The football (soccer) team you support has just lost another game. You watch an interview with the manager (coach) and they lament their bad fortune. They dominated the match, had countless chances to score, but were just unlucky. Is this true or are they just trying to mask another bad performance? To answer that question, there is a metric that can help. Expected Goals (xG) has become widely used in football and hockey in recent years. xG tells us the number of goals a team should have scored based on the quality of opportunities created. As with all metrics it is imperfect, but it does provide invaluable help in disentangling skill from luck. Fund management is another area where we have severe difficulties in seeing beyond randomness and chance. Could a metric like xG help, and how might it work?

xG models are complex, but what they are trying to achieve is simple. For every chance created in a game a likelihood of scoring will be ascribed to it, creating an ‘expected goal’ between 0-1.  These probabilities are derived from analysis of historic scenarios. For example, the long-run conversion success rate of a penalty kick is 80%, so, if your team is awarded a penalty, that will result in an xG of 0.8 (whether or not they go on to score).

Why is this information useful? There are three main benefits:

– It provides an insight as to whether a team is underachieving or overachieving (or are perhaps experiencing good or bad luck).

– It may highlight if a team is unusually strong or weak in the most important aspect of the game – do they persistently overshoot their xG, scoring more goals than the model suggests they should?

– It can highlight where a team is going right or wrong. Maybe it is not that they cannot shoot, they don’t even create any good chances to score. 

There is still a great deal of judgement required here – is my team unlucky or terrible at shooting? But just because a metric doesn’t give us a finite answer, doesn’t mean it is not useful.

Investors in active funds are wrestling with many of the issues that the xG metric seeks to address in sport. Are results more a consequence of luck or skill? What are reasonable expectations for performance?

The problem of using a similar idea in investing is that it is a far noisier activity than football. A complex adaptive system, compared to a discrete game with fixed rules and a vast evidence base of similar situations. This distinction, however, does not mean that employing such a concept for active fund investing is without merit. The underlying problem statement is very similar:

xG in football:  Given the opportunity, what was a reasonable expectation for a goal to have been scored?

‘Expected alpha’ in investing: Given the opportunity set, what was a reasonable expectation for a fund manager’s performance?

How do we go about estimating how much alpha a manager should have delivered over a period? There are two possible methods:

Top-down / factor based: In this approach, we can use historic returns to describe a fund manager’s results as sensitivities to various factors (value, quality, momentum, size etc…). We can then compare the performance of their fund to a simplified version of their strategy based on the returns to those factor exposures.

The advantage of this technique is that it is reasonably simple to build a model that is consistent with the historic factor sensitivities of a fund. The downside is that a performance track record of some length is required, and, for some managers, it may be difficult to capture their results through factor exposures. This might be because they carry lots of idiosyncratic risk, or their style shifts through time. Such situations will, however, be in the minority.  

Bottom-up / fundamental:  A more robust approach is to create a systematic replica of the manager’s approach (all fund managers should do this anyway). To do this we would need to understand the investment process in detail – characteristics of the securities purchased, positions sizing etc… In essence we are attempting to build a rules-based, systematic imitation against which we can compare the actual decisions made by the fund manager. This could be as granular or simple as we wished.

The benefit of this more nuanced system is that it is not reliant on historic returns, but the philosophy and process of the manager. It can also provide a clear contrast between what a manager is doing in their fund, and what is happening in our model. The downside is that it requires the bespoke development of a stock picking / portfolio construction model, and is very reliant on how we might interpret the process adopted by a given fund manager.

Both of these approaches are imperfect and noisy, and provide nowhere near the confidence that we might take from an xG metric in football. We are, however, in an industry where discussions of skill are sorely lacking, and there is a heavy reliance on simple past performance with little attempt to separate luck and skill.

Creating some form of ‘expected alpha’ model for funds would have two primary benefits.

First, it would help form sensible expectations for a fund manager’s performance and allow us to focus on the divergence between that and reality. If our expected alpha model is struggling it is reasonable to expect the manager to be performing poorly. This moves us away from constantly obsessing over underperformance and outperformance versus a standard benchmark

Second, highlighting disparities between a fund manager’s results and a simple approximation of their approach could help to identify some form of skill or edge. Is there something happening that is distinct from what can be easily, systematically replicated? Is it worth paying for?

There is no magic bullet in assessing fund manager skill or edge, but the idea behind xG in football points towards a more nuanced means of looking beyond the luck and noise that dominates investing. Assessing fund managers through the lens of ‘expected alpha’ could help investors not only set reasonable performance expectations but better understand if value is being added and, if so, where it is coming from.

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My first book has just 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).

When we make an active investment decision, we obsess over the particulars of a given opportunity, whether it be a security, fund or asset class. This, however, distracts us from a far more important issue, which is so often ignored – should we be participating in the activity at all? This must always be our starting point. To make it so, we need to ask ourselves these questions:

– What are the odds of the game?

The critical first step is establishing the odds of the game we are playing. We want to engage in an investment activity where the odds are in our favour, or at least more in our favour than in other games. The major mistake we tend to make is grossly overstating our chances of success due to overconfidence in our abilities. To paraphrase Charlie Munger, who cares that 90% fail when I am in the 10% that succeeds?

The best means of guarding against such biased thinking is to assume that we are average. Rather than ask how likely is it that I will be successful, ask how likely is it that any given person will be (you never know, we might even be average ourselves). This approach gives us a reasonable base rate or starting point.

– Do I have an edge?

Once we have established a satisfactory estimate of the odds of success in an activity, we need to gauge whether we have an advantage relative to the average participant. If we are going to engage in a game with terrible odds, we are either ignorant of them, playing for fun (like a trip to Las Vegas) or believe there is something about our approach that puts us in the 10%. 

For professional investors, there is one additional reason that we might play a game with a low probability of success – because the cost of participating is borne by somebody else. The chance of positive (lucrative) outcomes for a fund manager are often significantly greater than it is for their clients.

The worse the odds, the more conviction we must have that we have some form of advantage. 

– What is the edge?

It is not enough to believe we have an edge; we must be clear about what it is and why it might exist. For most active investors, an advantage can be categorised as informational (we have better information than others), analytical (we use that information in a superior way to others) or behavioural (we exploit the decision-making shortcomings of others).

It is often argued that financial markets are more informationally efficient than ever before. There is more data, greater transparency and less friction. Making a case for an information-based advantage (in most major asset classes) seems a somewhat heroic assumption. Analytical edges are possible but incredibly difficult to substantiate. Where an analytical advantage arises, it is probably not from the ability to synthesise information better but to use it for a different purpose. Are we trying to predict next quarter’s EPS for a business or its long-run value?

Most market inefficiencies stem from the vagaries of human behaviour. It is difficult to argue that investor behaviour is becoming more rational, and certainly possible that things are getting worse. There is a problem with a purported behavioural edge, however. Not only do we have to contend that other investors are irrational, but that we are not. We are somehow free from the psychological and institutional burdens that lead to poor decisions. This is far easier to say than do.

– Who am I playing against?

In zero-sum games, the ability of the other participants matters a great deal. My chances of winning at poker heavily depend on who else is sitting at the table. Investing is similar but different.

It is undoubtedly true to say that having sophisticated, well-resourced investors facing off against each other is not a great environment to find an edge. Yet there is a major difference between poker and investing. In poker, everyone is playing with the same objective; in investing, this is not the case. Even though it feels like it. If I have a twenty-year investment horizon (if only) and other participants take a one-year view, we are barely playing the same game. At best, we are playing the same game with very different rules. So, the question becomes not – who am I playing against? But – what is it they are playing, and why am I able to do something different?

A painful confluence of compelling stories and inescapable overconfidence means that we are prone to participate in investment activities where the chances of positive results are very poor. To guard against this, we need to better understand the odds and justify why we might be an exception.  

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My first book has just 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).

I am delighted to announce the launch of a new podcast, Decision Nerds. Paul Richards and I will be discussing a range of behavioural and decision-making problems with some fascinating guests. 

We know that there are a lot of podcasts out there, but there is nowhere near enough focus in the investment industry on how we can make better decisions in highly uncertain environments.

Our behaviour is the most important thing, yet we don’t talk about it anywhere near enough (apart from on this blog!)

We will be exploring a range of decision-making and behavioural issues with innovators, academics and industry specialists. 

In addition to these in-depth discussions, we will also be creating short episodes where we tackle listener questions and problems, and discuss the latest behavioural research. If you have an issue you would like us to cover, let me know!

In our first episode, we look at why investors can often be reticent to receive feedback on their decision making, with Clare Flynn Levy of Essentia Analytics. Clare founded a company with the express intention of helping investors become aware of their behaviour and improve it.

Put simply the quandary is this – to improve our decision-making, we need to clearly understand where we need to develop, admit that and then engage with a process that can help us. This sounds simple, but there are obvious risks as well as rewards. What if we find out we are not as good as we think we are, even worse, what if other people find out!?

Clare has been helping fund managers engage with these issues for many years, and shares some fascinating insights on the challenges around improvement and how they can be solved. There are some great thoughts and stories for anyone who wants to improve their investment decision making.

The pod is available on all your usual podcast platforms and also: here

Please leave a review and do let me know if there are topics you would like us to discuss in the future.

In my career, I have spent hundreds of hours with fund managers attempting to assess their investment approach. When I look back at this, aside from questioning my life choices, the one thing that strikes me is how little fund managers discuss skill. Of course, they talk about past performance (if it is good), but the randomness and chance in financial markets render this a terrible proxy. This is a puzzling situation, investors in active funds are seeking to identify and pay for skill, but the people managing them seem reticent to mention it. 

It has always struck me as odd that in active fund selection, the onus falls heavily upon the allocator to strive to prove that the thing they are buying (skill) exists. Surely the seller of the product should be making that case?

Before exploring the reasons why investment skill is such a rarely discussed topic, it is worth defining terms. What exactly is skill?

Skill exists where we can see a repeatable link between process and outcomes (what we intend to do and the result of our action). We are often guilty of focusing on the second part of this equation – if the result is good, then some skill must be involved. This can be an effective shorthand if the activity is simple (shooting free throws in basketball) or heavily structured with limited randomness in the outcomes (playing chess). It is when things get noisy that the trouble starts.

In activities where the results combine luck and skill, focusing on outcomes alone can lead us astray. The greater the involvement of chance, the greater the need to understand the process that led to the outcome.

This is easier said than done. Focusing on process as much, if not more, than outcomes means retaining conviction and confidence even when headline performance is disappointing. Two things are critical here – time and belief. Extending our time horizon should tilt the balance in favour of skill over luck, but in order to have the required patience we must (continue to) believe that skill exists.

Imagine we have a biased coin that is likely to come up heads on 52% of flips. We should have more confidence in this edge becoming apparent the greater the sample size. To prove this advantage, we would rather see 10,000 flips than 10. We can think of this as akin to lengthening our time horizon. The problem is that if after 50 flips the coin has landed showing tails more often than heads, we might start to doubt that the coin is weighted at all.

Even if we possess an edge, we must often sit through periods when results make it look like we do not.

In investing, if skill exists, then it is difficult to identify and, if we do discover it, tough to benefit from. That does not mean we should ignore it. Asset managers are not only selling skill; they are paying people a great deal of money on the basis that they possess it. They should probably think about it more than they seem to.

Why don’t they?

– Past performance is everything: The industry is obsessed with past performance, and it is so ingrained in how it functions that trying to have nuanced conversations about skill might be deemed to be pointless. Strategies with strong past performance sell; trying to evidence skill does not.  

– Stories sell better: Evidence of skill, which might be about the consistency of decision-making through time, is far less compelling and persuasive than captivating stories about an investment theme or star fund manager.   

– Time horizons are just too short: As time horizons in asset management seem to become ever-shorter, the relevance of skill diminishes. Nobody operates with a time horizon long enough to even attempt to prove they are skilful.

– Too much complexity: Looking at past performance is easy, trying to define and evidence skill is complex and messy.

– Don’t want to know: Let’s assume some active fund managers – but not many – have skill, 20%, perhaps. If I am one of the majority, it is in my interest to actively avoid the question of skill. My odds of a lucrative career are much better relying on random performance fluctuations and trends.

There are many reasons why the notion of skill is rarely discussed in the asset management industry, and all parties are complicit in its neglect. The existence and persistence of skill, however, is the foundation of active fund management and it needs to be talked about more.

If it is being sold, it helps to know what it is.

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My first book has just 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).

A friend of mine recently asked if I had read a book called Psychology of the Stock Market. Given the subject matter, I was quite surprised that I hadn’t come across it. Even more surprising is that it was first published over 100 years ago. So, how do George Charles Selden’s thoughts on investor and market behaviour from 1912 compare with today? Has much changed?

Let’s look at some highlights:

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“The market is always a contest between investors and speculators.”

Selden argues that there are two types of market participants. Investors – who are focused on the fundamental attributes of a security or asset, and speculators – who are concerned only with the direction of the price.

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“The speculator cares nothing about interest return…He would as soon buy at the top of a big rise as at any other time.”

The idea that large swathes of investors have no real concern about the underlying value of a security is similar to something I wrote about valuation and price in 2022. He just got there a little earlier than me.

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“However firm may be his bearish convictions, his nervous system eventually gives out under this continual pounding, and he covers everything…with a sigh of relief that his losses are no greater.”

Selden writes of a short seller who – despite retaining a stridently negative opinion – capitulates because of the pain of being the wrong side of a trade. Evoking not only loss aversion, but the emotional strain of being wrong.

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“It is hard for the average man to oppose what appears to be the general drift of public opinion. In the stock market it is perhaps harder than elsewhere.”

We are inescapably drawn towards the behaviour of the crowd. Taking and maintaining contrary views can be exacting and exhausting.  

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“the average man is an optimist regarding his own enterprises and a pessimist regarding those of others…he comes habitually to expect everyone else will be wrong, but is, as a rule, confident that his own analysis of the situation will prove correct.”

This description of overconfidence from Selden still resonates today. The odds and evidence are against everyone else successfully picking stocks, timing the market or making economic predictions – but, of course, I can do it.

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“If you are long or short the market you are not an unprejudiced judge, and you will be greatly tempted to put such an interpretation upon current events as will coincide with your preconceived opinion.”

Confirmation bias remains as strong now as it was back in 1912.

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“When the market looks weakest, when the news is at the worst, when bearish prognostications are most general, is the time to buy, as every school boy knows; but…it is almost impossible for him to get up the courage to plunge in and buy.”

Here Selden describes the difference between our behaviour in a hot and cold state. In our cool, calculating moments, it is easy to plan what we will do when markets are in turmoil; yet when that moment arrives our emotions will take hold with fear and anxiety overwhelming us. Selden was unknowingly advocating systematising future investment decision.

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“It is a sort of automatic assumption of the human mind that present conditions will continue”

Extrapolation remains one of the most damaging investor behaviours.

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“Some events cannot be discounted, even by the supposed omniscience of the great banking interests.”

Selden is writing of our inability to anticipate or price certain risks. Although we might think of this as similar to black swans, he goes on to mention earthquakes – so this is more about ‘known unknown’ tail risks, than events we have not even considered.  

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“Even the clearest mind and the most accurate information can result only in a balancing of probabilities, with the scale perhaps inclined to a greater or less degree in one direction or the other.”  

Selden alights on two vital topics for investors here. The need to think in probabilistic terms and the requirement to temper our confidence. Both are essential for dealing with such a complex system as financial markets. Humility is critical.

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“The professional trader…eventually comes to base all his operations for short turns in the market not on the facts but what he believes the facts will cause others to do.”

Selden pre-empts the Keynesian beauty contest here and describes the behaviour of many investors then and now. Decisions are not made based on new information, but how it is perceived other investors will respond to that new information.

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“Both the panic and the boom are eminently psychological phenomena.”

It is at the extremes of market behaviour that investor psychology is most apparent and difficult to resist.

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“The “long pull” investor buying outright for cash and holding for a liberal profit, need only consider this matter enough to guard against becoming confused by the vagaries of public sentiment or by his own inverted reasoning.”

By “long pull” Selden is referring to long-term, fundamentally driven investor. To benefit from the long-term benefits of stock market investing one must ignore the fickle and forceful shifts in investor opinion and resist our own behavioural foibles. Easier said than done!   
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“Another quality that makes for success in nearly every line of business is enthusiasm. For this you have absolutely no use in the stock market… Any emotion – enthusiasm, fear, anger, depression – will only cloud the intellect.”

It is difficult to overstate the extent to which our investment judgments are driven by how they make us feel. A good rule of thumb is – the stronger our emotion, the worse the decision.

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“Sometimes it may become necessary to close all commitments and remain out of the market for a few days”

Selden is writing from a trader’s perspective here, so most of us can turn his “days” into weeks, months and years. The less we check our portfolios and watch financial news, the better our outcomes are likely to be.

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Although Selden doesn’t use the same terms, it is impossible not to recognise the behaviours he describes. I am often asked whether an improved awareness of the pitfalls of investor psychology has improved behaviour. Unfortunately, I don’t think it has. Rather the ease of which we can trade, monitor our portfolios, and receive new information (noise) has made things worse. Selden’s words from 1912 are just as relevant today, if not more so. 

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You can get a copy of Psychology of the Stock Market here.

I am not sure if my book – The Intelligent Fund Investor – will still be around in 100 years, so in case it isn’t you can get a copy now – here (UK) or here (US).

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Before you stop reading, I promise this is not another SVB explainer. While (too) much ink has been spilled detailing the bank’s failure; it is often useful to take a step back from tumultuous market events and consider our own behaviour. What happens to us during such stressful periods and what does it tell us about how we deal with investment risk?

Our time horizons contract – The key danger for investors during periods of market stress is the contraction of our time horizons. Even if we have a long-term orientation, we quickly start to worry about the immediate future. All our carefully considered behavioural plans can be torn asunder, as we seek to remove the anxiety we are feeling right now.

We focus on one thing – It is not just that our time horizons contract, but our focus narrows. The attention of virtually all investors turns to one thing, typically at the expense of issues far more important to our long-term fortunes.

We feel like we must act – Never is the most damaging investor urge of ‘something is happening in markets; we must do something to our portfolio’ more powerful than during a concerning and unexpected market event. It feels like everything is changing, so our investments must also change. We never let our failure to predict what has just happened stop us predicting what will happen next.

We are all ‘after-the-fact’ experts – When a significant market event that nobody predicted occurs, hindsight bias runs amok. Many people have now cogently explained the risk inherent in the SVB model, not many did so before it failed. While everyone is busy discussing what transpired, it is worth reflecting on why nobody expected it.

Uncertainty hasn’t increased – During stressful periods in markets it is common to hear people comment that markets are now ‘more uncertain’. This makes no sense. Markets are always uncertain. If we felt more confident in the future before the surprising occurrence with SVB then it turns out that we were wrong. We simply don’t know what is going to happen tomorrow.    

Market / economic predictions are tough – I don’t recall reading many 2023 market forecasts which mentioned the failure of a major bank. The problem with complex, adaptive systems is that things change / events happen and that alters everything. Let’s stop making short-term market predictions.

The most meaningful risks are the things we don’t see coming – Both how we think about and model risk is conditioned by what we have seen and experienced. The most profound and material risks are the ones that we do not anticipate.

Risks are either understated or overstated – We are prone to treat risks in a binary fashion. Either completely ignoring them or hugely overstating them. We tend not to buy flood risk insurance until our house is under water.

We focus on risks that are available and salient – The risks that we focus on are those that are available (in recent memory) and salient (provoking emotion). This is why rising interest rates after a period of secular decline has been so problematic (see SVB, or LDI in the UK). It is easy to be complacent about risks that have not come to pass in a long time (perhaps in our living memory).

This risk is now available and salient – Now the type of risk encountered by SVB has become available and salient it will be at the forefront of our thinking and decision making – we will see it everywhere. Unfortunately, the next major risk event is likely to be something that is not.  

Exciting stories overwhelm risk awareness – A useful rule of thumb is that the more compelling an investment narrative – the more adulatory front pages and gushing stories – the greater the hidden risks. There are two reasons for this. First, good stories can leave us blind to detail. Second, when a captivating story is working or making money, it can feel too costly not to join the party.    

Unexpected market events are anxiety inducing and provoke some of our most damaging behaviours. It will be in most investors interest to focus less on the current issue and more on our response to it. Sensible investing principles – such as taking a long-term perspective, systematic rebalancing and being appropriately diversified – are designed to deal with situations like these. Let’s not forget them.  

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My first book has just 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 1907 English polymath Francis Galton published an account of a forecasting competition that had taken place at a country exhibition in Plymouth the year before. He described how 787 participants had attempted to win prizes by correctly guessing the weight of a slaughtered ox. After reviewing the entries, Galton observed that the median guess was within 1% of the actual weight.[i] This remains one of the foremost examples of the idea of the wisdom of crowds, whereby combining a diverse array of independent opinions can lead to robust forecasts, often superior to those made by any individual.

The notion of the wisdom of the crowd is often applied to equity markets, particularly those arguing that they are (at least close to) efficiently priced. Unfortunately, the conditions for the wisdom of crowds to function do not hold for public equities. In fact, the behaviour of the crowd – in a variety of ways – creates inefficiencies rather than removes them. The inevitable presence of inefficiencies, however, does not make markets easy to beat or mean that we should even try.

For the purposes of this piece, we can assume that efficiently priced means to reflect the best collective estimate of an asset / markets’ value based on all available information. It is easy to see why the wisdom of crowds is a compelling description of how equity markets operate. We have a vast array of distinct investors making independent judgements. Doesn’t that get us to a similar situation to Galton and the Ox? Not quite.

As investors know only too well, crowds are not always wise. There are several characteristics required before we can begin to value their wisdom. [ii] The three most relevant are:

– Diversity of opinion: There does not necessarily need to be different information but, at least, the same information interpreted differently.

– Independent judgement: Views must be reached without the influence of others.

– There must be a means of collecting diverse opinions: There needs to be some means of aggregating group perspectives.

While equity prices are certainly an excellent way of collating the individual judgements of a participating group; applying the wisdom of crowds to equities breaks down when it comes to independence and diversity of opinion.

Although it may seem that the sheer number of participants in equity markets guarantees that prices reflect a varied range of perspectives, there will be times – particularly during market crashes or bubbles – where investor focus becomes trained on a very narrow set of ideas. In addition to this, it is at such times where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will be generated and sustained by the shared stress, fear and excitement of the crowd.

This destructive crowd behaviour leads to what we can think of as acute or episodic inefficiency. Where the price of an asset or security can diverge wildly from any reasonable assessment of fair value because the crowd / market has lost its independence and diversity of opinion.
 
It is not simply these bouts of dramatic crowd behaviour that prevent the market being efficiently priced. There is something else. Galton’s ox and other similar examples (such as judging the number of sweets in a jar) work because everyone involved is trying to guess the same thing. To believe that equity markets are efficiently priced because of crowd behaviour assumes that all or most of the crowd are attempting to make decisions based on their estimate of the fair value of the underlying securities. But they are not.

There are a huge range of motivations as to why investors make purchase and sell decisions, which have little relation to any assessment of long-run fair value. Investors might be passively following a market cap index, they might be chasing price momentum, they might be attempting to assess which company has the best earnings revisions prospects over the next 12 months or simply predicting how other investors will react to the latest news. All are valid approaches, but none require the estimation of a security’s fair value.

We can think of this situation as akin to Galton’s ox scenario, but where each participant is guessing the weight of a different animal – one a pig, one a sheep, another a goat. There is no reason to believe the average of such estimates will get us close to the weight of an ox.

Contrary to the aforementioned acute inefficiency, this is a chronic inefficiency. Where we should not expect the views of the crowd to equate to fair value (at any given point in time) because different people are forecasting different things.  

How might these two types of inefficiencies interact? Markets are typically in a state of chronic inefficiency where prices fluctuate based on the behaviour of investors with differing objectives, but with some slight gravitational pull from fair value. This will be punctuated with occasional bouts of acute inefficiency where investors (the crowd) move in concert and focus on a particular issue or story.  

If crowd behaviour means that there are both chronic and acute inefficiencies with markets unlikely to approximate fair value, does that mean everyone should be an active investor? No. Markets being inefficient does not mean they are easy to beat.

Episodes of acute inefficiency create the greatest opportunities in terms of the level of divergence from fair value, which will often be extreme. Exploiting them is, however, no easy task. It will be incredibly difficult for us to escape the pull of the crowd or the specific issue that is the focus of their attention. Even if we do manage to separate ourselves, we have no means of predicting when the behaviour will abate. Avoiding the madness of crowds can be painful and costly.

Although taking advantage of chronic inefficiencies may not be as emotionally exacting as escaping the fervour of a crowd, it remains a herculean challenge. Not only do we have to have a means of identifying some reasonable range of fair value for a security or an asset; we have to wait for it to be realised. If investors in aggregate are not attempting to find this fair value (because they are investing for other reasons) there is no reason for it to reach it anytime soon. So we need analytical prowess and (a lot of) patience.

The idea of the wisdom of crowds tells us more about why markets are likely to be inefficient (at times extremely so) rather than efficient. It also provides insights as to why taking advantage of that inefficiency is quite so difficult.

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[i] A 2014 paper by Kenneth Wallis “Revisiting Francis Galton’s Forecasting Competition” found some discrepancies in the original work that actually served to strengthen Galton’s theory as the mean estimate of 1197lbs was found to have exactly matched the weight of the ox.

[ii] See James Surowiecki’s excellent  “The Wisdom of Crowds” for more detail on the conditions required for a ‘wise’ crowd.

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My first book has just 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).

I am in a forecasting competition and asked to predict global iPhone sales. I can choose to make an estimate over one of two time periods – either the next three months or the next ten years. Which would I prefer? This is a simple decision – the next three months. There will be far less noise and uncertainty over the quarter then there will be over the decade. This aligns with Philip Tetlock’s work on super-forecasting, which suggests that predictions for the near-term are likely to be more accurate than those we make for the distant future. Does it therefore follow that investors are best placed to focus their attentions on the short-term? Almost certainly not. In fact, where we do have to make forecasts, it typically is in our interest to take a long-term view. Why is investing an exception?

Before exploring this idea further, it is worth starting with a caveat. Forecasting most things is difficult and we are notoriously bad at it. Predicting the behaviour of a complex adaptive system such as financial markets is particularly challenging. Our default setting should be to avoid it, where at all possible.

But as investors we must make certain types of projections, even if we don’t realise it. When we build a portfolio the decisions we make (how much to allocate to equities? How much to bonds?) are underpinned by expectations about the future. Not all forecasts are created equal however, even when they are about the same asset class.

Let’s take equities. In very simple terms if we want to take a view on the prospects for global equities then there are two things that matter: sentiment (how other investors ‘value’ them) and fundamentals (the earnings stream we receive through time). The importance of each element alters dramatically depending on the time horizon applied.

The shorter the time period the more sentiment dominates outcomes. This creates a prediction problem. It is close to impossible to hold confident views about what events will occur and how market participants (in aggregate) will react to them. The amount of noise and randomness is pronounced, and the range of potential outcomes vast.

As the horizon extends, however, the fundamental factors start to matter more. The compound impact of earnings begins to overwhelm the influence of fluctuating sentiment. If we are making a ten year forecast for an asset class, we are thinking about the accumulation of cash flows / earnings over that entire period, not just what they are by the end of it.

The influence of multiple years of earnings should mean that the range of outcomes narrows as our time horizon increases. In the graph below we can see the breadth of annualised returns for global equities since the late 1980s:

A one year horizon is the point of peak sentiment driven uncertainty, which then tapers materially as the period extends.

If we are investing in global equity markets today, we know the starting yield, the valuation and can set a prudent expectation for growth (long-run global GDP). It is reasonable to expect our returns to gravitate towards this over the long-run. There are clearly no guarantees here and there remain profound uncertainties. We should, however, have more confidence in these types of assumptions than in what might happen in equity markets over the next year.

Although it is more likely that we will enjoy success in making long-term asset class return forecasts, it is important to define success. We are not going to predict ten year returns accurately to 2 decimal places (or indeed 1); one of the few things we can be certain about is that such point forecasts will be wrong. This does not mean, however, that long run views are without value; there are many situations where they get the odds on our side.

Take the below three examples. These are all scenarios where I would prefer to make a ten year to a one year prediction:

• Setting a sensible range of expectations of where asset class returns will reside: I would expect the dispersion of returns to narrow as the time horizon moves past twelve months.
  
• Ranking asset classes by relative preference: I have no idea about how equities will fare compared to government bonds over the next year, give me ten years and I will be far more confident.
  
• Judging the likelihood of positive absolute performance: The odds of positive returns from most traditional asset classes improve as our time horizon extends.

The benefits of adopting a long-term approach when setting return expectations is reliant on being diversified. If we are heavily concentrated (for example owning a single stock) we should not expect the spread of potential outcomes to contract materially as our time horizons extend because of the ever-present spectre of idiosyncratic risk.

Whenever we make a forecast we should seek to understand what the most influential variables are and how unpredictable they are likely to be. For investors making decisions based on short-run asset class performance it is critical to be aware that outcomes will be incredibly noisy, driven by erratic sentiment and have a wide range of potential paths. Although imperfect, extending our time horizons can give us a little more confidence.

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My first book has just 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).

It is often stated that the key to strong long-term investment performance is the ability to compound good short-term results. Although avoiding near-term disasters (such as severe permanent losses or extreme volatility) is imperative for all investors; the idea that an acute focus on the immediate future when managing our investments will lead to positive outcomes over long-run horizons is deeply flawed. There is a paradox at the heart of our investment behaviour whereby the more we care about what happens in the short-term, the worse our long-term performance is likely to be.

Although the precise definition of long and short-term investing horizons is somewhat hazy, let’s assume that short-term is under three years and long-term is over ten years (we can ignore the piece in the middle for now).

For most investors the core tenet of successful long-term investing is about making sensible, evidence-based decisions that put the odds on our side and then letting it play out. Although this sounds easy, it is far from it.

Whichever investment strategy we adopt, whichever funds or assets we hold, they won’t work every quarter, every year or even every three years. They will all go through spells of poor performance where negative narratives abound and our concerns will be pronounced. The temptation to change course will often prove overwhelming.

This is not about active versus passive investing. All approaches will come under scrutiny. We need only look at the number of obituaries being written for the 60/40 portfolio following an unusually difficult 2022. Investors of all churches will have to withstand periods of scrutiny and doubt in order to meet their long-run objectives.

The underlying problem is one of continually unhelpful feedback. Long-term investors receive constant feedback on their choices in terms of short-term performance and the narratives that accompany it. We perceive this to be meaningful information but it is nothing more than distracting noise.

Smart long-term investment decisions will often spend plenty of time looking like stupid ones. If we cannot endure this reality, we are likely to be drawn toward the dangerous allure of short-term performance chasing.

Trying to manage short-term performance is both exciting and exhausting. Exciting because we feel good about latching onto the latest fad or trend; exhausting because markets are fickle and unpredictable.

Caring about how we compare to others over the next quarter or next year will inevitably lead to poor outcomes. As we constantly chase our tail, predict the unpredictable, pursue grossly overplayed themes, buy at the peak, and sell at the trough.  

If such myopia is a sure route to poor results, why is it so prevalent? There are three primary factors at play:

1) It relieves stress and anxiety: Doing nothing for lengthy periods as a long-term investor is tough, particularly when we are receiving negative near-term feedback (our performance is disappointing). Making changes based on what is working right now makes us feel so much better.

2) We mistake short-term market noise for information: We are overwhelmed by a constant stream of data releases, opinions and, of course, fluctuating returns. The functioning of financial markets makes us believe that things are changing and that our portfolios must change as a consequence.

3) Our incentives are aligned with taking a short-term view: For professional investors, in particular, our incentives are almost inevitably aligned with adopting a short-term perspective. It is the safest way to build a career, stay busy and not lose our job / assets. People are happy with the short-term decisions we make as they will be pro-cyclical (buy the winners / sell the laggards) and we will have a story to tell. We won’t see the long-term costs because by the time they come to fruition we will most likely be in another job.

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Aside from a select few who wish to dabble in short-term market timing (best of luck), the vast majority of investors would be better off in focusing on the long-term. Unfortunately, that is far easier said than done. Both our behavioural wiring and the febrile nature of financial markets makes short-termism our default setting. If we are going to be long-term investors, we need to have a plan for how we are going to do it.

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My first book has just 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).

If you are a staunch advocate of index funds then the answer to the question of whether meeting active fund managers before investing with them is a waste of time is unequivocally yes. So, to avoid another active versus passive debate, let’s assume we have to invest in an active fund – is meeting with the fund manager necessary and does it improve the odds of success? During my all too long career fund manager meetings have been something of a sacred cow – of course you must see the ‘whites of their eyes’ before handing a fund manager your money, it would be madness not to. But is this true?

The received wisdom around the value of meeting fund managers is so pervasive that I have rarely seen any alternatives proposed – aside from the occasional and dreadful performance (chasing) fund screen. Of course, different people have different approaches to such meetings – some are happy to simply be presented to, while others prefer to grill a junior analyst on their forecast for operating margins in the smallest stock in the portfolio – but most seem to miss a critical factor. Whenever we enter into an interaction with another individual the decision we make will often be overwhelmed by a range of unconscious behavioural factors. We ignore these at our peril.

What are the main behavioural problems we are likely to encounter when meeting with a fund manager?

Halo effect – Perhaps the most challenging behavioural issue of fund manager meetings is the halo effect. This is where we allow a positive view of one aspect of an individual to impact our assessment of an unrelated trait. A fund manager is a compelling, articulate presenter – surely, they must also be a good investor?

Outcome bias – Even though past performance is a poor guide to future returns and the presence of skill; we are likely to find the answers of an outperforming fund manager persuasive and an underperforming manager weak. In this sense, fund manager meetings can serve to perpetuate destructive performance chasing behaviour.

Selection bias – Successful fund managers who raise assets are likely to be good presenters and confident communicators. It will have helped them through every stage of their career. The bad presenters are probably more interesting propositions – they have had the odds stacked against them in getting to where they are.

Reading people – Part of the appeal of meeting fund managers is to gauge whether they are trustworthy and credible. Yet most of us hugely overstate our ability to ‘read people’, understand their motives and separate fact from fiction.

Perpetuating tropes – We inevitably hold a range of misguided archetypes and tropes about what characteristics individuals in certain roles should possess. One of the reasons why so many fund managers are men (aside from deeply-ingrained societal issues) is that we are beguiled by gendered traits such as overconfidence and charisma – despite them being unrelated to being a successful investor. These traits are often well in evidence in traditional fund manager meetings.

People we like – Although it is difficult to accept, we will hold more favourable views of investors that we like as people.

Reciprocity – Another issue that we struggle to believe would influence us is the power of reciprocity. If someone does something for us, we feel compelled to return the favour, often in ways that are entirely incommensurate. Small gestures can have a huge impact and is a spectre that looms over relationships fund investors may have with asset managers.  

Charisma – Charisma hides a huge number of ills and a fund manager meeting is the perfect forum to mask a lack of competence with personality. There is nothing more dangerous to an investor than a lucky fund manager with charisma.

Information / confidence – There is often a conflation between the depth of research undertaken on a fund manager (“we have had 15 meetings with them”) and the quality of the resulting decision. There are two problems here. First, we can easily lose sight of what variables matter because we are subsumed by irrelevant detail. Second, past a certain point, more knowledge simply leads us to hold more confidence in our view without it becoming any more accurate. In this situation, increased information reduces decision quality.  

Information asymmetry – Inherent in the interaction in a fund manager meeting is an information asymmetry. The fund manager should know more about the securities they invest in than we do. Yet I have attended countless meetings where a view on a fund manager is formed based on how well they ‘know their stocks’. Unfortunately, rote knowledge of securities is not a necessary or sufficient condition for being a successful investor.    

Storytelling – An effective fund manager meeting (from the perspective of a fund manager) is an exercise in storytelling. It is designed to make us focus on the inside view at the expense of the outside view – that is to concentrate on the specifics of the fund manager in question, not the general probabilities attached to successfully finding a skilful active fund manager. “Who cares if the odds are 1 in a 100, that was a great meeting”.

Sunk costs – In a fund manager due diligence process, we must always be aware of the impact of sunk costs. Turning back or changing our minds after so many hours spent in meetings is a difficult thing to justify to ourselves and others.

Front stage / back stage – One approach some fund selectors take when assessing a fund manager is to observe team meetings to see how interactions take place and decisions are made first hand. This is viewed with scepticism by many who argue that if a team are being watched then it is not a genuine interaction. Yet these same critics are often happy to sit in a standard fund manager meeting, which is surely more artificial. The simple fact is that – as sociologist Erving Goffman noted – we all have a front stage and a backstage self. The waiter in a restaurant behaves differently when they are serving us to when they are in the kitchen. All fund manager meetings are performative, and we will never know the true functioning of a team unless we work at the organisation.

Management of self – It is not just the fund manager that performs in a meeting, it is the fund selector also. They might be in awe of the fund manager, who will often have more money and power than they do. They might even be in the meeting alongside their own boss or client. The temptation is often strong to ask questions that might reflect well on them, rather than those that help make a good decision. ‘Intelligent’ but empty questions are easily favoured over ‘simple’ but searching ones.  

A problem for other people – There is one overarching factor that amplifies the damage caused by behavioural issues and that is our ingrained belief that they don’t affect us: “Other people? Maybe. But they have never influenced my decisions.” Until we accept that they do, it will continue to undermine the effectiveness of fund manager meetings.

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The regard in which fund manager meetings are held is such that I have never heard any reasonable alternatives proposed, indeed suggesting such things might be regarded as heresy. But let’s try.

How about instead of a face-to-face meeting with a fund manager, we reserve time with them and ask them to respond to a set of bespoke questions by hand. They have to do it themselves and on their own. If we were assessing a group of fund managers, we could even blind the responses.

I can hear the howls of protest about the loss inherent in such a method. There has, however, been such little progress in this area nor acknowledgement of the behavioural pitfalls of the current approach that fresh ideas are needed.

One less controversial method to help enhance the value of fund manager meetings is simply for fund investors to be clear about what it is they care about. It is so easy to become lost in a sea of noise. The most effective way to alight on this is to ask ourselves – if I could only know ten things about a fund manager before investing with them, what would they be?

It is not simple to define, but can lead to a much sharper focus. Having an agenda is not enough, we need to be trained on what matters and why.

Would I want to invest money without meeting a manager? Probably not, but perhaps it is just because I have been conditioned to believe it is essential. What is critical is that fund manager meetings are based on evidence pertaining to the factors that we believe are important. We should also always be underweighting what is said and overweighting what is done.

Are fund manager meetings a waste of time? No. Is it a waste of time or worse if we don’t acknowledge or deal with the behavioural biases that we carry with us into those meetings? Almost certainly.

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My first book has just 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).