𝗛𝗼𝘄 𝗺𝘂𝗰𝗵 𝘁𝗶𝗺𝗲 𝗱𝗼 𝘆𝗼𝘂 𝗴𝗶𝘃𝗲 𝗮𝗻 𝘂𝗻𝗱𝗲𝗿𝗽𝗲𝗿𝗳𝗼𝗿𝗺𝗶𝗻𝗴 𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗺𝗮𝗻𝗮𝗴𝗲𝗿?

1. Hire a manager after a period of strong performance.

2. Watch in discomfort as you don’t experience that performance, maybe the opposite.

3. Spend a huge amount of thinking time and emotional labour working out why it wasn’t your fault.

4. Sack the manager.

5. Rinse and repeat with potentially similar outcomes.

Now that might not be you, but it is a story that plays out regularly.

Experiencing underperformance is one of the unavoidable realities of hiring an active manager. And it’s painful for everyone; clients, managers and advisers. And badly managed pain creates some predictably bad outcomes for all parties.

One important and manageable issue is time horizon mismatch. And this is what Paul Richards and I explore in the latest episode of Decision Nerds (link in comments). We explore:

𝗪𝗵𝘆 𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗲𝗱𝗴𝗲 𝗶𝘀 𝗻𝗼𝘁 𝗲𝗻𝗼𝘂𝗴𝗵 – managers need an appropriate amount of time to let their edge play out (if indeed they have one at all). It may be longer than you think.

𝗧𝗵𝗲 𝗕𝘂𝘅𝘁𝗼𝗻 𝗜𝗻𝗱𝗲𝘅 – a simple way of articulating time frames that can help everyone.

𝗘𝘃𝗲𝗿𝘆𝗼𝗻𝗲 𝗵𝗮𝘀 𝗮 𝗽𝗹𝗮𝗻 𝘂𝗻𝘁𝗶𝗹 𝘁𝗵𝗲𝘆 𝗮𝗿𝗲 𝗵𝗶𝘁 𝗶𝗻 𝘁𝗵𝗲 𝗳𝗮𝗰𝗲 – we posit that most people’s ability to predict how they will deal with the pressure of underperformance won’t reflect reality when things get tough.

We talk about the distinct behavioural pressures facing clients, advisers and managers and what they might consider doing to make things easier.

Available in all the usual places and below:

https://www.buzzsprout.com/2164153/14941612-underperformance-everyone-s-got-a-plan-until-they-re-hit-in-the-face

When investors consider the financial market impact of rising geopolitical risks the key underlying principle should be the late, great Daniel Kahneman’s maxim that: ‘nothing in life is as important as you think it is, while you are thinking about it’. That is not to suggest that such issues don’t matter, it is simply that they are likely to be less influential on our long run objectives than we think, and even if their impact was to be material our ability to navigate such situations well is highly questionable. Quite simply when we focus on issues that are high profile and salient, we tend to make poor decisions.*

When a geopolitical risk arises our natural tendency is to immediately become foreign policy experts, and also believe that we can confidently link complex and imponderable political situations to financial market outcomes. It is hard to overstate quite how difficult this is.

As is typical for investors, we treat each new event as an isolated incident and develop a convenient amnesia about similar situations in the past, which have either had limited long-term consequences, or where the impact was incredibly difficult to foresee.

It is not enough for something to matter, we must be able to predict it with some degree of confidence.

So, how should investors deal with geopolitical issues and the emergence of other high profile risks?

To keep something of a level-head amidst the noise and tumult, a checklist can be helpful.  We should consider the following:

1) Do I have confidence in predicting the outcome of the current situation?

2) Do I believe I can predict the financial market implications?

3) Are any of these financial market implications likely to be material over my investing horizon?

4) Does my portfolio remain appropriately diversified for a range of different outcomes?

5) Has there been any change to my investing objectives?

In most situations and for most investors, the checklist should result in there being a limited response to emerging geopolitical risks and other types of potential market shocks.

This sounds easy, so why is such an approach difficult to apply?

There is, of course, the incessantly damaging perception that if something is on the front pages, investors should be ‘doing something about it’, but there is an even more pernicious problem. At some point a geopolitical risk will have a major financial market impact, and we cannot face the prospect of having done nothing about it.

The fear of doing nothing whilst something important is unfolding is a real one, and leads many investors (often professionals) to make incredibly poor choices. When considering this conundrum, we need to ask ourselves two questions:

1) Even if we assume that an event will have a meaningful impact on financial markets, how confident are we that we can manage it adroitly? It is a herculean assumption that we will make good choices through a period that is likely to be chaotic, stressful and unpredictable.

2) Will we know in advance which of the many such geopolitical events will be genuinely consequential?  On the very solid assumption that we won’t, this will mean that we must constantly trade around such situations – just in case it is the one that matters.

Although it might be quite difficult to acknowledge, anyone who has lived through financial markets for any period of time will know that Kahneman’s maxim is right. We lurch from one potential major risk to the next, almost always overstating its importance and each time making some ill-judged predictions. Investors need to worry less about geopolitical events, and more about the poor decisions we will make because they are the focus of our attention.  

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* Hopefully, it goes without saying that when I am writing about how much such issues matter it is purely from a financial market perspective. The human costs and implications are often profound and far, far more important than any investing consequences that may transpire.

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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).

Behavioural finance has a problem. People talk about it a lot, but use it a little. If anything, improvements in technology and communication has made good investment behaviour even more challenging. Both the temptation and ability to make bad choices has never been greater. The central issue that behavioural finance faces is that – at its core – it is asking investors to stop doing things they inherently and instinctively want to do (and are in many cases are paid to do). That is an exceptionally hard sell.

If we take a deliberately simplistic approach to grouping some of our most problematic investing behaviours, we can see what makes adhering to the lessons of behavioural finance quite so tough:

We do things that are emotionally satisfying and anxiety reducing: Many of our actions – such as selling poorly performing funds or assets, or reacting to short-term market events – make us feel much better in the moment.

We do things that play to our ego: We want to believe that we are better than other people and this overconfidence leads us to engage in activities with horrible odds such as market timing,

We do things because of what other people are doing: We are social animals and take decisions because we want to be like other people or compare favourably to them.

We do things that are easy: We are cognitive misers and prefer simple explanations. That’s why we are so keen to translate a complex financial world into simple stories.

We do things that had evolutionary benefits: This one could really cover everything. Most of our worst investing behaviours are effective evolutionary adaptions and useful in many other contexts. Worrying about the short term and obsessing over recent events is great for our survival but not so good for meeting our long-term investing outcomes.

Viewed through this lens it is easy to see why encouraging people to think more about their behaviour is such a challenge. We are asking them to do the following:

• Stop doing things that give them immediate satisfaction and reduce stress.
  
• Accept that they are not as smart as they think they are.
  
• Stop looking at what other people are doing.
  
• Accept that markets are complex and unpredictable.
  
• Ignore most of what has your attention right now.

The idea that applying behavioural finance concepts is easy is nonsense. It is far far easier to give in to our ingrained dispositions which are natural and make us feel good – that’s why everyone does it. Improving our investing behaviour means going against our own instincts and often what other people are doing.

What makes matters worse is that the industry encourages and validates our natural and problematic behaviours. Lots of value accrues to turnover, stories, short termism and irrelevant comparisons. When I say value, I mean fees – not performance.

Another issue is that applying behavioural finance concepts has no immediate payoff, so it can be difficult to articulate its true worth. Any value that will accrue will take time and there is no obvious counterfactual. There is no benchmark for the poor decisions we would have made without it (a problem made harder by the fact they we will never accept that we would have made those poor decisions).

It is important to remember that behavioural finance would be redundant if it were easy; if it wasn’t hard it wouldn’t be useful.

Applying behavioural finance well is a skill. One that involves developing a plan that will ask us to act against what we think is our better judgement. We will struggle to evidence its value and there will be times when it looks like it doesn’t work at all – “why did you tell me to sit through a bear market when I could have got out at the top!?”

Absolutely integral to accruing the benefits of understanding and managing our behaviour is moving away from the idea that it is about simply doing nothing and ignoring markets. This might work for some but for most it is not realistic. Instead, it is about defining which types of behaviour add value and identifying those which are destructive ahead of time. This requires constant work and effort. It is not solely about creating disciplines but also continually reaffirming why they are in place. The concepts will be incessantly stress tested by fluctuating markets and ever-changing narratives.

Our default state is to disregard the lessons of behavioural finance. It is simply how we are wired. There are, however, huge benefits to be unlocked if we can take the time and effort required to engage with them. Our behaviour remains the most important factor influencing our long run investing outcomes, let’s not ignore it.

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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 investing is far noisier and uncertain than most card games, it is also an activity where understanding the odds is critical. While investors may feel uncomfortable talking about their decision making in probabilistic terms, it is inherent in everything we do – whether we are explicit about it or not. Much like assessing our chances in a particular game of cards, active investors should be asking themselves three questions before making a decision:

1) What are the odds of the game?

2) Do I have skill?

3) What hand have I been dealt?

Let’s take each in turn:

What are the odds of the game?

This is simply judging the expected long run success rate of an activity – on the assumption that I am an average player. If my objective is to win at a game, I want to play the one where the odds are most in my favour.

For active investors this is about seeking to identify the structural inefficiencies in a market that might create advantages relative to an index tracking approach. Although these dynamics might change through time, they should move at a glacial pace.

To take a simple example of what this could mean – I might assume that the odds of success for an active equity fund manager are better investing in Chinese A shares than US large cap equities. This is because the former has more retail participation and may price new information less efficiently (amongst other things). This may not be true (there are certainly reasons why active investing could be harder in the Chinese domestic market), but such issues should be at the forefront of our thinking.  

This is clearly not an easy judgement to make and there will be no precise answer, but it makes no sense to invest actively without first at least attempting to consider the odds of achieving a positive outcome.

Do I have skill?

The structural odds of a game are our starting point, but they will be impacted by the presence of skill. A poker player with evident skill should win more over time. The problem for investing is that skill is difficult to judge and far, far more people think they have it than actually do.

Skill can be quite an emotive term, so it is probably better to frame it as an edge. If I am going to engage in an investment activity with average or underwhelming odds, then I need to have an edge to justify participating.

Investors have terrible difficulty talking about skill and edge, but it is essential to do so. It might be analytical, informational, behavioural or something different entirely, but it must be something. If my choices are consistent with me believing I have an edge, I need to be clear about what I think it is.

What hand have I been dealt?

Sometimes the structural odds of a game, or the influence of my skill in playing it, can be dominated by whether I am dealt a great or terrible hand.

As an investor I can think of these as cyclical or transitory factors that influence my chances of outperformance. This is nothing to do with the perennial promises of it being a “stock pickers’ market” or other such empty prophecies, but rather factors like observable extremes in performance, valuation or market concentration that arise at different points through time and may have a material impact on my fortunes.

The best recent example of such a scenario would be in 2020 when a select group of high growth, actively managed equity funds had delivered staggering outperformance against the wider market. They had generated astronomical returns and held stocks that traded on eye watering valuations. Investing in such funds at this time (which investors unfortunately desperately wanted to do) is the same as being dealt a terrible hand in a game of cards.  It overwhelms everything else – the overall odds of the game and our level of skill become irrelevant. The probability of achieving good outcomes from such starting points is inescapably low.

Of course, such a situation is even worse than being dealt a bad hand in a game of cards because investors – buying into the story and beguiled by past performance – will play it like it is a great hand.

The sad truth is investors are more likely to go ‘all in’ with an awful hand and fold a great one.

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Investors seem to dislike thinking in probabilities. In part this is because it can feel like we are applying spurious accuracy, but more because it can betray a profound uncertainty about the future, which jars with our general overconfidence. Despite this discomfort, we cannot escape the fact that we are playing a probabilistic game. We will never get to the right answer, but it would help our decision making greatly if we at least tried to carefully consider what our odds of success might be.

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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).

The dominance of US equities has been one of the most significant features of financial markets over the last decade. The sheer magnitude of outperformance makes it easy to claim that it has simply been a case of an in-vogue market enjoying a substantial and unsustainable valuation re-rating, but that’s not quite true. Although a material multiple expansion has been influential, fundamental factors – better growth and improving margins – have also been significant. There is a problem, however, with using these earnings advantages to justify the compelling relative returns produced by US equities. Implicit in these arguments is often the idea that it was obvious that this would happen, and now it is equally obvious that it will continue. This is where investors will likely come unstuck.

To explain why, we can look at this chart from Alliance Bernstein showing earnings growth across US, EAFE and Emerging Market equities:

How many people in 2010 were thinking – “over the next decade I believe US equities will be the place to be because of their earnings growth potential?” Not many. With the benefit of hindsight, we might think we were, but we weren’t.

Instead, we were likely to be saying: “Emerging market equity outperformance over the past decade wasn’t a bubble or about a valuation re-rating, it was about the fundamentals – haven’t you seen the earnings?”

In 2010, it would have felt obvious why emerging market equities had outperformed (‘it’s the fundamentals, stupid’) and that this would continue. It didn’t quite turn out that way.

These are the same arguments that are made now for US equities, but just applied to a different case at a different time. Our behaviours don’t change, just the subject that they are focused on.

There are two powerful and pervasive behavioural foibles at play here. Hindsight bias makes us feel as if the path we have taken was inevitable, whilst extrapolation leads us to assume that what has come before will continue. There is, however, something else that is just as problematic for investors – an inability to separate what matters from what is predictable.

Just because something will have a significant influence on the performance of an asset class, it does not follow that we can predict it with any level of confidence. Take earnings growth – this is a critical component of equity returns (the longer the horizon the more it matters) but is also incredibly hard to forecast. Just because something matters does not mean that it is a good idea to confidently forecast it.

Imagine attempting to estimate the relative earnings growth trajectories of emerging markets and the US back in 2010. That would require a wonderful ability to foresee developments in the growth of China, commodity prices and the rise of oligopolistic big tech firms (amongst a multitude of other things). 

Added into this mix would have been the profound impact the strength of the US dollar has had on these fundamental fortunes. As currency forecasting ranks just below astrology in its accuracy, this makes life even harder. Earnings growth is really important, and it is also really important to understand our limitations in anticipating it.

When considering factors such as longer run earnings growth it is vital to accept that we are predisposed to be overconfident in our ability to forecast it and will also consistently assume that cyclical phenomena are structural. We should always start from a point of conservative assumptions based on long-run base rates and apply wide confidence intervals.

We must also remember that it should not be considered unusual for an outperfoming asset class to have had superior fundamentals. This is the critical part of the virtuous circle – better fundamentals – higher multiples – more persuasive stories. They feed on each other. The right question is not usually whether there has been any fundamental justification but whether it is sustainable and what is already in the price.

None of this is to say that the earnings advantage of the US will not persist. It is possible to make a perfectly plausible argument – probably around the rise of AI and the lack of effective antitrust enforcement – as to why this might be the case. It is, however, equally easy to contend that earnings are inherently cyclical and unusually strong tailwinds for certain markets (and industries within it) don’t tend to persist (they are unusual for a reason). This is without even considering starting valuations.

It is true that the outperformance of US equities over the past decade was heavily influenced by fundamental factors; it is not true that this was obvious before the fact, nor that it will necessarily persist. Anyone arguing otherwise is either wildly overconfident about their ability to see the future or trying to sell us something.

Things are never as obvious as they feel.

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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).