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.