A friend of mine was out on a run. He was on his usual route going down a narrow lane when he came across an ominously large puddle – it had been raining torrentially for the past few days. There was no way around it, he either had to turn back or go through it. Although the puddle was long, he assumed it would be shallow, so forged ahead. It was deeper than he expected, the icy water quickly covered his shoes. Thinking that would be the worst of it he carried on. But it kept getting deeper. The water went past his ankles and he wasn’t quite halfway through. As he was already cold and wet there was no point turning back, so he checked to see if anyone was watching and continued his increasingly slow paddle.  As he persevered and the water splashed up to his knees he wondered how long he would keep going if the puddle got deeper still. He had visions of just his head bobbing above the water. Fortunately, knee-height was as deep as the puddle got and he didn’t get to test quite how far his prior commitment would take him.

This must have been a bizarre sight for any onlooker.  Why would someone try to run through a puddle that deep? No rational human would consider that to be a sensible idea. Yet, of course, my friend would have agreed with this, right up until the point that he decided to put his foot in the puddle. As soon as he made that decision, everything changed.

It is easy to think of the choices we face as discrete, one-off decisions with a set of specific consequences (good and bad), but they are not. Each time we make a decision it impacts the choices we will be able to make in the future – it might commit us to a certain direction or close off other potential routes. There is a huge amount of path dependency in the decisions we make. This means that we should not consider only the immediate implications of any option we pursue but also its consequences for our subsequent behaviour.

Why did my friend continue running through a ridiculously deep puddle? Because he had already committed to the action. Not only had he incurred the cost of being wet, but he also didn’t want to feel or look stupid for choosing to do it in the first place. If he persevered it might look intentional.

He had set a new path.

There are three aspects to a decision that tend to influence how influential it might be over our future choices:

1) Does it impact our identity?

2) Does it change our incentives?

3) What costs will it incur?

Although these are inter-related, we can consider them separately:

Identity:

Whether a decision serves to shape our identity can be critical to our future choices. How we see ourselves or how we wish other people to see us will have profound implications for the choices we make or even the opinions we express. Once we make the implicit or explicit choice to create a particular identity, every subsequent judgement we make is framed by a desire to manage and bolster that it. We strive to make decisions that are consistent with our desired image.  

We see this behaviour clearly in politics – once we make a choice to align with a particular party or doctrine, everything we see is through that lens. Investors are also frequently guilty of allowing views and opinions to morph into an identity, through which all subsequent judgements are filtered. Often irrespective of evidence.

Incentives:

Incentives drive behaviour, so we must be particularly wary of any decision that materially shifts our incentive structure. We are likely to significantly understate how influential varying incentives will be on our future choices. The most painful and damaging scenarios are where there is a dissonance between what we believe and the direction that our incentives are pointed – “I believe that financial markets are highly uncertain over the short-term, but I make money if my clients trade more”. To resolve such friction, we will tell ourselves all sorts of stories to provide psychological comfort. In the end it is likely that our incentives will re-shape our beliefs.

Costs:

Sunk costs wreak havoc with future decisions. Whenever we expended significant time, effort or money on a choice, we find it incredibly difficult to change course. The idea of the sunk cost fallacy is now ubiquitous but it does not make it any easier to overcome.  Admitting we were wrong, moving backwards, or accepting ‘wasted money’ are too often deemed unpalatable. When we think about sunk costs we shouldn’t consider them as historic mistakes, instead they are very much recurring costs that are impairing the choices we are making right now.   

—

When my friend was considering whether to run through the puddle, he was judging how likely it was to be deep, whether he minded soaking his feet and if it would ruin his running shoes.  What he should have been assessing is what he would do if he decided to go ahead and the water was too deep – how could he turn back? The consequences for his future decisions were just as important. 

If a choice has implications for our identity, the incentives we face or the costs we incur, we should be especially careful when making it. This is not just about the difficulty of quitting or the problem of commitment escalation, but how decisions made today can change everything about the decisions we will make tomorrow.

—

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

There are still too many people investing in active funds. Not because they are unnecessary, but because owning them comes with a unique set of behavioural challenges that we are often unprepared for. If we are to have any hope of benefitting from holding them, we must accept and embrace these. The worst – and all too common – scenario is investing in active funds whilst holding entirely unrealistic expectations about the realities of doing so. This dooms us to almost inevitable failure and disappointment. Before investing in active funds there are three questions we need to answer:

– Am I willing to own a fund for the long-term?

– Can I discount short-term performance?

– Can I withstand long periods of underperformance?

Let’s take these in turn:

Am I investing for the long-term?

As the investment industry has become increasingly myopic, I have had to moderate my view on what the long-term is because it seems too outlandish. I have heard people discuss the long-term as three years or more, but this is far too short  – it is much closer to 10 years. The longer our time horizon, the greater the odds of investment success.  Why is an extended time horizon so important? Because the shorter it is, the more our results are beholden to randomness and fickle swings in market sentiment. If we believe there is a strategy with an edge, we must give it time to play out, for fundamentals to exert themselves over noise. This does not mean that we must persist with an active fund whatever happens or that simply increasing our time horizon guarantees better results, but it at least gives us a fighting chance.

Can I discount short-term performance?

It is one thing to say that we are willing to own a fund for the long-term, doing it is another thing entirely. The biggest impediment to long-term investing is obsessing over short-term performance. Not only is it an entirely fruitless activity that sees us attempt to read patterns in the chaotic fluctuations of financial markets, but we persistently make poor decisions based on such fleeting observations. Each time we check performance, write a report or hold a meeting we are creating a decision point; another opportunity to make a near-sighted judgment. We need to be realistic about our situation – if the short-term matters (whether we want it to or not) active funds really should not be for us – it will simply mean constant anxiety and frequently poor choices.

Can I withstand long periods of underperformance?

Although incredibly damaging, the hardest part of active fund investing is not the senseless fascination with short-term performance, but the prolonged and painful periods of underperformance that are an inevitable feature of any active strategy. All skilful (and unskilful) active fund managers will go through years of underperformance – this is inescapable. Living though this on a day-by-day basis is exhausting and exacting. The doubts about the strategy – whether the manager has lost her edge, whether the process is broken or the market environment irrecoverably changed – will often be overwhelming. Yet if we want to successfully invest in active funds then we need to find a way to withstand them.  The alternative is believing that we can time our investment into active funds so that we capture the good times and avoid the bad (we can’t).

The problem with this required fortitude is that it is music to the ears of the unskilled active fund manager who will be delighted if we persist in investing with them despite their lack of ability, but this is the job of the active fund investor – to identify skill without relying on past performance.  If we cannot tolerate lengthy spells of poor relative returns, we should not be investing in active funds.

—

If we answer these three questions in the affirmative, it does not mean that we should invest in active funds; these are simply the minimum entry requirements before we even consider attempting it. If we answer any of them negatively, we really should not be doing it at all.

None of these features are easy to deal with or manage, in fact the behavioural aspects of active fund investing are just as tough as finding a manager or strategy with an edge. Far too many investors neglect this and leave themselves in a position where the odds of success become vanishingly small. 

—

My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.