In those long-forgotten days when high quality bond yields were close to (or even below) zero, most investors longed for a return to a ‘normal’ environment. When a staple element of most multi-asset portfolios would once again provide an adequate return. For a time, it seemed that this day would never arrive and we would be in a permanent state of ‘return free risk’. Yet slowly and then suddenly everything changed. Bonds once again offered reasonable yields and provided genuine competition to other asset classes. And how did investors react to this much desired shift? By lamenting the losses incurred by bonds and questioning whether they are too risky to play a role as a conservative element of a diversified portfolio. Sometimes we are just never satisfied.

This shift in perspective on bonds highlights a major problem with investor behaviour. We have a tendency to make plans for future decisions – we will buy bonds when yields are higher or invest in equities after the next correction – but neglect to consider how we will actually feel when that time arrives. For bond yields to move higher or equities to get cheaper something has to happen, and that something is likely to make us not want to do it.

It is easy to form implementation intentions about the future, but far more difficult to apply them when we get there. This trait is apparent across all sorts of choices, not just investing – I will start going to the gym next week.

There are two major reasons for this behaviour:

1) Our future self is a far better person than our present self: Our future self is an incredible human being, unimpeachable and unaffected by any of the issues we are experiencing right now.

2) Things will be different in the future: There will be problems in the future – reasons not to act – that will only become apparent once we get there. From here it looks like clear water ahead, unfortunately that won’t be the case.

The second element is crucial for investors who make bold claims about waiting for better entry points into assets. These only arrive because developments shift the prevailing sentiment – they are a reaction to bad news – we will not be immune to this negativity.

When inflation was a non-existent problem and bonds had been in a bull market for decades, of course we hoped for an opportunity to buy in at higher yields – we just didn’t want anything else to change. Bonds paying nothing weren’t attractive, but perhaps the environment felt more comfortable.

We love the idea of buying cheaper assets, but blissfully ignore the pain required to get there and the difficulty of actually acting when they do.

Our present self is likely to staunchly disagree with our best laid plans when it finally comes to meet our future self asking: “what were you thinking, can’t you see how terrible everything is?”

How can we deal with our likely inability to enact future investment actions? There are several options:

– We shouldn’t make plans based on prices, yields or valuations; but think explicitly about what might happen for these to occur. These do not have to be precise forecasts about the future (because they will be wrong) but at least set reasonable expectations about the context in which a decision is likely to be made. If we want to invest in high yield bonds when spreads are historically wide, that will likely mean doing so in the midst of a deep recession, high unemployment and elevated default rates. Remember, bad things have to happen to get there. We should ask ourselves in advance – what is it that will make us not want to do this?

– Systematizing future actions is another powerful route. Most easily done through rebalancing, but also in more nuanced forms. By encoding systematic decisions we are acknowledging the likely divergence between our cool, rational forward-looking self and our hot state, in-the-moment, decision maker. Of course, it is important to remember that in times of stress we will likely try to ‘override the model’ and stop such systematic decisions, arguing that they don’t capture the gravity or nuance of the situation unfolding. In reality it will just be our emotions telling us not to do something inherently uncomfortable.

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Despite our best intentions, when investors talk of making allocation decisions when there are better entry points or more attractive valuations, it is highly likely that when the time arrives we will be reluctant to follow the intended course of action. The narratives will be bleak, past performance poor and we will struggle to avoid extrapolating the pessimism.

We will be given every reason not to act and gladly accept them.

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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).

Although it is easy to be cynical about forecasting (as I often am), embedded in all of our decisions are predictions about the future. In the latest episode of Decision Nerds, Paul Richards and I explore the practicalities and pitfalls of making forecasts in highly uncertain environments with Professor Paul Goodwin. We discuss:

– The pros and cons of scenarios analysis.
– How individual forecasts compare those made by groups.
– The Delphi Technique.
– When we should tweak a model
– The lessons from superforecasting.

And much more in-between.

You can listen here: Seeing the Future

Although we may not like to admit it, the past performance of an asset class or fund is likely to have an overwhelming influence on our decision making.  We may try and mask the hold it has on us, but we are inescapably drawn towards investments with strong recent returns. The more pronounced and persistent the outperformance, the greater the pull. There is probably no more prevalent nor puzzling paradox in investing – in order to enhance our returns we make decisions based on a measure that is likely to reduce them.

The past performance of an asset are returns that we are not going to enjoy. They have been (at best) drawn forward from the future – the better the performance before we invest, the worse they will be after. Unusually strong returns are typically the result of unsustainable tailwinds, random doses of good luck and the inescapable swings of market sentiment.

Periods of abnormally strong performance mean that an investment has become more expensive and that it has earned higher returns than it is reasonable to expect on average. Both factors acting as a gravitational pull towards future disappointment.

This type of behaviour is most pronounced in active fund selection. Here it is not even an implicit driver of decision making, but rather an explicit feature of most processes. The popularity of star fund managers is (at least in part) forged on the notion that exceptional returns in the past are a prelude to exceptional returns in the future. We ignore the realities of valuations, the spectre of mean reversion, and fickle hand of fortune, and instead assume that some form of idiosyncratic skill will overcome all of these factors. This is an assumption with terrible odds of success.

The pull of past performance is not unique to fund manager selection, it is pervasive across the industry. We only need to look at the clamour for US equities following a decade (or more) of stellar performance. Investors seem to behave as if the market’s outsized returns in the recent past increase the probability of a continuation of this pattern, when in all likelihood the reverse should be true.

Why do we have such a strong tendency to read the wrong signal from past performance?

Extrapolation: We seemingly cannot avoid believing that trends of the recent past will persist, even when this view seems to be contrary to any rational analysis. A critical part of this anomalous behaviour is the power of storytelling. When assets or funds deliver exceptionally strong (or weak) performance, narratives are weaved to explain them. These compelling stories that justify unusual returns also bolster our belief that they will endure.  

Outcome Bias: Aside from our inescapable short-termism (more on that later), outcome bias is probably the most damaging behavioural foible suffered by investors. Whether it be for a stock, fund or asset class, when we witness strong performance we imbue that thing with some inherent goodness (and vice-versa). High past returns give us increasing confidence in the credentials of an investment. It must be good, haven’t you seen the returns?

Career Risk: For many, being in thrall to past performance is a survival strategy. Most professional investors make decisions to survive over the short-term. Although performance chasing might objectively appear to be an odd strategy at an aggregate level, for an individual it might be the best way to keep our job or avoid another difficult meeting. Investing in the in-vogue areas of the market can be both irrational and rational at the same time – it depends on our objective / incentive.

Instant / Delayed Gratification: Inherent in the paradoxical impact that past performance has on our decision making is the trade-off between instant and delayed gratification. We have an ingrained preference for doing things that make us feel better in the moment over waiting for rewards that may occur at some uncertain future point. Performance chasing gives us an instantaneous, positive hit – we are investing in areas of the market that are working right now, the stories supporting it are captivating and everyone thinks we are making a sensible call. The alternative approach gives us pain now with any benefit someway off in the distance.

One clear signal of the dangers innate in performance chasing is that there is no behavioural cost. It is easy to do and feels good when we do it. Almost all positive investment approaches come with behavioural pain – something has to hurt.

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There is one important exception about the perils of making decisions based on past performance. The success of trend-following strategies, which are explicitly past performance focused. If there is evidence of this working, why is performance chasing such a problem? There is a critical distinction. The success of systematic trend-following strategies is about the consistent application of discipline and rules. Conversely, most investors engage in erratic trend-based investing (we invest in things because they have ‘gone up’) and rationalise the decision based on some post-hoc fundamental analysis.

We are largely secret trend-following investors not admitting how much past performance matters to ourselves or others, and absent the aspects that makes capturing such trends work. 

The paradox inherent in investors’ unhealthy focus on past performance does not mean that we should scour the market for the most egregious laggards, but rather be wary of the influence of high historic returns on our decisions and realistic about its likely consequences. Unusually strong past performance should make us concerned not confident. 

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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).