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

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

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

There are two major reasons for this behaviour:

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

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

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

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

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

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

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

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

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

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

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

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

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

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

And much more in-between.

You can listen here: Seeing the Future

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

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

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

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

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

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

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

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

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

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

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

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

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

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

–

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 Chapter 12 of ‘The General Theory of Employment, Interest and Money’, John Maynard Keynes writes of the increasing short-term focus of investors, lamenting:

“Investment based on genuine long-term expectation is so difficult day to-day as to be scarcely practicable”.

Keynes’ seminal work was first published in 1936, so although it is easy to consider investor myopia as a modern phenomenon, it is not. Rather it is an ingrained feature of how humans engage with financial markets. That is not to say that the most pernicious problem faced by investors has not been exacerbated – the temptations are greater than ever – but simply that it is our default state. Unless we make a conscious effort to mitigate it, we will likely bear the heavy costs of short-termism.

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The idea that adopting a long-term approach to investing can have a profound positive impact on our results can seem perverse. How can something so easy – doing less / paying less attention – lead to better outcomes? The critical misunderstanding here is the idea of simplicity. Long-termism is simple in theory but fiendishly difficult in practice. Everything from our psychological wiring to the broad environment in which we exist is dragging us toward making short-term choices. It takes considerable effort to extend our horizons.

Far from being easy, taking a long-term perspective is the most severe behavioural challenge that investors face.

Investing in the moment

Many of the decisions we make are a response to how we are feeling right now. Even when we think we are making a long-term choice, it is often a response to profound emotional stimulus. When we sell all of our risky assets in the teeth of a bear market we are relieving anxiety and fear – it feels good to do it at that moment. The cogent rationale we make for finally capitulating and buying stocks in the midst of a euphoric bubble is just a charade, what we are really doing is removing the stress and pressure of missing out. These types of feelings are smart from an evolutionary perspective – they helped us survive – they just make us terrible long-term investors.

It is not only our emotions and feelings that make us inveterate short-termists, but our inability to appropriately value long-term rewards. We are very poor at discounting and tend to give far more weight to near-term pay-offs than those that are stretched out far into the distance. We might be fully aware that staying invested is the best route to meeting our retirement goals thirty years hence, but the illusory lure of getting out of the market before the next crash might just prove too powerful.

Investing with a long-term mindset also requires us to ignore huge swathes of (potential) information. This is incredibly hard to do. We are being incessantly told that everything is changing, and we must respond to this by doing very little, which feels antithetical. A challenge exacerbated by the fact that what is happening in front of our eyes always feels like the most important thing. As Daniel Kahneman said:

“Nothing in life is as important as you think it is, while you are thinking of it”.

Taking a long-term approach means frequently ignoring issues that we and everyone believes – at that moment – are absolutely critical.  No wonder so few investors can do it.

Short-term is the norm

As if our own psychological foibles are not enough, there is another factor that makes it worse. Much worse. The environment in which we make investment decisions.

Most people are wired in the same way we are. We all want short-term gratification, so the investment industry is set-up to provide it. It is incredibly difficult to build a business or a career by saying: “Just wait thirty years and you will be okay”. If we want to get a promotion or sell an investment, then we need to be seen to be doing something. That almost always means taking a short-term view. We are incentivised to survive, and waiting for the long-term to play out is akin to a death wish.

Short-termism is not some elaborate profiteering plot, although it can feel like it, it is just the prevailing and powerful norm in investing. Everyone cares about it and lives by it, so everyone has to adopt that approach and play the game. Try saying we didn’t trade this quarter or last month’s performance was irrelevant and see how far that gets us.  

Nothing can stop us

If the Keynes quote at the beginning of this piece suggested that short-termism was nothing new, that is only partially true. There is a difference between our willingness and ability to be myopic. We were always willing but are now more able than ever.

There are two key elements that facilitate our short-termism. The amount of information available and the ease at which we can react to it. We are not inherently more short-term in our thinking than we used to be, but we are now faced with inescapable and overwhelming exposure to financial market noise – “7 seconds until the European market opens” – and can trade whenever we like. It is hard to think of a more toxic combination for provoking our worst investing behaviours. 

Technological innovations have been wonderful for investors, and also a behavioural disaster, inflaming our ingrained short-term predilections.

Say a lot, do a little

Are there any solutions? There are some. Not checking our portfolios or switching off financial news are likely positive steps toward better investment outcomes. But perhaps they are unrealistic. A more powerful approach might be an attempt to separate words from action.

Financial markets are incredibly diverting; they capture our attention and we cannot reasonably ignore them. Discussing them, however, should be entirely separate from taking active investment decisions.

One of the reasons that there is so much unnecessary and costly trading on portfolios is because investors feel like they must have something to talk about with clients. Trading creates narratives which creates comfort.  This plays to the notion that although tactical asset allocation doesn’t add value, it does help keep clients invested – because they feel happier that things are being looked after and it placates their desire to see short-term action.

Maybe this is inescapable, but if we want to enjoy the benefits of long-term investing, we need to find more ways of discussing financial markets without feeling compelled to constantly act.  

A long-term approach is (almost) always better

There is no greater advantage available to any investor than taking a longer-term approach. There is one important caveat, however. Long-termism is a great idea on the proviso that we make sensible decisions at the start. They don’t have to be heroic, they needn’t be optimal and there is no requirement for genius. Just some sensible choices and a long horizon will leave us better placed than most.

That’s far 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).

One of the most profound problems encountered by investors is deciding what matters. We are faced with an incessant barrage of noise and must somehow parse relevant information from it; it’s like attempting to quench our thirst from a fire hydrant.

The oscillations of financial markets make us obsess over what matters right now: Why did the stock market lose 1.2% today? What is the Fed going to do at its next meeting? What are the major themes that will define markets over the next three years? This carousel of explanation and prediction is the lifeblood of the investment industry. It writes stories, it sells, it creates jobs, it shifts allocations. It constantly tells us what we need to get right in order to meet our goals.

As soon as you step into this world it is easy to be captured by this vortex – if we don’t care about the same things that everyone else does, then we are an outlier. Everyone is talking about (insert topic of the day) so we must be interested and have an opinion. If we want to be part of the game, maybe we just have to play it.   

Or maybe not.  

Focusing on the wrong things is not only exhausting, but it encourages the worst of our investing behaviours – what we think is an effort to add value is very likely to be destroying it. Instead of engaging in the search for the next critical fragment of information or attempting to predict, with high confidence, the next meaningful variable, we should take a different approach and ask – what really matters? 

For it to matter to us, there are two questions we should always ask ourselves about a variable or piece of information we are considering:

– How influential is it likely to be in meeting my objective?

– How knowable or predictable is it?

For information to matter to enough for us to take an explicit view on it, we need two things to hold – we must be confident that it will impact the outcome we are seeking (usually returns) and be comfortable that either the information is already available, or we can accurately forecast it.

Let’s take some examples. Imagine we believe that the level of real yields will be influential for equity returns over the next three years; it is not sufficient to consider it an important variable, we need to believe that we can predict it with a reasonable level of confidence. If we assume that we cannot do this, then the level of real yields is not something that matters enough for us to take a high conviction view on – aside from being appropriately diversified across a range of potential outcomes.

Now assume we are a long-term (10 years +) investor and believe that valuation will be a key determinant of returns over our time horizon. In this scenario, both questions can be answered in the affirmative. The price we pay for an asset is more influential for the long-term returns we receive than anything else, and we know it with reasonable confidence in advance.

There is a caveat, however. If, in the valuation example, we contracted our time horizon – let’s say to one year – valuations would fail the test; although they are knowable, they are just not that influential over the short-run. Being clear about precisely what we are trying to achieve is critical in defining what should matter to our decision making.

The reason that short-term market predictions are so difficult to make is that we do not know what the most influential variables are likely to be (what market participants will care about tomorrow), nor – by definition – can we predict them. For short-term market forecasts everything and nothing matters.

For most investors there are two types of variables, dull and predictable ones (valuation, time horizons etc…) which always tend to matter over the long-run, and exciting and volatile ones, which tend to receive all the attention. This is understandable. Unpredictable variables are changeable, exciting and dominate our thinking. They allow us to weave compelling narratives and express distinctive views. It is hard to forge a career focusing on what everyone already knows and ignoring what everyone is talking about.

A huge host of things influence the short-term price movements in markets and this creates profound behavioural challenges; inevitably leading to erratic decision making and a loss of attention on what is important. A key first principle for all investors should be to define at the outset what factors matter most for us given our objectives. If we focus on these, it might just give us a fighting chance of cancelling out the noise.

—

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).

Whether it is a simple extension being built on a house or the bold development of a brand-new railway line, we know two things: both projects will take longer to complete than estimated and will cost more (often a lot more) than budgeted. In How Big Things Get Done, Bent Flyvbjerg – one of the world’s leading experts on megaprojects – and Dan Gardner explore the somewhat puzzling phenomenon of repeated cost and time overruns, and explain how projects can be improved. Although the complex construction of a bridge may seem poles apart from the (relative) simplicity of making an investment decision; they both share a stark vulnerability to the foibles of human decision making. They can both fail in similar ways. What can investors learn from how projects go awry?

It is obvious to see when a project goes wrong – we start with a set of expectations about the finished product, how much it will cost and how long it will take, and those are either met or not. For investment decisions things are a little trickier – good choices can have bad outcomes (and vice-versa). The randomness and noise in financial markets means that we cannot call every decision that fails to outperform or meet it target a failure.

Let’s take an example. Imagine I invest my entire portfolio in a niche thematic fund that has already produced startling returns and holds assets with stratospheric valuations. Over the next three years its ascent continues and it trounces the broader market. Does that mean it was a good decision? No, it was a terrible one, just extraordinarily lucky.

So, if a failed investment decision is not necessarily one where performance disappoints, what is it? One where the odds of success at the point we make the choice are poor. Bad investment decisions can often be seen from the very start. The same can often be said for large projects.

Psychology and Power

Flyvbjerg and Gardner identify two “universal drivers” that separate a successful project from a flop – psychology and power. Investors should be well-versed in the challenges of making good choices whilst battling our behavioural biases. Any decision-making process – whether it be for an investment or project – that does not explicitly attempt to address these is destined for trouble.

While the influence of power seems obvious for major projects – politicians attempting to impact outcomes to suit their personal agenda – it can seem an irrelevance for investors, but it matters. This is particularly true of institutions that can make investment decisions that are tainted by ambitions, hierarchies and misaligned incentives.

The problem of psychology and power is not just that they can dramatically impact the decisions that we make; it is that they are unspoken. Few people would admit that an investment was driven more by our psychology than our analysis, and nobody would ever say that politics played a part. If we don’t acknowledge it, we cannot do anything about it.

Think Slow, Act Fast

One of the foundations of successful projects, according to Flyvbjerg and Gardner, is the ability to “think slow, act fast”. The basic premise is that we should take our time in diligent planning, as getting the planning right dramatically improves the accuracy and speed of the subsequent work. Far better to find problems in the planning stage, than deal with them halfway through a project.

The difficulty is that planning has a stigma attached to it. People want to see action not spreadsheets and PowerPoints, so there is an allure to getting started. Action trumps thinking. Not only this, but individuals with a vested interest in a particular project are also keen to see shovels in the ground – they know that once costs become sunk and commitment is entrenched the ability to turn back is severely compromised.

Acting in haste and repenting at leisure is undoubtedly also a behavioural issue for investors. The nature of financial markets – the stories, the trends, the performance obsession – almost compels us to act immediately. Either we have no particular plan in place, or emotions ride roughshod over the plan we thought we were going to follow. So we act in the moment.

Most investors really don’t need to be acting fast, but if we do it should only be when following a prudent plan of action which is aligned with our goals.     

Why – at the start, middle and end

A common pitfall identified by Flyvbjerg and Gardner in major project work is losing sight of reason it was undertaken in the first place. A project should start with an understanding of why it is being carried out, and that should remain at the forefront of all decision making throughout. It is incredibly easy to imagine how large and time-consuming projects become so complex that everybody involved forgets what they were actually trying to achieve at the start.

Investors can easily forget what the purpose of their investment decisions are. We might begin with a plan to save regularly over 30 years to fund our retirement. Yet three years down the line we are revamping our portfolio because it underperformed the market over the past six months, or because of an article we saw in the weekend newspapers. Living our portfolios day to day, week to week can easily lead to us forgetting the reason that we began investing.

What’s the reference class?

An area where major projects and investment decisions share identical failings is a lack of willingness to understand appropriate reference classes. We tend to think that the situation we face is distinct – nobody has ever built a bridge like this before / this fund manager is uniquely talented. This is the ‘inside view’, where we obsess over the specifics of our circumstance and ignore the lessons that we might learn from the ‘outside view’ – a wide reference class of similar scenarios.  

This is the reason why very few people adjust expectations for the work being undertaken on their house despite being aware of the cost and time overruns suffered by everyone else. It is the same reason people flock to star fund managers despite the poor record of these types of investments (high level of assets / expensive valuations / unsustainable performance). We seemingly cannot help but think that the precise information that pertains to our case is far more valuable than general comparators.

Reference class / outside view thinking is quite dull, we lose the attractions of the compelling narrative and replace them with some dry probabilities. Yet for investing and major project management, dull is likely to win out.  

A failure to learn

Perhaps the real unifying feature of troubled major projects and poor investment decisions is that despite seeing them all around us we don’t learn the lessons. In both cases this is driven by an unwillingness to accept and address the realities of our behaviour, so we keep repeating the same mistakes.

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https://www.amazon.co.uk/How-Big-Things-Get-Done/dp/1035018934

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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 main challenge in capturing the benefits of long-term investing is that the long-term is comprised of very many days. Being able to cope with the events, cycles, shocks and stories that form a lengthy time horizon is a formidable task. Potential long-term investments should not be considered solely on their prospective return and risk, but also our ability to endure and survive the inevitable fluctuations in performance. The gap that exists between short-term pressures and long-term objectives is so significant that I have often heard people comment that they would make different choices if they could ignore their investments for 10 or 20 years. But what if that were true? What if we could put our investments in a time capsule and not touch them for many years.* What would you do differently?

Let’s assume we have to make a number of investments or investment views now, and, once decided, we cannot do anything with them for ten years (I would have preferred longer, but in this investing world even this seems extreme). They must remain untouched until a decade from today.

Below are six investment views I would place in the said ten-year time capsule. Clearly these are all probabilistic judgements in which I have varying levels of confidence, but such nuance is no fun in a time capsule so I will present them as binary opinions. Here goes:

– Equities over bonds (MSCI ACWI over Bloomberg Global Aggregate Bond USD Hedged): This seems like an easy call, and I have certainly been conditioned to believe through my career that this is close to a slam dunk, but global equity valuations are not cheap and bond yields are much more attractive than they have been for some time. Despite this I would still favour equities.

– Small cap over large cap equities (MSCI World Small Cap over MSCI World): Moving into more controversial territory, it has been an unusually weak period for small caps versus large cap indices driven primarily by the ascendancy of a group of staggeringly successful mega caps. Perhaps this is a new paradigm (it is certainly not impossible), but I would rather lean on the side of history.

– Non-US developed over US Equities (MSCI EAFE over S&P 500): There are many reasons why the dominance of the US market may continue for another decade and they are hard to disregard in the midst of a prolonged spell of outperformance, but I still tend to believe that (extreme) valuations matter.  

– EM over developed equities (MSCI EM over MSCI World): Taking a ‘close your eyes’ view on emerging markets can seem pretty risky – what if something happens in China? – but these risks always feel more acute when an asset class is already underperforming.

– Value over Growth (MSCI ACWI Value over MSCI ACWI Growth): After a brief period of respite, growth stocks have resumed their crushing dominance over their much-maligned cheaper counterparts. I am inclined to think that this will not continue for another ten years. (These indices are not the perfect way of capturing value and growth, but will suffice for the purposes of this post).

– 60/40 over hedge funds (MSCI ACWI / Global Aggregate Bonds over HFRI 500 FWC): Despite equities looking historically rich (in aggregate), I would still favour a combination of them and bonds to outstrip a collection of expensive hedge funds attempting to do incredibly difficult things.

—
 
Now these views are in the time capsule, I will not return to them for ten years. If most of them prove correct I will write a piece about the power of long-term investment thinking, if most are wrong then I will assume nobody will remember I ever wrote this.

There are a couple of serious points stemming from this post. First, is that these types of views are generally only ever meaningful at extremes of valuation and performance. For the most part such marginal investment calls are nothing more than superfluous, unpredictable noise; we are usually far better off doing nothing. Second, if there is a chasm between your actual investment position and your time capsule views, it is important to understand what is causing it and at what cost.

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* Recreating the magic of private equity.

# This post does absolutely not constitute investment advice!

—

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 2015 three academics, in conjunction with a smart beta ETF provider, published a set of research papers that showed that between January 1969 and December 2014 adopting alternative approaches to index construction produced better returns than a conventional market cap weighting methodology.¹ A market cap based scheme was so inferior that even sizing stocks based on the Scrabble score of their stock market ticker generated dramatically superior returns. Delivering outperformance seemed easy, so what happened next was almost inevitable. In the years that followed, market cap indices (in most regions) set about trouncing all other index types. Equity investors moved from “anything but market cap”, to “what’s the point in anything but market cap?” Was the research flawed or was something else going on?

Looking back at the studies, with glorious hindsight from 2023, the central argument seems entirely anomalous given what we have experienced over the past decade. The research showed not only that alternative approaches to equity index construction (such as equally-weighted, fundamentally-weighted or maximum diversification) are significantly better than the traditional market cap structure, but randomly selected ‘monkeys and dartboards’ indices also beat market cap (outperforming 99.9% of the time across 10 million simulations). Results that seem to run entirely counter to the evidence of the efficacy of market cap investing which has now become accepted wisdom.

What is the explanation for the apparent disconnect?

The obvious answer is fees. There are approaches where the evidence suggests that alternative weighting methodologies (or what we might also call active management) have an advantage over a market cap (traditional passive) process, but that evaporates once charges are taken into consideration. While this is true to an extent, it does not tell the entire story. Between 2015 and 2023, the S&P 500 generated total returns over 30% greater than its equal weighted counterpart without any help from a fee advantage. Something else is at play.

There is another simple explanation to the apparent quandary, which has some profound behavioural implications. In the period covered in the study (1969 – 2014) smaller and cheaper companies delivered higher returns. In the subsequent period, however, the reverse was true; stock market performance was dominated by a select group of mega / large cap companies making it extraordinarily difficult for non-market cap strategies to outperform.

Size (and Value) Matters

The research does indirectly touch upon this issue. It runs a factor attribution for the main alternative index construction strategies versus market cap, in virtually all cases (including Scrabble) the resultant indices have significant sensitivity to both size and value factors. They prefer companies that are smaller and cheaper. They also tend to be underweight momentum – this is to be expected given the inherent momentum tilt of a market cap index.

In recent years (with brief bouts of divergence) equity market performance has been led by mega cap, tech related names, and the US has been in ascendancy over other developed and emerging markets. This has meant that the odds of success from doing anything other than market cap investing have been very poor. Whether it be low-cost smart beta tilts or concentrated, high conviction active investing.

There have been certain exceptions to this most notably the UK, but this has been a market where smaller companies have outperformed the largest making it far easier to improve on the index.

There was nothing wrong with the research published in 2015. In the period they observed, alternative methodologies (which almost always have a bias towards smaller and cheaper companies) did produce better returns than a market cap approach. This is broadly consistent with the established factor investing literature. What has occurred subsequently doesn’t invalidate that, but nor does this research mean that market cap investing is a bad idea.

Inescapable Cycles

This post is not about the relative merits of market cap investing compared to other approaches, it is about the fluctuations of markets and how they lead us to make poor choices. Decisions that come with a far greater cost than the precise construction methodology we might prefer.

Markets move in cycles. These can be prolonged and pronounced. These are always accompanied by narratives that allow us to explain and extrapolate. At the peak of a particular cycle, we will feel as if there isn’t even a cycle.  The future path and the right decision to make will seem obvious. Performance creates story, story creates performance, performance creates story and so on.

When an equally weighted index goes through a period (or era) of outperforming a market cap approach then the narrative will be about the higher growth of smaller companies against leaden and expensive large cap names, of course equal weighting is superior. When a market cap index has its turn in the sun then large, dominant companies will continue to use their scale and influence to trounce and overwhelm smaller businesses.

These cycles can go on for so long that the strength of the story combined with the power of incentives makes them almost irresistible. We become unflinching converts to every new paradigm at its peak.

The major problem with these inescapable patterns is that they lead us to make terrible, costly decisions. Take the market cap approach to equity investing – right now it is the easiest decision in the world and a perfectly sensible approach to adopt. Yet it is close to inevitable that at some point it will go through another period similar to that observed between 1969 and 2014, maybe next year or maybe in ten years’ time.  Will that mean that market cap investing will become an awful concept? No, it will just feel like it (imagine the headlines). In a similar fashion to how holding a tilt towards cheaper and smaller companies has felt like the epitome of insanity for most of the last decade.

The Behavioural Challenge of Market Cycles

It is the incessant cycles of financial markets that makes them such a chronic behavioural challenge. Even if we make sensible long-term decisions, we will have to endure inordinately lengthy periods where they look foolish.

We can deal with these cycles in four ways:

1) Make prudent decisions and stick with them: This is simple in practice but fiendishly difficult in reality. Financial market cycles always tend to last one day longer than our behavioural tolerance is to bear them.

2) Timing cycles: Market timing is a wonderfully alluring notion and will always sell. It is just not clear that anyone can do it consistently well. Complex adaptive systems are notoriously fickle things.

3) Waiting for extremes: Although there is certainly some value in leaning against the prevailing wind when cycles become extreme (as suggested by Howard Marks), this is perhaps the most exacting behavioural challenge in investing. We can only attempt this if we have the right time horizons (long ones) and are in an environment that supports it.  

4) Buy and sell at the worst possible time: The most likely course we will chart is to make bad decisions at the point of maximum pain. This may sound disparaging, but it is not. The pressure to make pro-cyclical choices at the peak of a cycle is intense and, often, in our best (career) interests. It is incredibly difficult to avert this behaviour.

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Is a market cap index easy or hard to beat? It depends. Although financial markets are close to impossible to forecast, one thing we can be certain of is that they move in cycles. Sometimes a market cap approach will be a laggard, at others it will be unimpeachable. Our investment success with not be defined by our ability to predict such periods, but to withstand them.   

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1. https://www.bayes.city.ac.uk/__data/assets/pdf_file/0004/353866/what-lies-beneath-cass-business-school-invesco-powershares-part-2-nov-2015.pdf ↩︎

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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 enduring appeal of thematic funds can seem somewhat puzzling given their track record of delivering disappointing returns to investors (and sometimes worse).[i][ii] Yet from a behavioural angle, there is no puzzle to solve. Their composition exploits some of our most damaging psychological traits. No matter how many flavour of the month funds fail, there will always be a new story to sell.   

Although we like to frame our investment decisions with rigorous analysis and metrics, more often than not it is the stories that really matter. Our desire to believe a compelling narrative that draws a comforting line between cause and effect is an inescapably human trait. Financial markets are noisy, capricious and uncomfortable, persuasive stories help to remove that nagging pain of uncertainty.

Thematic funds prey on our desire for clarity by making everything easy. Something significant is happening in the world (usually some seismic and profound change) and we can profit by investing in it.

The vital sleight of hand played by the purveyors of thematic funds is that a story being true means that we are going to make money from it. These are always framed as being one and the same question – if you believe, then you should invest – but in fact they are two entirely distinct issues. There have been countless cases of narratives, themes and stories being valid – the internet was transformative / emerging markets did grab a far larger share of global GDP – and investors still losing plenty of money.

Key to avoiding the allure of thematic funds is finding some way of living with this cognitive dissonance – if the story is true how, how can it not be a good idea to invest?

Thematic funds are built on three core components that form a (for a time) virtuous circle: strong performance, a convincing story and social proof. Each element feeds the next inflating a form of micro-bubble. High returns need an explanation, so a narrative is forged, more investors are drawn in boosting performance, which further bolsters the credibility of the story. And so on…

At some point this circle of virtue (or profit) will turn vicious when each element will damage rather than support the next as the hype fades or shatters. In most circumstances we can be confident that this will happen, we just don’t know when.

All investors are either valuation or momentum driven. We invest because we believe that an asset is undervalued or because we think the price will (continue to) go up. Thematic fund investors are almost always momentum investors – they just might not know it. Why can’t thematic investors be focused on valuation? Because it is tough to believe that an area of the market can be underappreciated / materially undervalued and have a specialist fund launched to exploit it.

Momentum investing is a perfectly robust and proven approach, so why can’t thematic fund investing work on this basis? Because too many thematic investors don’t realise they are chasing momentum, instead they rely on the fundamentals of the story. Momentum investing works because of the deliberate and dispassionate application of rules – it is following a system not chasing a story. Engaging in it without acknowledging it is a recipe for disaster.

While it may be difficult for investors to make money from thematic funds, it is easy for asset managers. Stories sell and thematic funds come with in-built marketing. The investment thesis and sales pitch are the same thing. Not only is the sales message readymade, but financial markets are narrative generating machines. There is always the next story to place on the shelf.

Given the evidence around the disappointing outcomes from thematic funds, what accounts for their ongoing popularity? It is a classic inside / outside view problem, where we focus on a specific issue and ignore the general lessons. When we are considering the latest area of thematic fervour (AI anyone?) our attention is trained on the strength of that particular story, so we ignore the litany of failures of other themes that have momentarily captured and overwhelmed investor attention. It is the base rate of success in thematic funds through history that matters. Although the stories are different, the behavioural drivers and lessons are the same.

Most thematic fund investing is founded upon ideas that are simply not credible:

– Buying expensive, in-vogue assets tends to end well.

– Unsustainably strong performance will in-fact be sustained.

– We can make accurate forecasts about fiendishly complex economic / technological developments.

– Being correct about economic / technological developments mean that we will outperform.

– Abandoning diversification for thematic concentration can be a smart idea.

These make for a toxic set of implicit and erroneous beliefs. Maybe we can strike lucky and succeed with thematic investing, but the odds are horrible.

The sad truth is that the type of thematic fund most likely to make money would be one that very few people would want to buy.

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[i] Ben-David, I., Franzoni, F., Kim, B., & Moussawi, R. (2023). Competition for Attention in the ETF Space. The Review of Financial Studies, 36(3), 987-1042.

[ii] https://www.morningstar.co.uk/uk/news/236136/comment-thematic-investing-appeals-to-our-worst-instincts.aspx

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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).

You are a goalkeeper about to face a penalty kick. You have three options to make the save. You can dive left, dive right or stay in the middle. Having looked at the stats you know the probabilities are most in your favour if you stand still.* So what do you do? You dive to the left or the right. Why? Because if you don’t and the penalty taker scores it will look like you didn’t even try. Not only will you feel worse, but the fans won’t be happy – the least you could have done is put some effort in. This bias towards action is not just an issue for goalkeepers, it is a major problem for most investors. We just cannot stop doing too much.

The penalty kick example was taken from a 2007 paper exploring the concept of action bias.[i] This idea is something of an oddity as it runs counter to a more common behavioural foible – omission bias, which is our tendency to view the harm from doing something as greater than the harm from not doing something. Whether we have a bias towards action over inaction will depend on the prevailing norms. If there is a strong expectation for action in a given situation (whether justified or not) then not doing anything will likely be viewed harshly.   

For investors it is undeniable that there is a powerful and inescapable assumption that we should be constantly active. Why is the idea so pervasive?

– Markets are changing, so must our portfolios: The relentless variability and noise of financial markets means that there is always a new theme, new story, new paradigm, which we must react to. We cannot stand still whilst everything seems to be shifting around us.

– Our behavioural biases lead us towards action: A range of behavioural traits provoke action and activity. We trade because we feel emotional (fear or greed), we trade because we overweight the importance of what is happening right now, we trade because someone is making more money than we are. The fluctuations of financial markets stimulate some of our worst behaviours.

– Underperformance is inevitable: All investors, no matter how seasoned or intelligent, will experience painful periods of underperformance whatever their approach. Even if we are adopting the right strategy, for prolonged spells it is likely to be perceived as naïve, anachronistic or just plain stupid. Our tolerance for such periods is much shorter than we think, and so we trade.

– Justifying our careers / fees / jobs:  It is really difficult to build a career by doing less than other people. How do we keep our clients if we are doing nothing when performance is poor and the returns of people doing everything are better than ours?  If we are the person in the room suggesting doing nothing, our promotion prospects are probably not looking too good. Action is a rational career choice and an institutional imperative, it’s just often not in the best interest of clients.   

– We need to tell stories: Everyone wants to hear stories. What did you do last quarter? How are you reacting to the emergence of AI? If we don’t do anything it is hard to spin a convincing narrative. We make changes so we can tell a story. (One of the strongest reasons for the pervasiveness of TAA / market timing is that it provides us with regular stories to tell).  

While there are factors that compel us towards action, there are several reasons why we should avoid it:

– Predictions are difficult: The more changes we make to our portfolios, the more we are likely to be engaging in short-term market predictions. It is reasonable to assume that the average (and above average) individual is not great at forecasting economic events nor the market’s reaction to them. We need to be right twice and most of us fall at the first hurdle.

– Whipsaw risk: It is not just that making forecasts about a complex adaptive system is a pretty difficult ask, it’s that we find ourselves reacting to each captivating narrative that the financial system spits out. Trading and tinkering incessantly. The notion that we will get this more right than wrong seems entirely fanciful.

– There is a reason for diversification: One of the primary reasons for diversification is that we do not know the future (if we did, we would only own one security). A sensible level of diversification creates a portfolio that survives different environments and where there is always something working and something lagging (this is a feature, not a bug). An appropriate level of diversity should allow us to do less.

– Negative compounding: Too much investment activity results in the incredibly powerful force of negative compounding, where the costs of our trading (a combination of fees and being wrong) act as a material long-term drag on our returns.

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The typical response to the idea of investors doing less is: “well, you can’t just do nothing”. Yet the point is not that there is never a reason to make changes – of course there are – but the default must be flipped from “what have you been doing?” to “why have you done anything?” The threshold for change must be higher.**

It seems ridiculous to suggest that thinking of ways to reduce our activity could be a route to better investment outcomes. Yet, as always, the things that seem unfeasibly simple in investing come with significant behavioural challenges. These are not impossible to overcome, we just need to find a way to do less in a system that incentivises and encourages us to do more.

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* There is a bit of a quirk here in that the best penalty taker may only strike the ball into the centre of the goal because they have already seen the goalkeeper dive. So, if the goalkeeper does stand still, the player may not kick the ball towards the centre of the goal. But let’s not let that spoil a good analogy.

** The underlying assumption here is that we have made sensible choices to start with. If we have made some terrible initial decisions, change is good!

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[i] Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action bias among elite soccer goalkeepers: The case of penalty kicks. Journal of economic psychology, 28(5), 606-621.

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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).