What Happens if the 60/40 Portfolio Underperforms for a Decade?

The success of the simple 60/40 portfolio has been one of the defining features of the investment landscape over the past decade. A combination of persistently declining bond yields and exceptional performance from US equities has meant that it has trounced most alternative allocation approaches. Doing anything but hold a 60/40 portfolio (or a derivation of it) has almost inevitably come at a cost. It is now considered to be the natural, default option by many investors. It is not clear, however, whether this status is because of something innate in the 60/40 structure that makes it the neutral choice, or whether investor opinions would change if it endured a prolonged spell of disappointing returns.   

This piece is not another critique of the 60/40 approach (most of which are attempting to sell another product), nor an assertion that investors must do something else (aside from lower their expectations for future returns). It is about how investors treat evidence. What evidence we choose to use, what we choose to discard and the importance we place on certain elements.

A ‘passive’ allocation to a 60/40-type portfolio is often framed as the obvious, evidence-based investment decision, and there is certainly compelling support for it. The returns have been stellar, particularly since the secular decline in yields began, and it has inevitably been boosted by the low costs typically attached to this approach to investment. Yet in assuming this is now the only approach to adopt in the future, we are inescapably ignoring other pieces of evidence.

Investors in 60/40 portfolios hold significant allocations to the US equity market (which has been a particular boon for non-US investors) and long duration sovereign / quasi-sovereign bonds. Holding a US equity focus in a portfolio now is to choose to ignore the evidence that over the long-run expensive markets tend to produce lower returns than those which are more attractively valued. Furthermore, owning long duration, low yield assets is a recipe for higher volatility and underwhelming returns.

If we suspend our disbelief and imagine that over the next ten years US equities have been trounced by other developed and emerging markets, what would our reaction be? Would the 60/40 still be the in-vogue, evidence-based default, or would something else now be in its place? Given how sensitive our investment perspectives and purported beliefs are to historic performance, it is almost certain that investment industry would be awash with obituaries for a 60/40 approach, probably at the precise time it becomes a more compelling option.

When an investment strategy has been successful, particularly for a sustained period, it is incredibly difficult to envisage this changing. Yet we only have to look at the performance of the value factor over the last ten-years (plus) to understand how this can occur. Having exposure to value is well-supported by the evidence but has failed to deliver meaningfully for a sustained period. Even investment approaches that work will go through arduous period when they don’t. No strategy is immune to this.

In the scenario where a 60/40 portfolio has struggled relative to other options, investors have endured a cost because they have focused on a certain piece of evidence (the long run success of this approach) and ignored other relevant information (the long run poor results of expensive assets). This is perfectly reasonable. All investors are faced with a plethora of evidence, and it is upon us to filter this and focus on that which we believe to be most robust and material.

The danger is to assume that any view we take is neutral. It is not. We are always making judgements and trade-offs. It is easy now to state that a 60/40 approach is simply following the evidence because it has performed so well, for so long. Yet we frame and weigh evidence through the window of recency. If something is working now, then the evidence we have supporting it seems more important and more obvious. It is easy to disregard or underweight evidence to the contrary.

We can see how past performance informs our use of evidence by looking at the typical home equity bias held by investors. From an investment philosophy standpoint there is limited compelling evidence for holding a heavy bias towards our domestic market, but how any given investor perceives the home bias is likely to be dictated by where they are located. In the UK, there is an ongoing clamour to remove this home skew. Not because everyone has suddenly alighted upon the evidence, but because returns from the UK equity market have been wretched (on a relative basis) for years. By contrast, is it unlikely that US investors are desperate to increase their exposure to underperforming international markets.

If anything, in this scenario, it is UK investors that should be more circumspect about the speed of such a shift in allocation given the evidence of strong long-run performance from undervalued markets, but this is far from the case. Recent performance is not only used as the most important piece of evidence, but it also frames how we perceive all other information.  

Our time horizons are also a major defining factor in the evidence we choose to follow and that which we choose to ignore. Investment approaches supported by the most robust evidence only play out over of the long-run (if at all) and patience is required to see it come to fruition. One thing the investment industry has little of is patience. That is why the evidence of what is performing well right now is so compelling. We are not asking people to wait, to believe something different to what they are currently witnessing or bear uncomfortable risks.

Even if we consider something to be the neutral investment option it is imperative to consider the evidence we are using to support that view and also justify why we have chosen to ignore other pieces of evidence. We also need to envisage a future where the default disappoints and understand how we would react in such a scenario. The 60/40 has been a great option for many investors, but we cannot forget that it is an investment view and should treat it as such.  

Only Invest in Active Managers If You Can Withstand Prolonged Periods of Underperformance

The argument against the use of active management is often focused on the difficulty of identifying a fund manager with the requisite skill to outperform the market. This perspective, however, ignores a critical element of employing active fund managers. It is not simply about finding the right ones, it is about being able to stick with them over the long-term. An elegant study recently released by Vanguard put this into sharp contrast. It showed that even successful active funds endured protracted, multi-year spells of underperformance. The message is simple: if we are not able to withstand years of under-par returns, we should not be using active managers at all.

The Vanguard study, which looks at the performance of open-ended actively managed equity funds with US domicile, covers over 2,500 funds across a 25-year period. The entire piece is worth reading but there are some critical observations:

– “Close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one, three and five year evaluation periods”.

– “Eight out of ten outperforming funds had at least one five year period when they were in the bottom quartile relative to their peers”.

Underperformance is an inevitable and expected part of the return profile of all active managers, even those with skill who manage outperform over the long-term. Hopefully, the study lays to rest the spurious but pervasive notion that years of consistent outperformance is either a reasonable expectation or anything more than random patterns being weaved.

Identifying a skilful active manager is incredibly difficult; but even if we can do it, it will not matter if we are unable to cope with the barren periods. The first question we ask before considering investing in an active manager should not be – do we have the ability to find one? Rather, are we in a position where we could hold them for the uncomfortable and volatile long-term? If the answer is no, we should not even begin the search.

It is easy looking at historic underperformance on a screen before we invest; living through it is an entirely different proposition. The doubts about the quality of an underperforming manager or their suitability for the prevailing market environment are relentless. Fund investors spend most of their time worrying about the managers who are underperforming. It is difficult to overstate how behaviourally taxing it is. The easy option is always to switch from the bothersome laggard and into a flavour of the month leader to make the questions and concerns disappear, at least for a time.  

Persisting with an underperforming active fund as an individual is extremely challenging, but even if we have the personal wherewithal, the problem does not vanish.  It is not just us that has to endure it – it is the other stakeholders too.

The underperforming fund manager and the firm they work for must also retain conviction. It is of little use if we stand firm only to see the manager change their approach or their employer fire them.  The incentive of the fund manager is to keep their job and for the asset management company to preserve assets; keeping faith with an under-scrutiny investment strategy which has delivered years of poor results is not aligned with either of those. Unfortunately, for a fund manager, possessing investment skill might not be enough.

For professional fund investors, the final hurdle is the people we are accountable to. Do we work in an environment that is supportive of adopting a long-term approach and willing to endorse investment decisions that will look wrong, often for sustained periods?  There is no point investing in active funds if we will repeatedly be forced out of them (due to pressure from others) after three years of underperformance. As a pattern of investment behaviour, it is hard to think of a more pernicious strategy.  

There are no easy solutions to the problem of persevering with a struggling but skilful active fund manager. The temptation to sell will often be overwhelming. There are two ways of giving ourselves a fighting chance. The first is setting the correct expectations at the outset – we need to be abundantly clear about the prospects for a fund or manager with all interested parties. Even if we are right, multiple difficult years are inevitable.

The other potential ameliorative is manager blending. Combining active fund managers of different styles should not only smooth returns and provide diversification benefits; if done well it is an effective behavioural tool. When one manager is experiencing a fallow period, another is likely to be enjoying a tailwind and delivering superior results. The whole concept of blending is built on the notion that not everything will work, all the time. Even attempting it helps in setting the correct expectations. Furthermore, the pain of the underperformance from one fund will be offset (somewhat) by its more productive counterpart.

Blending is no panacea. It is far from a precise science and if it is done too well, we will end up owning an expensive version of the market. It will also not stop us and others worrying about the straggler. The pain felt about the underperformer is likely to be more acute. These issues notwithstanding, it is the best option available to investors in active funds.

Unfortunately, even if we can hold active funds through tumultuous periods of performance it is not enough to guarantee positive outcomes. The manager we invest in might actually be underperforming because something has gone wrong, and the right course of action is indeed to sell.

Nobody said it was easy.



Vanguard Study: Patience with Active Performance Cyclicality

How Should We Judge The Quality of a Sell Decision?

Determining whether a decision to sell an investment was correct seems like one of the simpler judgements that we make. If it continues to perform well after we have sold it then it was a mistake; whereas if it goes on to struggle it was a wise choice. Unfortunately, it is not always that easy. Focusing on the outcome of a decision alone can often be deceptive and lead us to draw entirely erroneous conclusions.

To explore why this is often the case, it is useful to offer some examples. The main issues we face when assessing the quality of a sell decision is dealing with known costs, hindsight bias, and tail risks:

Known Costs

The manager of a value fund sells a stock once it returns to its fair value. Following its sale, the stock continues to perform well and reaches a historically expensive price.

This can easily be viewed as a fund manager making the error of selling too soon or failing to run their winners. But is it? The manager has a philosophy and process built on buying undervalued securities, should we really expect them to continue to own a position when it becomes expensive?  This would invalidate the process. In such situations following the process is the correct decision even if it appears to be a mistake from a pure outcome perspective.  

If a manager persistently encounters situations where they are selling stocks that go on to outperform, they could adjust their process to capture this momentum. The alternative route is simply to state that missing out on these returns is a known and accepted cost of their approach.

Hindsight Bias

We are investing in an actively managed fund that undergoes significant changes; the asset management company is acquired, and the fund manager departs. An individual with minimal experience is appointed to run the fund. We decide to sell our position in the fund. It performs incredibly well over the next five years and is amongst the strongest in its peer group.

When we review a sale, we will inevitably incorporate information that was not available at the time the decision was made. The potent combination of hindsight and outcome bias means that not only we will think it was a mistake to sell the fund, but that it was obvious that we should not have done so.

In this instance, the new manager may simply have been lucky. Even if they do possess skill, we did not have sufficient knowledge at the time to make such a judgement. The choice to sell the fund was unequivocally the correct one. It will appear, however, as if we sold a talented fund manager at precisely the wrong time.

Tail Risks

We are investing in a fund which has a stellar track record but are becoming concerned about certain developments, particularly around the behaviour of the fund manager. We are not sure how serious these are but estimate that there is a 5% chance of the fund ‘blowing up’. Given this, we decide to sell the position. The fund continues to deliver outstanding returns in the years that follow.

This is a simplified example designed to portray the most difficult type of sell situation faced by an investor. Despite the decision being correct, we will likely be considered foolish for making it. As if we were worrying about nothing and have needlessly forgone performance.

When we judge the success of decisions solely on outcomes, we are likely to consistently penalise those choices that seek to avoid the cost of low probability, high impact failures. As, by definition, they do not often come to pass. Prudent, risk conscious choices will frequently appear unnecessarily cautious.



It is not that results are unimportant when assessing the quality of sell decisions. They can tell us a significant amount about our investment behaviour, particularly if we can build a large enough sample size. They do not, however, tell us everything. Successful investment is about creating a process that gets the odds on our side. In a system where randomness and chance can exert an overwhelming influence, we need to think less about the result of a given decision and more about whether it was consistent with a robust process.

All Active Fund Managers Should Run Systematic Replicas of Their Portfolios

If you asked a traditional active fund manager whether they could effectively replicate their investment approach in a systematic fashion they would almost certainly say no. They would likely cite the advantages of human judgement and the nuances of their process that cannot be captured in a purely quantitative system. And, of course, they have to say this. To suggest otherwise is to infer that the activity they are richly rewarded for can be efficiently and cheaply emulated. Yet incentives and self-interest aside, developing a systematic replica of their fund or portfolio is exactly what every active fund manager should be doing. There is no better way of isolating the noise that impacts their own judgements or better understanding the often-ambiguous advantages that come from qualitative input.

It should not be difficult for a fund manager to create a version of their fund that is run on a systematic basis. All that is required is an algorithm built on a defined set of decision rules.  It can be more sophisticated than this – you might use some form of machine learning – but this is not essential.  The only question the fund manager needs to answer is: if you had to run your fund in a purely quantitative fashion, how would you do it?

In its most basic form all that is required is a set of portfolio construction rules (number of positions, position sizes, concentration) and criteria about when to buy or sell securities. This can be as simple or complex as is desired, provided it can be managed and maintained by a computer with minimal human involvement.

There are three key reasons why such an approach should be valuable to active fund managers:

Idea Generation: Although not its primary purpose, it can function as a buy and sell idea generation tool that is more sophisticated than a screen or filter. If you continue to hold a stock that the systematic version of our strategy has sold, you should be able to justify why.

Noise Cancelling: The most impactful feature of the approach is the ability to observe investment decisions being made absent much of the noise that influences human judgement. There are a multitude of factors that lead us to make inconsistent and erratic choices. Running a systematic version of a fund removes this issue by focusing solely on the rules prescribed.  How much of the potential loss in rigour and detail is compensated for by the removal of noise?

Identifying Value-Add: Active fund managers often struggle to convey what their true value-add or edge is. Too often it is overly generic (‘growth at reasonable price’) or suitably vague (some kind of ‘secret sauce’ or ‘art’). This is a problem. If fund managers are attempting to sell a skill at a high price, it would be helpful to know what it is. Running a systematic version of a fund can be incredibly beneficial in this regard. 

By comparing the behaviour of the standard (qualitative) fund to the systematic replica it is possible to contrast the divergences in decision making. Through time a history of disparity can be built. By understanding when and why these occur a fund manager can identify exactly what the specific tasks or behaviours are that add value relative to a systematic approach.

Not only is creating a systematic replica useful in conveying to potential investors what the skill of the manager or team might be, it should also greatly assist the manager in refining their process. It should allow them to focus on circumstances and situations where they are most likely to prosper, and abandon those where they consistently fare worse than an algorithm.

There is a glaring problem with this whole idea. What if it tells a fund manager what they don’t want to hear? What if a simple systematic approach consistently makes better decisions? But this shouldn’t really be the case because most fund managers must believe that what they are doing is superior, otherwise it would be a fairly unfulfilling (if lucrative) endeavour. Fund managers should also always be willing to better understand their own decision making and seek to improve it.

Before worrying about beating a benchmark, active fund managers should first try and beat a systematic version of themselves.

What are the 10 Biggest Mistakes Made by Fund Investors?

Based on years of observation and bitter, painful experience; here are my thoughts on the ten most significant mistakes made by fund investors:

1) Searching for performance consistency 

There is perhaps no more damaging feature of the fund selection industry than the quest for performance consistency. By this, I mean the reverence for funds / managers that deliver outperformance compared to their benchmark over a variety of short time periods (consecutive months, consecutive quarters, consecutive calendar years). The problem is not that it is a bad outcome (it is clearly an incredibly positive one), but that it is used as a shorthand for skill or an indication that such patterns will persist into the future. Both notions are false. 

For performance consistency to tell us something meaningful about future fund returns or the presence of active management skill, we need to believe one of two things: 

a) That the manager or team have the foresight to predict short-term market movements: Most investors would surely accept that market returns over the short-term (at the very minimum) are highly unpredictable and variable, yet by using fund performance consistency as an indicator of skill or quality we are suggesting that the manager responsible can indeed predict market movements over the next month, quarter or year. If they couldn’t then their fund would not deliver consistent excess returns. 

b) The tailwind a fund is enjoying from style or market conditions will persist indefinitely: If we reject the notion that any individual or team can accurately and regularly forecast future market conditions, then performance consistency must arise from some style or bias inherent in a fund that has been in-vogue for a sustained period. Whilst style and factor performance can persist for prolonged spells (often much longer than we think), they will not be maintained forever. So often fund investors mistake factor and style momentum for skill. There is nothing wrong with using fund performance consistency / momentum to make investment decisions, provided we are clear about our intentions and set appropriate rules. We shouldn’t pick a fund because it has outperformed for six consecutive years and then carry out four manager meetings and hours of due diligence to justify a decision based on performance momentum.  

The only consistency fund investors should worry about is consistency of expectations -is a fund behaving in a manner that is consistent with reasonable expectations about its approach? It is critical to remember that if the returns of active funds were all entirely random, there would still be those that produced a remarkable consistency of returns by sheer chance. 

Not only does the search for performance consistency lead us to misattribute skill and luck, but it encourages some of our worst behaviours – most notably lurching between outperforming and underperforming funds. If we buy a fund based on performance consistency, what happens when it inevitably falters? We sell and move on to the next name at the top of the performance tables.

The problem is that the notion of performance consistency is incredibly compelling and has captured all market participants from regulators to private investors. Unrealistic expectations abound. The simple fact is that if we cannot accept inconsistency and maybe years of underperformance, then we should take as little active risk as possible. 

2) Neglecting the circle of competence 

If we are investing in an active fund, we are assuming that the manager or team possess some form of skill that allows them to outperform, but we are often vague about what the particular skill is. The worst form of this to classify someone as a ‘good investor’ (what does that mean?) Even when we attempt to be more specific – ‘macro’, ‘picking cheap companies’ or ‘selecting companies that beat the fade’, they don’t go anywhere near far enough. If we are not clear about exactly what skill(s) are evident then we are liable to allow managers to stray well outside of their circle of competence and into dangerous waters.  

When a fund manager develops a strong track record, we often seem to be comfortable watching them creep or leap outside of their circle of competence into areas where they have no credible history or expertise. The failure of the UK’s leading fund manager was a circle of competence issue. Neil Woodford’s shift into small and unquoted, often speculative, companies was not hidden, he was (for the most part) very transparent about what he owned. His shift was accepted* because of his past performance; even though this was produced doing something entirely different. 

If we are invested in active funds where skill is an expected feature, we need to be precise and explicit about what it is. If a fund manager shifts away from their core competency, we should start to worry. 

3) Seeking smooth returns 

Investment frauds are often not about stratospheric returns, but instead something that might be even more desirable – smooth performance. The attraction of funds that move on an unperturbed path upwards is entirely understandable – drawdowns and volatility are painful and bring about poor behaviours – but it is an entirely unrealistic expectation. If we are to invest with even a modicum of risk then we will witness variability in returns. Fund investors need to accept this rather than find ways to avoid it. That doesn’t mean we cannot make the journey smoother by implementing sensible investment principles such as diversification, but volatility is inevitable and indeed it is a reason why long-term equity returns are so high. 

Even away from frauds we can easily be tempted into funds that provide apparent diversification and smooth returns, simply because they are priced on a different basis to more liquid assets. The idea that certain private equity strategies, for example, are diversifying and lowly correlated to public equities because their assets are marked to model is nonsense. This type of situation is worsened by employing mean variance portfolio optimisation approaches that compare volatilities across asset classes with different pricing methodologies.

We should never let the attraction of smooth performance leave us blind to what assets a fund is actually investing in. 

4) Ignoring the odds of the game 

The first question we should ask about a fund selection decision is – what are the odds of success? But it is one that is rarely posed. It is possible to argue that it is too difficult to make a reasonable estimate of the chances of a good outcome, but this is not credible. If we want to know whether to participate in a game, then we should at least try to understand the odds. There is no precisely right answer, but there are critical questions we should always ask. If we are investing in an active strategy in a particular asset class, what is the history of success for active managers? Do the underlying returns within the market tend to be highly dispersed? We can easily build a picture that gives us a sense of how difficult or easy our task might be. So why don’t we do it? 

Aside from the difficulty of making an accurate probability assessment, there are two additional issues: 1) We tend to think that our case is special and falls outside of the odds of the normal game, 2) We are overconfident. We don’t care about the odds of the game, because we are that good they don’t apply to us. 

To make informed judgements about fund selection decisions, we need to seek to understand whether an investor has skill and if they are operating in an environment where their skill gives them a material opportunity for success. How difficult is the game being played likely to be and who are they playing against? 

5) Being complacent on capacity 

Capacity is a perennial problem for fund investors. Issues around fund size are only likely to occur in funds that are performing well (making us reluctant sellers) and the asset manager is unlikely to acknowledge that a key revenue generator should be closed to new business. 

Despite a disinclination to act on capacity from either fund buyer or seller, it is inescapable that asset growth serves to constrain a fund (when above a minimum viable threshold). A rising fund size limits the investable opportunity set, restricts flexibility, and fosters liquidity risks. 

We are often warned that we should not expect a fund to repeat historic excess returns because the environment is likely to be entirely different in the future. When capacity problems arise, it means a fund could not replicate past successes even if the environment were identical because it is encumbered by the size of assets managed. 

Fund investors need to take ownership of the capacity question, not rely on assurances from asset managers or wait until performance deteriorates. 

6) Buying thematic funds for the wrong reasons 

The continued growth of thematic funds – particularly in ETF structures – is a problem masquerading as an opportunity for fund investors. The potent combination of strong (often hypothetical) past performance and a compelling narrative can be behaviourally irresistible, but frequently leads to disappointment. Thematic funds are often little more than price momentum strategies with a story attached and absent any of the rules that define traditional momentum approaches.  

There is nothing intrinsically wrong with investing in a thematic fund, provided that the reason for doing so is sound. It is a pure way to benefit from the price appreciation brought about by pronounced flows into fashionable areas and we might profit in a second order fashion by predicting how other investors will behave. The major danger in such an activity is knowing when to exit.

The less credible argument is a fundamental one – that the securities captured by a theme are somehow unknown or undervalued. If a theme has performed so strongly and is sufficiently well known to have funds launched based on it, it is probably already in the price.

Thematic funds need little marketing because its sales pitch is embedded in investment philosophy. Tread carefully.

7) Forgetting we are all active investors 

The binary distinction between active and passive investing is simple and effective, but it is not strictly true. All fund investors exist somewhere on a spectrum between the two extremes, no portfolio or fund decision can be considered purely passive. Even in the most basic 60/40 construct there are decisions to make: Is just developed market equities, or should emerging market equities be included? What is the neutral duration position? Should high yield be incorporated? What about gold? 

The critical point is that investors who believe they are passive are not immune to many of the behavioural issues that more active investors face. In my time running passive only multi-asset funds, most of the questions I received were about why we were underperforming other passive funds with different asset allocations.

The prolonged success of long US and long duration portfolios has led to the assumption that people can simply invest and forget, this is great in theory, but unrealistic in practice. What happens if US equities underperform for five years? How strong will the temptation be to shift to the passive manager with a greater exposure to emerging market equities or a significant non-US developed market bias? 

We are all taking some level of active risk, fund investors need to acknowledge what that is and be aware of the behavioural temptations that come with it. 

8) Getting lost in complexity

We should avoid investing in things that we do not understand or cannot explain.  Owning complex funds is incredibly tempting – it makes us look good (see how smart we are!) and offers the prospect for a stream of returns different from traditional funds (uncorrelated, non-directional, through all market environments etc…) Yet mixing complexity (funds) with complexity (markets) often compounds risks rather than reduces them and in ways that can be impossible to foresee. Returns from simple investment strategies have been incredibly strong in recent years and will almost certainly be lower in the years ahead, despite this we should remain circumspect about complex funds.  

9) Starting with the assumption that a fund manager will outperform 

Selection effects such as survivorship bias can run amok when carrying out fund research. When seeking to identify a fund in a particular asset class the opportunity set will already be biased towards funds have had some solid spells of performance by virtue of the fact that they still exist.  In addition to this, we will probably have filtered the universe further through some form of quantitative performance screen.  As the funds we are researching will likely have been strong performers, we typically seek to discover how they have managed to outperform and why they might continue to do so. This is the wrong starting point. Our default position should be that every active strategy is destined to fail even if they have performed well in the past (maybe because they have). There must be exceptional evidence to the contrary to take a different view.

Framing our shortlist of candidate funds as a group of skilful managers who are likely to outperform in the future sets the bar far too low.  We need to begin by assuming everything will underperform.

10) Having time horizons that are far too short

If there was one thing that could be done to improve the decision making of fund investors it would be to extend our time horizons. The shorter our timescale the more we are captured by chance; consistently making judgements based on random and unpredictable market movements.

The irony is that as we try to become more sophisticated and diligent investors our time horizons inevitably contract making us worse investors. We check our funds too frequently, make confident inferences based on little but noise and overtrade. Unfortunately, it never feels or looks like this at the time. We have so much ‘information’ available to us that every choice appears reasonable and well-informed in the moment. Each switch from an underperformer to an outperformer feels good whilst we are doing it. It is only when we reflect that we are likely to observe the long-term costs.

This is an issue that is getting worse.  Our time horizons are becoming ever shorter. More observation points, more near-term scrutiny, and more unnecessary activity. What is good for preserving our careers or getting us through that next difficult meeting is probably to the detriment of our long-term returns.

* Private investors can not reasonably have been expected to know this; professional investors should.

Why Do Fund Investors Neglect Base Rates?

Given the vast amount of time, effort and resource dedicated to fund research it would seem absurd to suggest that the most critical pieces of information are ignored or neglected, but it often seems that they are.  Fund research can be defined as an inside view activity; one where the precise details of a particular case can dominate our decision making. This might be the pedigree of an active manager, an impressive track record or the attractions of an in-vogue investment theme. The allure of these specific features leaves us prone to ignore the general lessons from similar situations (the outside view). This means we make decisions without even knowing where the ballpark is[i].

The most effective form of outside view is the formulation of a base rate.  Although popularised in recent years, the idea of employing a base rate in decision making can still seem a somewhat arcane activity.  But a base rate is simply an observation derived from an appropriate reference class of similar examples[ii]. If we knew nothing about the specifics, then the base rate would be our only guide.  Let’s say we wanted to estimate the operating margin of a certain airline. The inside view would be derived from the specific features and operations of that company, whereas the outside view / base rate would be based on the operating margins of all airlines.

For fund investors, we can think of the base rate as answering two questions:

What do similar scenarios tell us about the likely outcome?

and

What do similar scenarios tell us about the odds / probabilities attached to our decision?

Fishing for a base rate

Imagine we are asked to make a forecast of how many fish a fisherman will catch on a single day. We speak to the fisherman and find that they are incredibly skilful and experienced and utilise the most sophisticated equipment.  They are supremely confident that they can catch more than 10 fish. We have our inside view. Is that sufficient to make a robust prediction? No. We need an outside view.  On further investigation we find that over the past year fisherman at the lake catch on average only one fish per visit. This is our base rate.

We might refine our reference class and look at the average catch of fisherman at different times of year or in certain weather conditions, but a good base rate needs to balance sample size and specificity.  Once we have a base rate, we understand the history of similar scenarios and have an idea of the odds of certain predictions being correct (the chances of catching more than 10 fish seems low). We are now much better placed to decide.

The base rate is a vital piece of information. Imagine attempting to forecast the number of fish caught without it.  It does not provide us with the answer, but it does offer a starting point.  We can still make a decision that is contrary to what the base rate tells us.  For example, we might argue that fishing is an activity heavily influenced by skill, and therefore the skill of the chosen fisherman will render the base rate less relevant – but at least we are clear in the assumptions we are making. Underweighting the base rate in a transparent fashion is far better than ignoring it.

Fund investing and base rates

Unfortunately, there is no single base rate that we can take from the shelf to apply to our decision making. We need to define and identify an appropriate reference class. There also might be multiple angles around which we wish to apply a base rate to a decision.  There are a range of base rates fund investors might adopt. Here are some hypothetical examples:

Over the past 10 years X% of active managers have outperformed the benchmark. 

This is a relatively straightforward and easy to source base rate with a clearly representative reference class. We don’t have to be beholden to it, but we should be explicitly aware of it as a measure of the odds of success in selecting an active manager. Again, we might argue that the figure is unrepresentative of the future because, for example, the dominance of a select group of large companies made it unusually difficult to improve on the benchmark over the past decade. However we use such a base rate, we should be clear on what it is and how it impacts our choices.  

On average, funds that outperform by more than 10% annualised over 3 years, return X% over the subsequent three years.  

This is a different type of base rate more attuned to the tendency of fund investors to chase past performance and for fund excess returns to mean revert. If we are buying a fund with a stellar track record it is critical to understand how likely it is that this will continue; particularly as the inside view at the point of maximum performance will be incredibly compelling. A good example of this type of thinking is an article by Morningstar observing the performance of funds after they had risen by more than 100% in a single calendar year.[iii]    

Equity markets that have outperformed over the last decade and are relatively expensive, underperform by X% over the subsequent decade.

Base rates for fund investors are not simply about the classic, binary active versus passive debate. All investors are active in some form. Even if the underlying funds we use are trackers, the asset allocation involves active decision making – nothing is purely neutral. If we have benefitted from being heavily invested in US equities for the last decade by virtue of the construction of a particular index, we still need to apply base rate thinking to the implicit views we are expressing.

Why are base rates ignored?

Given how valuable base rates are to effective decision making, it is somewhat puzzling that they are not more widely and obviously used by fund investors. There are several factors that limit their employment:

Overconfidence: An exaggerated belief in our own abilities means that the base rate or average does not apply.  Odds of 10/1 against are meaningless to us.

Exceptionalism: Overconfidence means that we think that we are exceptional; in addition to this we tend to think that our specific case is the exception. This time / this one is different, so the base rate again does not apply. 

Salience and Stories: The inside view is far more interesting and persuasive than the outside view / base rate, therefore it tends to overwhelm it. The backstory to a specific manager or market is so much more diverting than looking at historic experience and averages.

Time: As with all incidents of (poor) investment judgments time has a central role to play.  Base rates often exert their influence over time but can be of little use over shorter time horizons. Without the right level of patience or appropriate environment the importance of base rates will diminish.

Difficulty: Although the concept of base rates is relatively simple, its application for fund investors is not easy. Aside from having access to the required data, it is not always obvious which element of a decision we wish to apply a base rate to and what the appropriate reference class is. There is no perfect answer here but doing something is a dramatic improvement on doing nothing.

Incentives: At times base rates will tell us information that we don’t want to hear, so we consciously or unconsciously ignore them.  



An attempt to incorporate an outside view and ascertain appropriate base rates should be integral to any fund investment we make.  Establishing a base rate not only improves our judgement, but it brings clarity as to why we have made a particular decision.  We need to allocate time away from the specific to better understand the general.


[i] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/daniel-kahneman-beware-the-inside-view#

[ii] https://plus.credit-suisse.com/rpc4/ravDocView?docid=gIamqy

[iii] https://www.morningstar.com/articles/1017292/what-to-expect-from-funds-after-they-gain-100-or-more-in-a-year-trouble-mostly

Why Should Equities Be Fairly Valued?

Investors spend a great deal of time thinking, writing and talking about the fair or intrinsic value of equities, whether it be an entire market or individual company. This is a critical issue. There is probably no greater determinant of the long-run returns we make than the price that we pay. The obvious challenge is ascertaining what fair value is – how do we estimate the current worth of cash flows we expect to receive in the future?  If this task is not difficult enough, there is another problem. Even if we knew the fair value, what would we do about it?  There is no reason to expect that equities should be fairly valued today or tomorrow.

When we discuss equities being cheap or expensive the underlying view often seems to be that at some point ‘the market’ will identify this anomaly, creating the opportunity to profit from a revaluation. The glaring assumption here is that the majority of participants are interested in the same thing. It presumes that most investors are engaged in an effort to calculate the fair value of an asset, they are just coming up with different answers. This is some distance from reality. Investors have a multitude of motives, approaches, and philosophies, many of them with a time horizon far shorter than one which would make defining fair value relevant.   

Wisdom of Crowds

It is easy to think about equity market pricing as a wisdom of crowds model, but it is not. In the classic example, individuals guess the weight of an ox, and the average of these are superior to most individual estimates. This idea can be used to claim that equity markets have a similar form of efficiency. Yet this wisdom only emerges if everyone is trying to guess the same thing. If, instead, some participants guess the weight of a pig, some a sheep and others a cow, the average would not be that useful in gauging the weight of an ox.  

This is the situation for equities. It is not that investors are using identical information but coming up with different answers; it is that they are using information for entirely different purposes. If investors are making decisions based on price momentum, multiple expansion, monetary policy, fiscal stimulus or simply adopting a passive approach, why should the assets in question be priced at their fair value?

The same applies to time. If we are focused on outcomes over one week, one month or one year, what is the relevance of the long-run valuation? If investors are investing for different reasons and with varied horizons, why should equities be fairly valued?

When Valuation Matters

This is not an argument that valuations do not matter, but rather there is no reason to believe that they will matter on any given day, nor is there a constant search by the market to discover fair value. It is best to think of valuations as having a weak gravitational pull over asset prices. Prices will fluctuate through time as cycles evolve and investors extrapolate. They will happen to pass through fair value at various unpredictable points.  

Considering valuations in this fashion leads to two critical observations. First, is the trite but true point that valuations are not useful in timing investment decisions. Second, is that extremes matter. A weak gravitational pull means that prices can diverge materially from fair value, but not become entirely disconnected.

If most investors are not investing because of fair value considerations, why would valuation exert any influence at all?  Because at extreme prices behaviour will change – for example, at dramatic levels of cheapness in an asset class or security the near-term cash flows will be high enough to attract an increasing number of investors.  Similarly, investors will eventually move away from a staggeringly expensive asset, in favour of competing assets with a more attractive cash flow profile.  

To take an absurd example, if an equity market is trading on 100x earnings and paying a 0.1% dividend yield whereas high quality bonds in the same market yield 4%; this will impact the decision making of investors and companies. This is a gross simplification to make the point that there is an unidentifiable juncture where some form of valuation consideration will start to matter more to more people.

The problem with this idea is that we know neither what fair value is nor what extreme means. We can make an estimate of fair value for any asset, but the range would have to be broad, and we might still be wrong. We can even build a framework for defining an extreme divergence, but this will not help us with timing. If we believe that asset prices are extreme then we are paid to wait for when the price again moves through fair value, but we will have no idea when this might occur. 

Extreme dislocations are meaningful because they account for the noise and uncertainty inherent in estimating a fair value for an asset class. If prices are a great distance even from a fair value assumption with a wide range, we can be more confident of the anomaly. Furthermore, extremes matter because they change the probability of suffering from disappointment and disaster. Very expensive assets are likely to carry a greater risk of the long-run disappointment of low returns, and the short-term disaster of a dramatic, permanent reset in price. 

The Valuation Dilemma

Valuations are vital for long-run investment returns, but there is no reason for an asset class to be fairly valued on or by any specific point. We should be aware of extreme dislocations between price and valuation, but these are not easy to define or time. This presents something of a quandary, so how should investors think about these issues?

– Any notion that the pricing of equity markets is efficient because it represents our best collective guess at its fair value based on the information available is unlikely to be true. Investors are using the information in a multitude of ways often unrelated to any approximation of fair value. That the market is not efficient in this form, does not mean it can be easily exploited however.

– Even if we knew the fair value of equities, there is no reason to believe that they will be priced at that level at any given time.  The market is not ‘attempting’ to find fair value.  We should not wait for other investors to ‘realise’ what fair value is.

– Because we operate with such short time horizons, perceived over or under valuations of an asset class or security are often viewed as an opportunity to participate from mean reversion, but we cannot hope to predict this. The more important element of valuation discrepancies is the ability to secure higher cash flows and reinvest at a higher rate of return and avoid the opposite – low cash flows with lower rates of return. This requires time.

– Buying assets that appear extremely cheap based on some view of fair value should be beneficial (on average) because the rates of return should be high, and we should be confident that prices will not become entirely detached from valuation (but can get pretty close to it).  Taking aggressive and concentrated views, however, based on this belief is always a bad idea.

– The longer our real time horizon the more likely it is that we might benefit from extreme scenarios. If our time horizons are short, notions of fair value are close to meaningless. Not only can we not predict when an asset class might become fairly valued (as there is no reason for it to be), but the higher cash flows that we might benefit from over the long-term, are likely to be overwhelmed by short-term factors such as price performance, momentum, and stories.  The premium for long-term investing exists because it is so difficult to do.



There is no reason for equities to be fairly valued at any specific moment. Over time they will pass through some fair value range for unpredictable reasons, at unpredictable instances.  Despite this, for long-term investors, valuations are likely to define our outcomes and periods of extremes will create the greatest opportunities and threats.  

Does Sustainable Investing Change What Shareholders Want?

At its heart, the shift towards sustainable investing is driven by the disconnect between the attempt of companies to maximise short-term shareholder value and the impact their activities have on other stakeholders and wider society. The doctrine of shareholder value maximisation is best expressed by Milton Friedman’s assertion that the “social responsibility of business is to increase its profits”.  It is hard to dispute the notion that this philosophy has defined the motivations and actions of most companies and shareholders in recent decades.

Listed companies have an obligation to their shareholders.  This requirement is typically viewed as generating the highest possible returns on capital in its business activities and producing a rising stream of profits. Until recently these ideas were uncontroversial and rarely disputed, but is this still the case? Has the rise of sustainable investing changed the entire notion of shareholder value maximisation?

This is a question investors must answer, and one that is rarely addressed.  We currently exist in an environment where there appears to be a perception (or at least a sales message) that an improved focus on sustainability and responsible investing will inevitably improve financial returns. Yet this cannot always be the case. The notion that capital can flood into certain in-vogue areas driving down the cost of capital whilst returns remain high seems fanciful at best.   

It is not a conversation that anyone is keen to have, but what if, in certain companies and industries, the move towards sustainability (and other ESG goals) depresses returns to shareholders at the expense of other stakeholders, society and the environment? Are investors willing to accept this?

Let’s take a hypothetical example. A large oil company is considering investing in a sizeable offshore windfarm project. The investment would help the business transition away from fossil fuels, but the torrent of new capital into renewable energy means that the expected returns from the windfarms are low in all but the most optimistic scenarios; significantly lower than the returns that they enjoy on their existing business. Should they make the investment?

From Friedman’s perspective the answer is clearly no, companies should not be making decisions that are likely to diminish the value of a business, and, if they do, they are failing to act in the best interests of their shareholders. But presently investors seem to be supportive of this type of activity. Why are investors encouraging developments that may reduce the returns they make? There are four potential explanations:

  1. They do not see such projects as low return and believe they are a superior use of capital even from a traditional, shareholder profit maximisation perspective.

  2. They believe that moves into fashionable, growth industries will create positive share price momentum, (they are not interested in fundamentals).

  3. Over the very long-run, fossil fuel activities will become obsolete, whereas returns from renewable energy will persist. If you stretch your time horizon into the distance, the latter activity may be more valuable.  

  4. They are willing to accept lower returns because of the greater stakeholder good delivered by the move to renewable energy.  In essence, the argument here is that shareholder returns are a much broader concept than the cash flow we receive from our investment.

Different investors will have different perspectives on the scenario presented, but to navigate the field of sustainable investing as it develops, we must be able to answer it.  It is naïve to believe that sustainable investing automatically leads to higher returns for shareholders, or to ignore the fact that it threatens to change the common definition of shareholder value.

Sustainable investing is about returns we may never notice

Investing sustainably means we must consider what we want our investments to achieve away from the narrow lens of headline performance, and decide whether we are willing to potentially sacrifice returns to achieve it.  

For sustainable investing to change the asset management industry profoundly and permanently there needs to be an appreciation that the returns it generates are far broader than that which we typically associate with our investments. It is not only about profits and losses, or performance relative to a particular benchmark. Instead, it is about a form of returns that we may never notice.

These returns can occur in two ways. First, the widespread adoption of sustainable investing should force and encourage companies to improve behaviour and focus on a wider group of stakeholders over a longer time horizon. The benefits of such a transition could be incalculable.  If it aids in limiting the rise in global temperatures, such activity is worth far more than any relative outperformance against a benchmark, but it is an improvement we may never perceive because there is no counterfactual.  No parallel universe where these changes did not occur.  

Second, our long-term investment returns – in the broadest terms – may be higher because of the shift towards sustainable investing.  The disastrous impact of a failure to keep climate change in check – for example – would almost inevitably depress returns across many asset classes; thus, the aggregate influence of increased sustainable investing may help boost long run performance of most risky assets. Again, we will never observe this or experience what would have happened in alternative scenarios.  

If we treat sustainable investing as merely a theme to boost stock or fund performance the movement will fail to have a lasting impact. Inescapable periods of poor returns will lead to capital being withdrawn and behaviours changing. Despite the current fervour around sustainability and ESG factors we really don’t know how dedicated asset managers and investors are.  What happens after three years of underperformance? Do investment committees start sacking managers and abandoning previous commitments?

If we are adopting a sustainable approach to investing it is critical to reframe how we think about returns. Our rationale cannot be founded solely on a desire to outperform traditional strategies – we might, but there are no guarantees and no robust evidence. Rather we do so because we care about more than simply the narrow financial returns of our investments, and because we believe that the widespread acceptance of sustainable investing will improve everyone’s outcomes in the long run, in a multitude of ways. That is an exceptionally different type of shareholder value creation.

The Inflation Story

This is not another piece about inflation. Well, it is a little, but it is really about stories. Just as most things in investment are. The market narrative of the moment is inflation. The possibility of long dormant consumer prices rising, perhaps substantially, as a recovery from the pandemic (in some parts of the world) meets substantial fiscal and monetary stimulus. The potential implications for interest rates, asset classes and future returns are undoubtedly significant. But what should we do about it?  As investors we lurch from one diverting story to the next, usually forgetting what we were obsessing about in the previous quarter. How do we know how much we should really care?

Financial markets are narrative generating machines. Creating stories is the only way we can deal with the discomfort caused by their complexity and unpredictability. Some can be long-running undercurrents (secular stagnation, for example), others can flare up and come to dominate but only for fleeting periods. The current fascination with inflation is in the latter group, it might morph into something more enduring, but nobody really knows.

We spend most of our time obsessing over these short-term narratives. They spread and bloom with incredible speed. This is both due to their salience (they quickly become incredibly prominent) and their transmissibility – even if you regard an issue as short-term noise, if a client or colleague is aware and asks you a question, you need to respond. A particular story can rapidly become an issue that everyone must address and have an opinion on. It comes to be the focus of every meeting. It is remiss not to mention it. This is where inflation is now. That is not to say it doesn’t matter, but rather because we cannot predict it, we don’t know how much it matters or what to do about it.

Asset prices movements are frequently used as validation for these types of flourishing stories, but that is getting the order in reverse. Often it is the movement in asset prices that creates and fuels the story. Price gyrations must be explained, so a narrative is forged, and its persuasiveness creates increased momentum in prices.  Either a vicious or virtuous circle depending on your positioning.

Most macro investors are playing this momentum / story dynamic (save for a few contrarians). Although they may make bold proclamations about the forthcoming economic environment and its impact on markets, it is typically just momentum trades with a narrative attached. The alternative is to believe that people can accurately predict staggeringly complex systems like economies and markets, but nobody really thinks this, do they?

Inflation is the story today, but there is always something. These often ephemeral, self-reinforcing stories that investors fixate upon have a range of consistent features:

1) Everything is amplified: The implications of a major story are usually greatly exaggerated. We don’t have a mild rise in inflation from unusually low levels, we have an inflation problem. Bonds are not returning to yields of a year ago, it is a rout.  Unfortunately, the power of a narrative is not often related to its credibility or importance.

2) Temporary experts: We will hear most from people whose views have been long aligned with the story that comes into the spotlight. In that moment, they will be considered an expert, even if they have been wrong for the previous decade.

3) Everyone has an angle: People will talk their book on any given story. Don’t ask a bond investor or a commodity investor for their opinions on inflation. We know them already.

4) Stories are often transitory: In the moment, certain stories will feel overwhelming and all-encompassing. What we see is all there is. It is hard to believe that we might well be focusing on something else in a few months’ time. But so often we are.

5) Stories sell: Prominent narratives provide a perfect opportunity to sell products. Stories are how we understand financial markets, they dominate how we feel and behave. Asset managers will inevitably shape their offerings to match the story that – for the moment – has our rapt attention.

Investors are constantly battered by a torrent of stories. These are used to explain or predict market behaviour, from daily price changes to long-term trends and themes. The sheer volume of shifting and often contradictory tales make it impossible to ascertain which are valid and what we might do about them.

Inflation is an important risk that investors must be aware of over the long-run, we should prepare our portfolios for its lasting impact and be appropriately diversified in order that we are reasonably insulated irrespective of the outcome. We should not, however, make rash decisions based on short-term narratives about things we cannot predict.

It is Difficult Being a Skilful Investor

If I am a skilful tennis player, it is obvious. I win more points, games, sets and matches. There will be the occasional dose of bad fortune and the waxing and waning of form, but it is easy to tell if I have skill. In many activities results alone are sufficient to gauge ability. Investment is not one such activity. Skilful investors will often appear incompetent, amateurs can outstrip professionals and idleness can better action.  This is what we would expect in any environment where randomness has a prominent influence on outcomes. It is not, however, just bad luck that talented investors must contend with; in a dynamic system, they must always question whether their perceived skill remains effective.

We can think of skill as there being a consistent link between process and (desired) outcome. Hitting a forehand in tennis 70mph onto the baseline 95 times out of 100 is a skill. It is specific, deliberate and repeated. The ease in identifying skill depends, however, on the task in question. If luck has a meaningful involvement, then skill becomes incredibly challenging to locate with any level of confidence. 

The effect of randomness is the most obvious problem faced by skilful investors. It means that they can attempt to apply a skill in a consistent fashion but achieve disappointing outcomes. They will also lose to others who have less skill and may come to be perceived as having no skill. The notion that skilful investors are often thwarted by misfortune, however, is based upon a significant and precarious assumption – that investing skill is stable.

An oft-used analogy for the luck and skill dichotomy in investing is that of poker. A game that clearly mixes elements of both. The problem with this comparison is that financial markets and poker are different types of system. Poker is a system with a fixed set of rules attached; although player behaviour may alter, we can understand and model potential outcomes. Financial markets are a complex adaptive system; akin to a game where we don’t know all of the rules and some are likely to change through time.

Defining skill in an activity with amorphous rules is not an easy task. Even if an investor possessed evident skill that delivered strong results in the past, we cannot be certain that it will work in future. It is not sufficient to know whether skill exists, we need to judge whether it can persist. Such doubts are exacerbated by the randomness of markets, which mean the skilful often appear as if they are not. Even skilful investors do not receive continually positive rewards and feedback. When struggling, they must constantly wrestle with the quandary of whether to persevere because poor results are just noise or adapt because the requirements of the game are no longer the same. 

To better understand investment skill, it is critical to disabuse the notion that there is such a thing as a ‘skilful investor’.  Skilful at what exactly? Using skill in such a broad sense renders it entirely devoid of meaning. It is one of the reasons that people often appear so willing to follow a previously successful fund manager when they stray outside of their narrow circle of competence, with inevitably grim consequences. 

The more that chance influences the outcomes of an activity the more important it is to separate skill into its component parts because headline results alone can be incredibly misleading.  It is far better to think of investing as a vast array of specific and distinct activities – varying by instrument, market, time horizon and discipline. If there is any hope of identifying and monitoring skill, then it is critical to be precise about what it is and how it may change.

Defining a specific investment skill is just the beginning.  We also need to understand why the skill is likely to deliver some benefit or advantage and whether the skill is still relevant – how sure are we about the rules of the game?  It is difficult becoming a skilful investor and difficult remaining one.


How Do You Identify Skill?