As Glastonbury has just drawn to a close Paul Richards and I have recorded a bitesize, festival-themed episode of Decision Nerds, where we uncover some behavioural lessons from the stars of rock and pop.

We discuss:

– Lana Del Rey – the need to understand who’s got the power (literally in this case).

– Van Halen reconsidered – does a rider request about brown M&M’s make them divas or behavioural gurus?

– Elton John – the peak-end rule and what set lists can teach us about being remembered.

Click below to listen, or get in all your favourite pod places.

https://www.buzzsprout.com/2164153/episodes/13119587

My daughter is soon due to change schools and I recently spent an hour being shown around a potential destination for the next seven years of her education. As we were being told about how many lunch options there will be available each day, my mind started drifting off into the topic of decision making under uncertainty (a very tedious character trait). Choosing the ‘right’ school for your child can be an incredibly tough decision and, much like investing, the difficulty stems from the challenge of disentangling signal from overwhelming noise.

In England, most children attend different schools between 5-11 (junior school) and 11-18 (secondary school). The jump between the two is significant and in most areas involves a process of assessing a range of secondary schools (relatively) local to you and then applying for your preferred choice. In the area where I live many secondary schools are also selective, meaning that a child must pass an exam if they are to have a chance of obtaining a place.  

For parents, a critical part of choosing the preferred school for your child is a visit. These are near identical irrespective of the school – you will walk around some unusually quiet, well-behaved corridors and classrooms (often with a guide), then you will listen to a generic talk from the headteacher (principal) and hear the experiences of a precocious student and witness a performance by a piano virtuoso.

There is nothing wrong with these events, except they provide you with precious little information about whether the school is likely to be a good fit for your child. Outcome bias is also rife – parents know about the ‘performance’ of these schools in the form of exam grades, so no doubt take these tours with pre-conceived ideas about whether it is a ‘good’ school.

Similar to fund investing, one of the reasons that academic performance carries such a weight in the decisions that parents ultimately make is because it is difficult to know what the most meaningful criteria are. Also similar to fund investing, an obsession with headline performance inevitably leads to some poor decisions.

Not only does strong academic performance seem like a vital indicator amongst a sea of ambiguous information, there are also some other behavioural foibles at play. As parents we like to signal to our contemporaries that our children are smart by sending them to the school with the highest historic grades. We also believe that our child deserves a spot because they are obviously above average – overconfidence by proxy.

There is a jarring disconnect between the idea that the school where your child will be happy will be the school with the highest grades, but this is not the only problem – grades are often a poor guide to the quality of a school because of a major selection bias issue. Selective secondary schools that achieve the best grades will pick the children achieving the highest grades at junior school. There are a range of factors that will impact which children achieve such results aside from ‘general intelligence’, including whether they attended fee paying junior schools, or the socio-economic background of their parents.

Whatever the reason, that many of the most highly rated secondary schools select from the children with the highest academic achievement prior to joining means that their subsequent strong results are the least we might expect. Not necessarily a signal that they are superior institutions.

There are measures of success for a secondary school that are more nuanced than exam grades, such as a ‘value add’ score that seeks to measure how much a student improves; yet these feel less influential than knowing how many people a school sent to Oxford or Cambridge.

Another common decision-making trait when uncertainty is high is the use of gut feel. Parents will often prefer a school because of some form of instinct – usually driven by an experience when visiting – your guide was especially kind, or your child enjoyed the science demonstration. These signals are not without value, but we are likely to hugely overweight their importance.  

Stories and anecdotes are also incredibly powerful. Parents may discount schools as options because someone they know had a bad experience. Again, such scenarios may not be without merit but n=1 decision making is rarely a good idea.

What does my rambling about selecting a school have to do with investment decision making? They are both choices taken under huge uncertainty, where we aren’t always clear what the critical variables are, and where past performance can be misleading.

Amidst pronounced uncertainty we are also prone to strive for more and more information. Past a particular point, however, (earlier than we think) more information leads to greater confidence, but not greater accuracy. Furthermore, obtaining superfluous evidence may well lead us to neglect the things that really matter.

What is the answer? It is not possible to make a high uncertainty decision easy – whether it is an investment view or a new school for your child. The outcomes will be far more heavily influenced by randomness than we would ever like to think. We can, however, attempt to simplify complex decisions by narrowing our focus to the most important things. For most investors, aspects such as valuation, time horizon and cost will likely dominate other factors. Selecting schools can be an even harder choice but being clear and honest about what we care about and why is always a good starting point for a sound decision.

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My first book has 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 (UK) or here (US).

In 1999, Richards J. Heuer, Jr – who worked for the CIA for almost 45 years – produced a volume of writing called: ‘Psychology of Intelligence Analysis‘. It collated internal articles written for the CIA Directorate of Intelligence. Its aim was to provide analysts with the tools to reach judgements in situations which “involve ambiguous information, multiple players and fluid circumstances”. The insights drawn together by Heuer, Jr are designed to assist in the profound challenge of using our limited human mind to tackle deeply complex problems. Investors face this exact test but spend far too much time focusing on getting more, better or new information, and far too little time on how we process it. Good analysts and investors need to think about thinking. This book is an excellent place to start.

The full text is available to download, but here are some of my own highlights:

“the mind cannot cope with the complexity of the world. Rather we construct a simplified mental model of reality and then work with this model.”

We use mental models (consciously and unconsciously) to help us interpret a fiendishly complex world. We cannot escape all the limitations of this necessarily parsimonious approach, but we can be more aware of the models we use, why we use them, and the implications they have for the choices we make.

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“perception is demonstrably an active rather than passive process; it constructs rather than records reality.”

As investors we do not impartially receive information, but instead interpret it based on our own experiences, identity, biases and incentives.

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“When faced with a paradigm shift, analysts who know the most about a subject have the most to unlearn.”

I am always become nervous when investors talk about ‘paradigm shifts’, as it is usually a prelude to losing money. The point Heuer, Jr raises is a good one, however, in that experienced analysts can often be vulnerable in situations where the environment changes dramatically. Moving from an environment of no inflation to high inflation might be a good example of this in recent times.

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“Events consistent with these expectations are perceived and processed easily, while events that contradict prevailing expectations tend to be ignored or distorted in perception.”

If feels great when things transpire as anticipated, but quite troubling when they don’t. It risks our thesis being wrong or our credibility being questioned. Therefore, when we receive information that seems contrary to our view we are prone to reinterpret it to fit our narrative, or downplay it.

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“despite ambiguous stimuli, people form some sort of tentative hypothesis about what they see. The longer they are exposed to this blurred image, the greater confidence they develop in this initial and perhaps erroneous impression.”

We tend to make initial, snap judgements based on sketchy information. Although this might be an effective adaption (is that a lion approaching?) it can also be a problem. We can easily become wedded to that first impression even if the evidence is weak.”

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“The amount of information necessary to invalidate a hypothesis is considerably greater than the amount of information required to make an initial impression.”

We live in an investment world where people not only want an opinion on everything, but they want it instantly. This is incredibly dangerous. Initial judgements are not throwaway, they can have a sustained impact on our future decisions, even if they are deeply flawed.

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“dealing with highly ambiguous situations on the basis that information that is processed incrementally under pressure for early judgement….is a recipe for inaccurate perception.”

Speed and pressure are a terrible combination for good investment decisions.

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“There is, however, a crucial difference between the chess master and the master intelligence analyst. Although the chess master faces a different opponent each match, the environment in which each contest takes place is stable and unchanging.”

Financial markets are a complex, adaptive system. This makes them both endlessly fascinating and incredibly difficult to predict. Investors need to understand the nature of the game they are playing.

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“A historical precedent may be so vivid and powerful that it imposes itself upon a person’s thinking from the outset”.

Salience of past events has a dramatic impact on how an investor thinks. Understanding the events that we have experienced is likely to provide a good read on how we might interpret a new situation.

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“inferences based on comparisons with a single analogous situation are probably more prone to error than most other forms of inference.”

The worst type of chart crime in investing – a current bear market overlaid with an historic bear market – is a vivid example of the dangers of using one striking historic precedent as a basis for judgement. That is not how complex adaptive systems work.

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“Analysts actually use much less of the available information than they think they do.”

More information often does not lead to better decisions, just greater confidence in those decisions. How much of the information in that 134-page research report really influenced our judgement?  

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“Information that is consistent with an existing mindset is perceived and processed easily and reinforces existing beliefs.”

Confirmation bias is one of the most powerful forces in investing. We see the information we want to see.

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“analysts typically form a picture first and then select the pieces to fit.”

Most investors start with a conclusion and then select the appropriate analysis to justify it.

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“Critical judgement should be suspended until after the idea generation stage of the analysis has been completed.”

Generating new ideas and hypotheses is very difficult. It is particularly challenging if they are immediately criticised and killed (it is easy to dismiss something new). The best way to avoid this friction is to separate the development of fresh thinking from its criticism. (Idea first, critique later).

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“Analysts start with the full range of alternative possibilities, rather than with a most likely alternative for which the analyst seeks confirmation.”

As much as we may dislike it, there is always a range of potential future paths ahead of us and we need to be clear about what they may be. Point forecasts or singular views are a recipe for poor judgements (although they will occasionally make us look very smart).

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“The most probable hypothesis is usually the one with the least evidence against it, not the one with the most evidence for it.”

Investors should spend as much time looking for ‘broken legs’ – reasons why their view is flawed – as they do seeking to prove they are right.

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“certain kinds of very valuable evidence will have little influence simply because they are abstract.”

Investors love the inside view – this fund manager has delivered stellar returns and has an incredible backstory – and ignore the outside view – only 5% of fund managers in this area deliver alpha.

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“Coherence implies order, so people naturally arrange observations into regular patterns and relationships.”

Financial markets are chaotic and full of randomness, which we abhor. Thus, we spend our time attempting to find spurious links and causality.

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“two cues that people use consciously in judging the probability of an event are the ease at which they can imagine relevant instances of the event and the number or frequency of such events’.

The availability heuristic can easily overwhelm our probability judgements. Recent and high-profile occurrences become high(er) probability.

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“an intelligence report may have no impact on the reader if it is couched in such ambiguous language that the reader can easily interpret it as consistent with his or her own preconceptions.”

It is okay to be specific about probabilities. Not only does it immediately acknowledge uncertainty it makes it far easier to change our mind than a single point forecast.

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Nothing is more important for investors than spending time considering our own behaviour and thought processes. What we believe to be cool headed, impartial judgements are no doubt choices shaped by a sea of incentives, biases and foibles many of which we will be oblivious to. It is hard to admit it, but we don’t’ really know why we make the choices we do. Heuer, Jr’s book can help.

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Heuer, R. J. (1999). Psychology of intelligence analysis. Center for the Study of Intelligence.

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My first book has 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 (UK) or here (US).

There is a pervasive idea in the active fund industry that a fund manager investing heavily in their own strategy is a uniformly positive signal. The more they invest the better. Not only does it mean they are invested alongside us, but they have genuine conviction in their approach. This feels right, but is it true? Probably not.

Why is this widespread assumption likely to be flawed?

Unclear Causality: Although there is some research suggesting that a link exists between the level of fund manager ownership and performance.[i] It is not entirely clear which way the causality runs. Is a fund manager investing in their own strategy a prelude to improved returns, or does a fund manager invest more after they have performed well?

Many confounding variables: It is difficult to isolate a fund manager owning a significant stake in their own strategy from other related factors such as experience (long-serving managers are more likely to have the wealth to invest) or firm size (managers working at smaller firms might have greater ability or necessity to invest in their own funds).

Chasing past performance: The type of fund managers with the ability to invest large amounts in their own funds are most likely to be those that have performed well in the past and are now responsible for a significant amount of money. Strong past performance and substantial assets under management is generally not a fantastic recipe for positive future returns. Does that mean that too much investment from a fund manager is a bad sign?

Not a sign of skill:  It is not entirely clear why fund manager ownership should be an important performance indicator. Active fund investors are looking to identify skill, do we think fund managers know whether they do or do not have skill? This seems incredibly unlikely. Many more will believe they do when they don’t than knowingly possess some form of edge.

Following overconfident fund managers:  If we make the safe assumption that there is a selection bias into fund management roles for overconfident individuals; surely it is dangerous and imprudent to believe that heavy investments into their own funds is some form of relevant validation. We are a more impartial judge than they are. 

Fund manager investment doesn’t really measure ‘skin in the game’: One compelling argument behind the benefits of skin in the game through fund ownership is that the fund manager bears the same risks as their investors, but this is usually a spurious notion. I recall working on a team earlier in my career where there was a high conviction in an experienced fund manager launching a new and niche strategy primarily because they had made a substantial personal investment into it. But their situation was entirely incomparable to ours. They were incredibly wealthy and could afford to bear the stark risks of the approach far better than we could.

Skin in the game is only effective where the responsible individuals face similar (or worse) consequences for bad outcomes. An inexperienced fund manager at a small, fledgling firm has far more skin in the game than an experienced, established manager, even if the latter is able to invest far more in their own strategy. As a standalone measure, a fund manager’s investment in their own fund is not a great indicator of skin in the game.

Prudent investors diversify: A fund manager’s salary, bonus and career should be dependent on the success of their fund. Not only does this lead to some (imperfect) alignment, it makes it imprudent for them to invest substantially in their own funds. A well-calibrated individual that understands the randomness of financial markets and the low probability of success in active fund management would probably invest away from their own strategy.

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There seems to be three possible reasons why fund investors believe that fund manager ownership is a positive sign.

1) The fund manager knows something about themselves (that they possess skill) or have some distinctive insights into a particular area of the market.

2) The fund manager bears the same risks as their investors.

3) The fund manager will focus their attention on the portfolios where their own money is invested.

Of the three, only the last seems credible and is, at best, marginal. Even if it is true, additional focus doesn’t transform an unskilled investor into a skilled one. There are also far better measures of focus (such as the number of strategies they manage, or the additional responsibilities that they hold).  

Understanding how a fund manager personally invests is interesting information and may, at times, be telling. The idea, however, that it provides a powerful predictor of future returns or measures skin in the game effectively is difficult to substantiate.

Maybe the fund managers who invest less in their own funds understand probability and diversification better than those that invest more.

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[i] Khorana, A., Servaes, H., & Wedge, L. (2007). Portfolio manager ownership and fund performance. Journal of financial economics, 85(1), 179-204.

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My first book has 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 (UK) or here (US).