Humans hate uncertainty. The more uncertain we feel the more we take actions to restore a sense of control. For investors one inevitable response to increasing uncertainty is to make more predictions. If we can see the future, then we don’t need to worry about it. This creates the paradoxical situation where the harder predictions are to make, the more we want to make them. 

In his fantastic book ‘Alchemy‘, Rory Sutherland gives an example of our aversion to uncertainty:

We are taking a flight to Frankfurt, which departure board would we prefer to see?

Option 1: BA 786 – Frankfurt- Delayed 

Option 2: BA 786 – Frankfurt – Delayed 70 minutes

Although the delay in Option 2 is frustrating, it is far superior to Option 1 because it reduces the nagging discomfort of uncertainty. It gives us a little more confidence that the plane will actually take off and some idea of how much time we have. In Option 1, we know next to nothing and that causes considerable psychological pain.

In a similar fashion, Sutherland gives the example of the maps provided to show us where our Uber driver is. They don’t make the car get to us any faster, but they negate the uncertainty around when it will arrive. Investor predictions are a form of map making. They give us a guide to the future and, in theory, help to alleviate uncertainty. The problem is that financial markets are so chaotic and complex that the maps investors make are not much use.

It is possible to argue that hopelessly predicting our way through an uncertain environment is a good thing – if it makes us feel less anxious, maybe it is okay? I don’t think this is true. Investors holding a false sense of confidence about how the world will play out is likely to lead to worse decisions, not better. 

Successful investing is about making choices that acknowledge uncertainty, not acting as if it can be avoided. 

Our dislike of uncertainty makes selling certainty incredibly lucrative. We see it everywhere in the investment industry. Whether it is investment funds that claim they can navigate all environments with equanimity, or soothsayers selling investment forecasts. They prey on the pain of uncertainty by acting as if they are somehow prescient. (They are not).

Despite the discomfort that uncertainty causes investors, we do have a tendency to make things worse for ourselves. By engaging with markets too frequently we exacerbate our feelings of helplessness. We seem to believe that interacting with markets more will give us that elusive sense of control. Unfortunately it has the opposite effect. The more we immerse ourselves, the more likely we are to be captured by its ingrained unpredictability and amplify the behavioural risks we face.

There is no way to remove the uncertainty inherent in financial markets but we can adapt our behaviour to better deal with it.

The most important step is to value principles far more than predictions. A focus on sound investment principles such as diversification, long horizons and the power of compounding rather than inaccurate forecasts about an unpredictable future is essential. 

Robust investment principles do not remove uncertainty (particularly over the short-term), but make us more resilient to it.

We also need to care about the right things. I have no idea what inflation will be in two years’ time nor what the Federal funds rate will be (nobody does), but I am reasonably confident that over the long-run economies will grow and that will flow through into corporate profits and stock market performance.

Nothing is certain but some things are more certain than others.

We all loathe uncertainty, but it is an inescapable feature of investing that we have to deal with. Our attempts to minimize it can lead to greater anxiety and poor judgements. Rather than seek illusory comfort from unreliable predictions or constantly redrawing useless maps, we are far better off accepting uncertainty and ensuring that the investment principles we hold are sufficiently robust that we have a chance of withstanding it.

That is the only way of being a little more certain of better long-run outcomes.

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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).

One of the key challenges faced by investors aiming to generate long-term returns with a diversified portfolio is ‘line-item thinking’. This is where we obsess over the success or failure of individual positions, often losing sight of our true investment goals and the principles of sound diversification. A good investment decision is not the same as a good portfolio decision. 

Portfolio objectives are often framed in terms of beating a benchmark or ‘optimising’ for a given level of risk. Neither of these feels quite right. A benchmark-centric approach implicitly assumes that the benchmark is the correct base mix of assets for our requirements; while optimisations that are striving for ‘return maximisation’ within certain parameters suffer from inputting forecasts that we know will be wrong into a system very sensitive to those incorrect forecasts.

Rather I think for most individuals the objectives of our portfolios should be something along the lines of:

To maximise the probability of delivering good outcomes and minimise the probability of very bad outcomes.

It follows that any decision we make regarding our portfolio should be consistent with achieving those aims; and this is where the issue of line-item thinking arises.

What is line-item thinking? It is characterised by these types of behaviours:

– Thinking about the attractiveness of an investment on a standalone basis, or relative to one other asset. (I expect US equities to outperform emerging market equities, so I am overweight).

– Thinking about how an investment will perform in one future scenario. (I don’t think there will be a recession this year, so I prefer high yield to high grade credit).

– Thinking in terms of profit and loss, and whether an individual position ‘added value’. (This position detracted value and therefore was a mistake).

Although line-item thinking can seem reasonable in isolation, it is often antithetical to good portfolio decision making. None of the three examples above really help me achieve my portfolio objectives as described; they may even hinder it.

Positive portfolio decisions can often seem like bad line-item decisions.

Portfolio Neglect 

The principal reason we build portfolios that combine different assets, funds and securities is diversification. The future is unknowable and therefore we want to create a combination of holdings that is resilient to that uncertainty. If we could predict the future, then we would only hold one security in our portfolio.

This brings us to the central behavioural challenge of diversification. Proof of it being effective comes in the form of assets and positions performing poorly (certainly relative to other things that we hold), but we have little appetite for owning stragglers. 

Good diversification is about making choices that we expect to work in a world that we don’t expect to happen.

Line-item thinking exacerbates this problem because instead of considering the role each holding plays in meeting the objectives of our diversified portfolio, we think about them independently  – did this asset, fund or view outperform or not? It works in binary, deterministic terms.

It is always about outcome bias

Outcome bias (our propensity to judge the quality of a decision by results alone) is one of our most pernicious and powerful behavioural failings. We cannot resist assessing portfolio performance after the fact and judging how the different components have fared. The underperformers and idlers are classed as poor decisions that cause us anxiety, while the outperformers are evidence of sound judgement.

This perspective makes sense through a line-item lens, but it is entirely inconsistent with making sensible portfolio decisions. We can quite easily make choices where an individual position performs well, but fails both criteria of increasing the probability of good outcomes and minimising the probability of very bad outcomes (particularly when only observing short-run returns).

The central issue is that good portfolio decisions are designed to make us robust to a range of unpredictable future results; if we do this, by definition, a decent chunk of our portfolio will look ‘wrong’ with the benefit of hindsight.

Our portfolio performance assessments come once a single market or economic path has been charted.  Diversification always feels like a cost because nothing seems uncertain through the rear view mirror. Line-item thinking comes to the fore here – we look at each position, assess its performance and probably focus on the ones that have struggled.

This seems reasonable but is a terrible idea from a portfolio perspective. But what is the alternative? There are three critical portfolio-thinking questions to ask about the performance of individual positions:

– Was the decision reasonable at the time it was made given what we knew?

– Has the asset behaved in a manner that was broadly consistent with expectations / or its role in the portfolio?

– Did the decision meet the criteria of increasing the probability of good outcomes and minimising the probability of very bad outcomes?

Of course, asking people to think less about outperformance / underperformance of any given position is an entirely futile exercise. What’s measured is what matters! But the more that we think in such a manner, the less likely we are to make decisions that are consistent with meeting our overall portfolio objectives.

Line-item thinking is everywhere. Not a year goes by when the last rites aren’t read for a particular type of asset that hasn’t performed well. Bonds, value investing, liquid alternatives, non-US equities…have all come into the crosshairs in recent times.

These types of claims make sense from a line-item perspective, few of them do from a portfolio one. 

Line-Item Duty

Given that it is portfolio outcomes that matter to us, not the ‘success’ or ‘failure’ of any specific position, why is line-item thinking so prevalent? One undeniable reason is simply availability – we see the line items, so we care about each of them – but there is a deep irony here. We like to check that we are diversified by looking at all the underlying holdings in our portfolio (we don’t want to see just a single line in our valuation even if there is plenty of diversification underneath that); but when we can view each of the underlying positions, it inevitably makes us want to rid ourselves of the poor performers.

Our desire to find proof of diversification leads to behaviour where we become less diversified.

Line-item thinking is also easy. Easy to prove and easy to measure. Positions either work or they don’t, and we were either right about how things panned out or we were wrong. Even attempting to explain why we might be happy that certain positions looked to have performed disappointingly, or why a decision that looks like a poor one actually made a portfolio more likely to meet long-run objectives is likely to be met with scorn.

The consequences of line-item thinking

There are several significant and deleterious consequences of line-item thinking:

Increasing portfolio concentration: Removing the laggards and increasing exposure to the winners is an inevitable consequence of line-item thinking – we don’t want to hold positions that are underperforming, so we reduce diversification and concentrate on the things that we got ‘right’. We create portfolios for the known past, not an uncertain future.

Less portfolio resilience: Line-item thinking means that we focus on whether a position is likely to outperform / underperform, rather than consider the role it might play in making a portfolio more robust to certain outcomes. A position that performs very strongly in a future that has a 30% probability of occurring can be incredibly valuable, even if on 70% of occasions it will look like a failure (on a line-item basis). 

Too much risk: Line-item thinking will perpetually bias us towards higher return / higher risk assets. If we have the choice between two assets – we are always likely to favour that with a higher return potential even if it carries more risk and is less diversifying, because from a line-item perspective it is more likely to outperform.   

Too much trading: Over-trading is an inevitable consequence of line-item thinking as we continually trade in and out of assets as they go through their performance cycles. Not only will we trade too frequently, but we will also almost always do it at inopportune times: Why don’t we hold more of that asset that has outperformed everything else in the portfolio, has enjoyed huge tailwinds in recent years and is trading on stratospheric valuations?

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The more we think about the standalone merits and performance of any given holding or ‘line-item’ in our portfolios, the less likely we are to make sensible, well-calibrated decisions and be appropriately diversified for an uncertain future. 

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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 supine support offered to the new US President by multiple technology billionaires may be frustrating to some people but should be a surprise to nobody. They are responding to incentives, and incentives, more than anything else, drive behaviour. Our desire to understand and map the intricacies of human activity can sometimes lead us to overlook this inescapable truth. 

In his wonderful talk: ‘The Psychology of Human Misjudgement’, Charlie Munger states:

“I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power.”

Humans are, of course, wonderfully complex, intricate and often irrational beings, but in some ways we are simple and predictable – particularly when it comes to incentives. If we had to anticipate the behaviour of an individual or group, the one thing we would want to know, far more than anything else, is the incentives at play.

This raises the question – but what incentives? We can be motivated and incentivised by many things, but if we start with money and power (and everything related to those aspects) we are probably on safe ground.

Despite the importance of incentives, it still feels like a neglected subject. Corporations spend vast amounts of money and time trying to understand individual and team behaviour, with barely a passing reference to the thing that is inevitably driving most of it – incentives.

One of the central reasons that big groups struggle to make good decisions or large companies become woefully inefficient is because with size comes increasingly divergent and misaligned incentives.

Misplaced incentives can have a profound impact on society. The seeming inability of corporations and governments to favour long-term thinking over the prospect of short-term wins is largely an incentive problem. Neither the CEO focused on the market reaction to their company’s next set of results, nor the politician two years away from re-election have incentives that encourage taking a longer-term perspective.

If incentives are so important to our behaviour, why do we so often ignore their influence? An undoubted issue is that few of us are willing to admit that our choices are driven by such brazen and base things. We almost always cloak behaviour driven by incentives into some more fulsome and thoughtful justification to make it palatable – both to other people and ourselves.

A key element of behaviour change is shifting incentives. If we observe divergent behaviour then we should immediately check whether the incentives have altered. While if we want to promote new behaviours then incentives are the most effective place to begin.

The first question we should ask when we are considering anything to do with behaviour or decision-making is – how are people incentivised? The answer will explain a lot.

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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).