

Fees are the immutable, overwhelming impediment to successful active fund investing. They are a minor problem over any given year, but compound into a major, often insurmountable hurdle through time. The higher the fee level, the closer the probability of outperformance gets to zero.

People often misattribute the struggles of active management with efficient markets or incompetent professional investors, but this is generally not the case. The trouble is fees. Active funds are too expensive in aggregate, and this shifts our starting odds of success far lower than the 50% they would be before costs are considered.

In recent times there has been a conflation of two arguments: that low fees are incredibly beneficial to investors and that a market cap allocation approach is inherently superior to other methodologies. The first contention is true, the second is not. This mistaken thinking has arisen because most low-cost funds adopt a market cap indexing approach, and this methodology has enjoyed a prolonged period in the sun in many markets (the US in particular). There have been decades in the past where a market cap allocation has been inferior to other techniques (such as equal or fundamentally weighted).

The point is not that a market cap allocation is a poor strategy to adopt (it is perfectly sensible for most investors) but rather that the travails of active funds are more to do with the structural problem of high fees, rather than the cyclical issues of mega cap US companies making market cap indices hard to beat.

Staunch advocates of active fund investing often tend towards complacency on fees on the basis that certain managers are so skilful and will generate such a high level of alpha that the fee level isn’t a major concern. This is a dangerous mindset.

It is inconsistent to compare a certain cost with an uncertain benefit. If fees for an active fund are 1% and expected alpha is 2%, we need to haircut that forecasted outperformance for our own fallibility. We might be wrong that a manager has skill, or invest at an inopportune time (following a spell of stellar performance, for example). Active fund investors often talk about the hit rate required to be a successful fund manager (not much more than 50%), is it that different for fund investors? **

For active investors, reducing fees paid is the easiest lever to pull to improve the odds of success.

Constraints

Active fund investors must also seriously consider the constraints they encounter in their investment approach; these will substantially reduce their chances of delivering the desired outcomes.

The most obvious impediment is likely to be size. The larger the level of assets, the narrower the opportunity set and the more difficult it becomes to generate outperformance. Although (for obvious reasons) asset management companies do not like to acknowledge it, it is an inescapable fact that above a certain minimum viability threshold a rising level of assets impairs future returns. The extent of this hindrance will vary depending on the asset class involved but in almost all instances it is a major drawback.

It is not only size that serves to constrain active fund investors, but there is also a host of other implicit and explicit limitations that will impair returns and reduce the likelihood of success. ESG restrictions are an obvious area in the current climate, as are controls on variables such as tracking error or manager tenure. A requirement to recommend or own too many funds is also highly problematic (investment skill, if it exists, is scarce not abundant).

Some fund investors must even deal with disastrous constraints such as only holding funds that have delivered outperformance over certain historic periods (such as the last three years). This is the type of constraint that immediately puts the chances of long-run success at zero.

Anything that restricts the investable universe or limits the agency of the investor reduces the probability of successful active fund investing. It is critical that we know what these are before we start.

Behaviour

Even if we have skill in selecting active funds, manage fees prudently and face limited constraints, there is one thing that can make it all redundant – our behaviour. Active fund investors must be acutely aware of behavioural challenges (and be able to deal with them) if we are to have any hope of prolonged success.

The most significant behavioural challenge is related to time horizons. To invest in active funds there must be a willingness to not only hold for the long-term (we should be thinking ten years) but withstand the inescapable bouts of prolonged underperformance that will occur during these periods. Let’s be clear, on the time horizons and incentive structures of most fund investors, Warren Buffett would have been fired on numerous occasions.

An obsession with noise-laden short-term numbers – such as poring over quarterly results – or a bizarre fascination with the spurious idea of consistent calendar year outperformance are the type of traits that will eviscerate our chances of long-run success.

When owning an active fund for the long-term we will be regularly provided with reasons to sell. If an active fund manager has underperformed for three years, we will always be able to identify ‘process issues’ that have caused the underwhelming returns, and will not resist the urge of asking them “what are they doing?” to address their poor results (in most cases, hopefully nothing).

The added problem is that there will, of course, be times when selling is the correct course of action. Nobody said it was easy.

It is vital not to underestimate the harsh behavioural realities of active fund investing, but unless we are able to discard the rampant myopia and find ways to manage our preoccupation with short-run outcomes, we should be investing in index funds.

Improving the Odds of Success

This post has been somewhat negative as it has focused on those factors that make successful active fund investing so difficult, rather than address the positive steps that can be taken to improve the odds of success. Although I will cover this in another post in more detail, there are ways in which this can be done. Tilting towards empirically sound factors at a low cost (such as value, momentum and quality) should enhance long-term outcomes, identifying investors with skill is difficult but possible (it has little to do with past performance) and making counter-cyclical decisions (investing when valuations are cheap and performance is poor, rather than the reverse) is a painful but productive approach.

The problem is that the proactive measures we might take to improve our odds are irrelevant unless we first deal with high fees, burdensome constraints, and poor behaviour. These will conspire to overwhelm any other positive actions we might take. If we want to invest in active funds, we need to be clear about how we are going to address these three key issues. If we cannot then we really should not be doing it.

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*This is a deliberate simplification, which assumes no skew (lots of small funds outperform and a few large funds underperform, for example) and that active investors invest only in their defined market.

** It is, of course, not just a hit rate that matters but the win/loss ratio too.

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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.