Something Has to Hurt

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.

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

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.