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.
Overconfidence: 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.