Why Can’t We Stop Changing Our Investment Process?

Imagine we are attempting to design a stock picking model that will outperform the market over the next ten years. After a great deal of forensic research and testing we finalise our approach. Although we couldn’t know this in advance, the system we devise is optimal – there is no better way of tackling the problem we are trying to solve. Given this, what are we likely to do with the investment process we have developed over the coming years?

Change it and make it worse.

Even if we design a perfect investment approach the temptation to tinker and adjust is likely to prove irresistible. Why is it so difficult to persevere even when we have a sound method?

There is a mismatch between short-term feedback and long-term goals: If the objective of our investment process is long-term in nature; using short-term performance as a means of assessing its robustness is likely to be at best meaningless and at worst entirely counter-productive. All investment approaches will endure spells in the doldrums and reacting to these with constant process modifications is a certain path to poor results.  

The need to always be doing something:
Keeping faith with an investment process for the long-term means a lot of time doing nothing. This sounds easy but is anything but. Financial markets are in a constant state of flux, perpetually generating new and persuasive narratives. Temporary fluctuations in markets often feel like a secular sea change when we are living through them. The urge to act is strong.

Doubting the process:
When our approach suffers from poor short-term performance there will be intense pressure to change. This will be through internal doubt (what if my process is broken?) and, for professional investors, external pressures – ‘you are underperforming, do something about it’. Changing our process can make us feel better (less stressed, pressured, anxious) even if we don’t believe it is the right thing to do.

Feeling in control: The instability and uncertainty in financial markets can be deeply disconcerting; process adjustments can, erroneously, feel like we are wrestling back some form of control.

Overweighting recent information:
Recency bias means that we will tend to overweight the importance of current events and heavily discount the past. Given the inherent variability of financial markets over short time periods this will mean we are continually tempted to adjust our process based on what is happening right now.

Our ability to have a positive impact is hugely overstated. If we have a prudent investment approach to start with, improving it is not likely to be easy. We will inevitably grossly exaggerate our ability to implement changes that will improve our odds of success.

Optimising not satisficing:
Our desire to adjust and attempt to enhance our investment process is driven by a belief that we should be optimising – finding the very best solution. While this is a noble aim in theory, the profound uncertainty of financial markets makes it dangerous in practice. An eternal and elusive search for the best investment process is likely to lead to at least as many bad decisions as good ones. Satisficing – adopting a strategy that is good enough – and maintaining it is likely to be the best route for most of us.

Intellect over behaviour:
Our process changes will tend to be focused on the intellectual pursuit of finding new sources of information or applying them in different ways. Scant attention seems to be paid to the behavioural challenges of investing. The most robust investment approach will be torn asunder if we don’t have the fortitude to persevere with it.

It may seem as if I am suggesting that we should never attempt to improve our investment process. This is not the case. Striving to learn and develop is vital. It is critical to understand, however, that our tendency will inevitably be to do too much, often at the wrong time. We need to have an appropriately high threshold for change.

Never underestimate the advantage gained by an investor who has a sensible method and can stick with it.

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 get a copy here.

Should We Listen to Outperforming Fund Managers?

Outperforming fund managers are dangerous for investors. Performance is cyclical and often mean reverting, and we tend to invest after periods of unsustainably strong returns. If these features aren’t damaging enough, there is another problem. If a fund manager has a strong track record we listen with rapt attention to everything they say about anything. If their returns are poor, we disregard their words. This may sound sensible but it is anything but.

We can see this phenomenon with certain growth / quality orientated active fund managers in recent times. As they generated stellar returns for a decade, we were hanging off their every word. Happy to treat them as sagacious on whatever subject they chose to opine on. Now performance has deteriorated our reaction to their utterances is more likely to be: “why would we listen to this idiot, haven’t you seen their returns over the past year?”

This mindset set is steeped in two behavioural issues: outcome bias and the halo effect.  Outcome bias means that once we see the result (in this case fund performance) we jump to a conclusion about the quality of the process that led to it. The halo effect is where an individual’s success in one field means that we (usually erroneously) hold a positive view of anything else they turn their hand to.

This is a toxic combination, which leads us to pay attention to people we shouldn’t and ignore those we should take heed of.

Why is it such an issue?  

There is a huge amount of luck involved in investment outcomes: From the unique life experience of a star fund manager to the early morning ice bath routine of a successful entrepreneur, we cannot help drawing a causal link between an individual’s success and their past actions. Yet so often the outcomes we see are nothing more than a mix of luck and survivorship bias, this is particularly true in the field of fund management.

Fund manager performance is cyclical: For even the most talented investor their fortunes will move in cycles. Periods in the sun will inevitably be followed by spells in the doldrums, even if the long-term trend is positive. Our use of performance as a marker for credibility means that we will frequently see the words of the prosperous chancer as more convincing than someone with genuine expertise.

Expertise is particular: Skill in investing, where it exists, is narrow and specific. Yet once a manager is outperforming, they have the freedom to confidently pronounce on any subject within the universe of financial markets (and sometimes far wider than that). Not only do they pontificate on these issues but we are willing listeners – their track record doesn’t lie! The pinnacle of this behaviour is where a fund manager – through some combination of hubris and necessity – shifts into an entirely different area to the one in which they forged their reputation and investors follow in their droves. This always ends well. 

We use past performance as a heuristic. In this context, as a quick and simple shorthand to give us an easy answer to the complex question: Should I pay attention to what this person is saying?

Amidst the squall of investment voices that surround us applying a (industrial strength) filter is essential, but if past performance is fickle and ineffective how do we go about it? There are three simple questions we should be considering:
1) Is it a relevant subject? The critical starting point is asking whether the subject is even worth our time. Is it something that matters to our investment outcomes and where expertise can exert an influence? If it is someone speculating on what will happen in markets over the next three months, we can happily disregard it.

 2) What are their motives?  We should always be sceptical in listening to a perspective from someone who is trying to sell us something, but this is not as straightforward as it may seem. If an investor genuinely believes in what they are doing, then they will inevitably be seen as “talking their book” but what else would they talk? It is not always easy to separate a knowledgeable advocate from a slick salesperson. The best differentiators are probably consistency, humility and depth.

3) What is their circle of competence? Judging an individual’s circle of competence is essential, and there are two aspects to consider. First, we need to understand the specific expertise they may possess. We should be as precise as possible here – “investing” does not count! Second, we must gauge why the individual has pedigree and credibility in their field, particularly relative to others.  

This approach may not quite be as effortless as checking whether a fund manager has produced stellar performance before deciding whether to pay attention, but it is likely to be more effective. The fact that there are far too many voices distracting investors is problem enough, we don’t need to compound the situation by listening to the wrong ones.

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 get a copy here.

Do Active Funds Need a New Fee Model?

The long-term struggles of active funds versus index funds is primarily a problem of fees. There are other factors that influence the success rate of active strategies – most notably, in equities, the performance of small and medium sized companies relative to their larger counterparts – but it is the compound impact of highs costs over the long-term that causes most of the damage. Attempts to create charging structures that diverge from the simple % of assets under management model are typically focused on the use of performance-based fees, but in the vast majority of cases these (somewhat counter-intuitively) increase the negative asymmetry experienced by investors. Too often we pay lavish short-term rewards for underwhelming long-term results. To improve the odds of active fund success, the fee model needs a rethink.

One of the most egregious problems faced by fund investors is the problem of scale. As the size of a fund grows its profitability for an asset manager increases materially. Not just in terms of the revenues generated, but the profit margins. High operating leverage means that the marginal cost of an additional $100m invested into a $10bn fund is low. It is in the interests of asset managers to keep growing their largest funds.

There are two major difficulties that this model causes investors. First, is that the benefits of scale rarely have a material impact on the costs that they incur. As fund size grows and costs are spread across a greater revenue base this results in an improved margin for the asset manager but rarely a meaningful fee saving for the investor. Second, above a minimum threshold the growth in assets of a fund reduces the potential for future excess returns. Rising fund size means that the opportunity set is reduced, flexibility is compromised, and liquidity deteriorates.  

We are left with a situation where the investor faces a lower probability of outperformance whilst the profitability of a fund for an asset manager increases.

This is a major incentive problem for asset managers and creates a jarring misalignment with the objectives of their investors. Undoubtedly it is one of the primary reasons that funds are so rarely closed due to capacity constraints.

Is there a way of mitigating this problem and improving the situation for fund investors?

One option is to apply a $ revenue cap. How would this work?

A fund would launch with a standard fee level, let’s say 0.5%; but there would be a provision stating that all revenue earned over a certain amount ($Xm) would be reinvested into the fund. This would mean that above a given threshold of assets under management the benefits of scale would accrue to the underlying investors and provide compensation for the cost of asset growth in terms of declining performance potential. It would also greatly reduce the incentives of asset managers to ride roughshod over capacity concerns.

The advantages of such an approach are clear, but what are the potential drawbacks:

– Asset managers might increase fee levels to compensate for the cap. This is certainly possible but would only serve to further inhibit future performance.

Asset managers may launch more products to mitigate the impact of capped costs, in particular launching similar / mirror versions of the constrained strategy. The last thing anybody needs is more funds.

It might subdue innovation and development as large, ultra-profitable funds are no longer able to subsidise fledgling ventures or research. I am not sure I believe this is a genuine problem even as I write it.

There may be technical difficulties (documentation etc…) if the size of a fund declines and investor fees increase. This doesn’t seem to be an insurmountable hurdle, but fee variability is not ideal.

A $ revenue fee cap is clearly going to be unattractive to the largest and most profitable asset managers, and this is not the only way that the current fee model can be improved. It is, however, an area that is ripe for disruption and where there is significant potential to improve both investor alignment and outcomes.

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 get a copy here.

How Will Investors Behave in 2023?

Although many people do it, making forecasts about how financial markets will fare in 2023 is an entirely pointless endeavour. What we can predict with some confidence, however, is how investors will behave – that doesn’t change much. So, what will we all be doing in 2023?

– We will spend a lot of time dealing with an event that hasn’t yet occurred and which will not matter to our long-term returns.

– We will make changes to our portfolios based on what happened in 2022. Not because it makes sense from an investment perspective, but so we can avoid having painful conversations about underperforming funds and assets.  

– We will speculate that an asset class or investment strategy is dead and no longer works.

– We will forget that we once said an asset class or strategy was dead after it makes a dramatic resurgence.

– We will become an ‘expert’ on an issue that we don’t currently know anything about.

– We will view what occurs in 2023 as inevitable, after it has happened.

– We will wonder what an underperforming fund manager is “doing about” their poor returns.

– We (alongside 7,534 other people) will spend a lot of time writing meaningless, short-term market commentary that few people will read, nobody will remember and pray that ChatGPT will soon come to our rescue.

– We will check markets and our portfolios far too much.

– We will have even less time to think than we anticipate.   

– We will tell somebody that the free time in our diary wasn’t an available slot for a meeting, but actually an opportunity to do some work.

– We will talk in certainties, not probabilities.

– We will speak confidently about short-term market performance as if it isn’t just random noise.

– We will extrapolate whatever happens in 2023 long into the future.

– We will not spend any time on how to improve our behaviour or think long-term, even though it always seems like such a good idea.

We know that these behaviours are damaging, but it is difficult to stop them. It is in our interests to play the game. It is more lucrative and less personally risky to be part of the problem. We either feed the monster or get eaten by it.

What should investors be doing? Thinking, reading, walking, ignoring and trying to appreciate how much of the behaviour that is expected of us is of detriment to our long-term results.

If nothing else, we should all spend 2023 trying to give off a little less heat and a little more light.

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.