One of my favourite Daniel Kahneman quotes is: “Nothing in life is as important as you think it is while you are thinking about it”.  It beautifully encapsulates our tendency to significantly exaggerate the importance of whatever is on our minds at any given moment. This is an issue that is particularly troublesome for investors. There is just one problem – the quote gets it wrong.

I am asleep in my bedroom one night when I am awoken by the sound of an alarm going off. I then see smoke creeping underneath the door. I quickly realise that there is a fire in the house and need to work out what to do next.

Sometimes, just sometimes, events might be as crucial as we think they are when we are thinking about them.  

We have a tendency to overstate the significance of whatever has our attention because – on rare occasions – it will be profoundly consequential.

From an evolutionary perspective this makes perfect sense. Worrying a lot about things that might be a threat to our survival is a highly effective adaption. We can’t reproduce if we cannot survive.

Kahneman’s quote might instead have been: “The vast majority of things in life are not as important as we think they are while we are thinking about them”. Not as catchy, I grant you.

If nothing was ever as important, then we wouldn’t act as if a lot of things were.   

This gets at a core issue of why investing is so difficult. Many of the behaviours that have made humans such a successful species, also make it difficult to be good, long-term investors.

Our overreaction to short-term, visible, in-the-moment risks, is just one of them. There are plenty of others – including herding, aversion to losses, and our susceptibility to stories.

Discussion around investor behaviour often seems focused on creating a long list of detrimental biases that humans suffer from as if we are just a poorly wired species, ill-equipped to make good decisions. This is not the case – it is simply that certain ingrained behaviours that are incredibly effective in some contexts, can be detrimental in others.

That investment issue that you are currently worrying about is very unlikely to be as vital as you believe it to be, but it is very human to act as if it is.

The key to good investment decision making is to understand what makes us human, and then to adapt those elements which might also make us bad investors.  

—

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).

Other things equal, a higher valuation for an asset should make it less attractive. Returns are being pulled from the future to the present. So why does the reverse often seem to be true? Why do investors often behave as if their return expectations are increasing alongside valuations? *  

It is easy to characterise this phenomenon as simply characteristic performance chasing behaviour. Many investors don’t really care about the valuation of an asset; they are focused on recent returns – either attempting to capture momentum or crudely extrapolating the past into the future. Yet while these types of investors are not valuation-driven, changes in valuation are exerting a significant influence on their decisions.

Changes in the valuation of an asset can create self-reinforcing valuation loops – where a rising (falling) valuation directly leads to an increase (decrease) in investor confidence. It looks something like this:

A rising valuation boosts performance, stories are created to justify the strength of performance and this in turn increases investor appetite for the asset thereby increasing the valuation. And so it can continue.

Let’s take the example of US equities over the past decade. A substantial portion of its outperformance has been due to this market becoming more expensive (alongside good fundamental growth). This rise in valuation inevitably played a role in the emergence and persistence of the ‘US exceptionalism’ argument. As the market became more expensive it became more exceptional.

Ultimately, investors care more about performance and less about what is causing it.  

But there must be a limit to these valuation loops, surely the value of an asset can’t keep going in one direction? While there usually is a limit, the strength of it depends on how much of a valuation anchor an asset class possesses.

A valuation anchor is simply some fundamental features of an asset that exert a form of gravitational pull on how cheap or expensive it can become. There are three key factors that dictate how much of a valuation anchor might be apparent:

– Does it have cash flows or any other fundamental means of valuation?

– Are cash flows contractual / constrained?

– Is there a maturity point or is it perpetual?

For example, a ‘AA’ rated corporate bond with two years to maturity has a very strong valuation anchor. Its cash flows are contractual, and it will mature in twenty-four months. There is only so far its valuation is likely to move in that period.  

Conversely, an asset like gold has no anchor and is perfect for sustained valuation loops. It doesn’t have cash flows and is a perpetual instrument. Its price is its value, and its value is perceived to increase the more it rises. Does gold become more attractive if it falls 50%? Probably not for the vast majority of investors.

I think there are three broad groupings that frame an asset’s susceptibility to self-reinforcing valuation loops:

Strong valuation anchor: Most fixed income securities qualify for this group as they have contractual returns and a fixed maturity. Although when discussing quasi-perpetual assets like a ten-year US treasury the anchor is far weaker.

Weak valuation anchor: Equities reside here. Although they do have cash flows and a ‘fair value’ can be estimated, they are perpetual and have no (hard) limits on the theoretical future cash flows that can be generated. There is not much to prevent fantastical stories being used to justify either very high or low valuations. There are, however, certain extremes where valuations start to bite – US equities might trade at 30x earnings and the rest of the world at 15x, but it is hard to imagine the US reaching 100x.

Many commodities would probably fit into this category also, not because of cash flows but because of competitive market dynamics.  

No valuation anchor:  Gold and crypto are the obvious examples and what I would call belief assets.** They are perpetual with no cash flow and no reasonable means of valuation. It is not that stories are used to justify a rising price / valuation, it is that the price is the story. This creates the potential for prolonged trends where a rising price serves to increase the validity of the asset, and it does so without any obvious anchor to a valuation level. This can be extremely attractive, but it is critical to remember that this exact phenomenon can also operate in reverse.

–

Antti Ilmanen of AQR recently wrote a piece suggesting that equity investors extrapolate while bond investors look for mean reversion. I think one of the reasons for this contrasting behaviour is the strength of the valuation anchor for each asset class. The weaker it is, the greater the likelihood of investors acting as if higher valuations are making an asset class more attractive (and vice-versa). There is nothing to get in the way of the stories.

—

* By the valuation becoming more expensive, I mean paying more for the same expected cash flows, not a situation where a higher valuation is due to improving fundamentals.

** This doesn’t mean you should not own these assets – some may have useful characteristics (gold has Lindy properties) – but they are inevitably high risk and come with a wide range of outcomes.

—

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).

Is Warren Buffett attempting to ‘time the market’ by holding over $300bn in cash?

In a word, no.

I have written regularly about the folly of attempting to skilfully predict and time the movements of financial markets. It is an incredibly difficult, probably impossible, activity to perform consistently well and most investors should avoid it. One challenge I often receive when expressing this view, however, is that as all active positions require us to take on some form of market risk, most of us are market timers – whether we like it or not. We either engage in market timing or do nothing.

I don’t buy this argument – I think it falls into the trap of confusing process and outcome.  

Market timing is a very distinct investment activity that has two characteristic features – it is a decision that specifies both why something will happen and when it will occur.

It includes both the identification of a catalyst (or catalysts) and a moment. Let’s take a simple example:

‘I believe that US equities will outperform over the next 3 months as tariff concerns abate.’

This is clearly an attempt at market timing. We are predicting the cause of a price movement in an asset and when it will occur.

Let’s contrast this with another scenario. A value-orientated equity fund manager is holding 20% in cash because, after applying their investment process, they are unable to identify enough attractive opportunities.

This is not market timing. The fund manager is saying nothing about what will cause prices to move nor when that may happen. It is perfectly reasonable to be uncomfortable with an equity fund holding a high cash weighting and the risks that stem from it (outcome), but it doesn’t mean that the decision that led to it is an effort to time the market (process).

Although the fund manager is not seeking to time the market, they are exposing themselves to the same risks as if they were. We can have two identical investment positions where one is the result of market timing and the other is not – investors can carry equivalent risks but for entirely different reasons.

Take two multi-asset portfolios:

– Investor A is 5% underweight US equities because they believe the next jobs report will cause an equity market sell-off.

– Investor B is 5% underweight US equities because they believe that, on the balance of probabilities, rich valuations are likely to lead to lower future returns.

The critical point is that intent matters. We don’t simply need to be comfortable with the risk being taken, we need to be comfortable with the reason that the risk is being taken. Investor A is attempting to time the market by forecasting its movements; Investor B is taking the same position but is agnostic on when and why something might occur.

Just because something isn’t market timing (as I would define it), does not mean that it is a good idea. We might be uncomfortable being subject to significant market risk, or we might believe that a process being adopted is weak or unconvincing. There are lots of ways to make bad investment decisions – market timing is just one of them.   

All active investment views are subject to the chaotic fluctuations of financial markets, but only in some are we explicitly trying to predict them. Given how hard it is to get right, it is important to know market timing when we see it.

—

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 recent years, the idea of a behaviour gap in investing has become commonplace. Although there are several ways of defining what this actually means, it is most typically used to describe the cost of our poor investment decisions. The difference between potential and realised returns. While this might seem intuitive, for me it is quite an abstract and almost ephemeral concept – it is hard to really know what our ‘potential’ returns are and therefore how to close the gap.

Many conversations around addressing the behaviour gap often seem to assume that our aspiration should be to behave as if we are a super-rational, all-seeing and all-knowing decision maker. I am sorry to say that we will never reach this state, and judging ourselves against this ideal is wholly unhelpful.

Most of us will also be unable to avoid the decision making challenges that blight investing by going for thirty years without touching our portfolio. This might be a sensible approach, but such stoicism is an entirely unrealistic expectation for most of the humans I have met.

We should not be aiming to be the perfect decision maker nor someone who rarely ever makes a decision. Instead, our focus needs to be on avoiding major, consequential mistakes.

When thinking about a behaviour gap what investors should focus on is the difference between the outcomes we might achieve by making reasonable choices and what we end up with after making some very bad choices.

All most investors really need to do is make some reasonable decisions over time and they will be just fine.  

There is no ideal set of choices that we can make (except with the benefit of hindsight), and striving for incredible outcomes is often the cause of our worst decisions.

After the fact there will always be better choices we could have made. We will also always make decisions that have disappointing results. That is inevitable and perfectly acceptable. These really won’t matter that much – it is the big mistakes that will count.

And what do these major mistakes look like? Not investing at all, selling equities near the trough of a market decline, abandoning investment principles to participate in a mania or bubble, constantly switching between assets or funds as performance waxes and wanes, becoming concentrated in a particular fad, theme or trend, I could go on…

While these are different types of mistake they are all driven by our behaviour and all have the potential to incur significant costs that compound over time. I think there are three key features of financial markets that make them so common:

The Power of Stories: Humans interpret the world through stories, and financial markets are narrative generating machines. When we make poor investment decisions, they are inevitably deeply intwined with a story we are using to interpret a complex and chaotic environment. It is easy to look at historic financial market events with equanimity because we know how these stories unfolded, it is an entirely different proposition when we are in the midst of an event – because we don’t know how the story will end.  So, we make up our own ending and invest accordingly.

The Passage of Time: It is easy to look at the impressive returns delivered by equity markets when investing over 20 years, we can do that in a second; that in no way prepares us for the challenges of living through those 20 years to receive those returns. In investment theory time is nothing; in practice it is everything. We have plenty of time to make bad decisions.

The Pull of Emotions: Almost all of our investment decisions are driven by our emotions. The problem with investment theory is that it is anodyne – it provokes little feeling. Think of the difference between knowing that equity markets from time to time will suffer from declines of 30-40% (or more), and then experiencing such a loss – they are not comparable in any useful fashion.

Our desire to tell stories to deal with uncertainty, the sheer length of time over which we invest and how emotions dominate our decision making all combine combine to create the real and costly behaviour gaps. What can we do about it?

Unfortunately, there is no sure-fire way of avoiding the gap, but I think there are five steps that can help us avoid the worst outcomes:

1) Make decisions by design: As far as possible we should design our portfolios to mitigate the issues that cause severe mistakes. Sensible diversification is essential, as is a disciplined approach to rebalancing and regular investment. Don’t design a portfolio based on investment theory alone, design it based on the realities of investing over the long-run and the challenges that brings.  

2) Set clear and realistic expectations: Being open and honest about what investing over the long-term might look like is absolutely vital. Surprises are an inevitable cause of poor decisions. We won’t know what will cause the next bear market, nor where the next bubble will occur, but we know that they will happen – so be explicit about it. We should be saying: “at some point I expect equity markets to lose 40%, and this might see your portfolio value fall by £%, but this is to be expected and won’t stop us meeting our long-term goals”. It is far easier to avoid these conversations and focus on the long-run return of equities over time, but setting expectations correctly so that when certain things occur in markets we can say: “this is what we discussed” is invaluable.

3) Get the framing right: How we frame something matters far more than we think it should, and we must use that to our advantage. Equity market declines can be viewed as a disaster, as a material loss of value and a prelude to even worse times. Alternatively, they can be framed as the price of admission – the reasons long-run returns are so high – or an opportunity to add to our portfolios at more attractive valuations. For long-term investors, it can also be helpful to frame near-term volatility as a concern for short-term investors – and that is not what we are.

4) Control our environment: Although in a cold state we might think that we can control our behaviour through time, the chances are that when stressful periods arise we will make irrational choices. The best way to deal with this is not to think that we can re-wire our psychology, but rather take ourselves away from the cause of the stimulation. If we are removed from the day-to-day fluctuations of financial markets, then many of the main causes of our major mistakes just fall away. Taking ourselves out of the environment is essential – if we don’t want to drink alcohol then avoiding the bar is usually a sensible step. Stop checking our portfolio values, don’t download the app and don’t read financial market news. Given how the industry wants us to engage in all of these things it is hard to escape it, but if we can, it is likely to greatly improve the chance of good outcomes.  

5) Have implementation intentions: Making plans for how we will act in a specific situation in the future can be a useful behavioural tool. For example, if we commit to increase our equity exposure or invest more if markets fall by 30% it both helps to re-frame how we might feel in such situations and also decrease the risk of poor decisions. When markets fall by 30%, are we going to follow through? Probably not (for all the reasons already discussed) but the fact that we have stated that we had planned to, might just help us avoid doing the exact opposite.

—

The behaviour gap is driven by the divide between investment theory and practice. Investment theory is scientific and clinical, which is great but has one slight flaw – it leaves out the influence of emotion and psychology – and that is the whole ball game! Investment theory ignores the lived experience of investing.

How do we deal with the behaviour gap? We don’t need to strive to make perfect investment choices, and we don’t need to optimise for anything. What we need to do is avoid making big mistakes – that’s the gap that really matters – and that is easier said than done.

–

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).