If you work in the investment industry then you must have a view. Always. About everything. When will inflation peak? Will the Fed pivot? How will Japanese equities fare over the next six months? Is Amazon expensive? Does this fund manager have skill? If we don’t have an opinion then we either lack knowledge or conviction, perhaps both. As professional investors this is what we are being paid for, isn’t it?

No, it isn’t. Quite the contrary. The ability to not have a view on most subjects is a major advantage, just one that is incredibly difficult to exploit.

There is a stigma attached to saying “I don’t know”, not just in the investment industry but in many walks of life. Nobody wants to sit on the fence or stand in the middle of the road, but for investors this is absolutely the correct place to be most of the time. We are operating in a highly complex, uncertain environment where most predictions are either difficult or impossible. Being well-calibrated means spending a lot of time not having an opinion.

The majority of investors have all sorts of views. Does this mean we are poorly calibrated? In many cases, yes. There are two reasons why investors are so keen to predict everything. The first is simple overconfidence – we think we are better than we are.  The second is because it is expected of us – our clients want us to have a view, so we must form one.

Why is there an expectation for investors to have views on everything? Because it gives a sense of control. Financial markets are messy, chaotic, and anxiety-inducing; when an investor makes predictions and trades on them it feels like there is a steady hand on the tiller, rather than our portfolios being a hostage to fortune.

This is the enduring appeal of tactical asset allocation despite the compelling evidence that people cannot time markets successfully and consistently. Things are happening so investors need to be seen to be doing something about it.

But having wide-ranging and ever-changing views on markets is not harmless, it is damaging. Not only are investors constantly forecasting things when we cannot reasonably expect to have any skill in the task; it also means that we will be trading far more than is necessary – destroying value through transaction costs and the losses that stem from predicting the unpredictable.

The erroneous views that investors hold come in two forms. We can be operating far outside of our circle of competence – it is not feasible to have credible expertise in UK mid cap companies, the Chinese real estate sector, and the implications of the latest US non-farm payrolls report. Most common, however, is simply to have views on subjects that are not reasonably inside anybody’s circle of competence – typically these are short-term market perspectives: how is the Russell 2000 going to fare relative to the S&P 500 over the next six months? Who knows?

The vacillations of deep and intricate financial markets are endlessly fascinating but being intrigued by them does not mean we need to take a position or trade.

When Should Investors Take a View?

So if investors should avoid taking views most of the time, when should they do it?

The critical questions to ask are whether it is reasonable to have a view at all (is it something we or anyone can predict) and are the odds on our side in getting it right?

Let’s take an example.

I am asked to predict whether global equities will generate positive returns over the next six months. I have no idea. Over short run horizons markets are noisy and unpredictable, and I would simply be guessing with little confidence in my outlook.

But what if I am asked to predict whether global equities will generate positive returns over the next ten years. Here I have a view. Over the longer term the performance of equities will likely be driven by the cash flows they generate. History also tells me the odds are in my favour in having a confident (though not certain) perspective.

We should only express forthright views and take positions where we have a long-time horizon and a robust evidence base that suggests the likelihood of our view coming to pass is strong. This will often only occur when markets are priced at extremes, everything else we can think of as noise.

Wilful Ignorance

Not having an investment view on every imponderable in financial markets can seem like ignorance, but it actually shows an acute awareness of the environment in which we operate. It is far more ignorant to believe that we can accurately predict all manner of complex and unfathomable things.

Rather than have an ever-evolving set of views and positions, we would be far better off allowing others to pontificate and trade, and instead wait until there are opportunities where the probability of good outcomes are firmly on our side.

Investors would be far happier (and better off) not having a view on most things most of the time.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

It has been a bruising spell for ESG investing. Not only has the war in Ukraine brought into sharp contrast some of the potential trade-offs involved (fairly and unfairly), but it has faced numerous stinging criticisms. Tariq Fancy – formerly CIO of Sustainable Investing at BlackRock – labelled it a ‘dangerous placebo’, Stuart Kirk made his now infamous ‘Miami underwater’ speech and Aswath Damodaran – probably the pre-eminent scholar of business valuation – suggested people working in ESG were either ‘useful idiots’ or ‘feckless knaves’. As is symptomatic of the world today, ESG investing has become another polarised debate. It is either unimpeachable and essential, or little more than an asset management confidence trick. This lack of nuance is incredibly unhelpful and makes a complex topic even more problematic. How can investors successfully navigate these issues?

Why Has Criticism of ESG Investing Increased?

There are two central factors that have driven the increasing level of criticism faced by ESG investing. First is some of the unsubstantiated claims that arose from the asset management industry. When companies in the ESG sweet spot were enjoying prodigious performance tailwinds, it was easy to make naïve yet compelling assertions about how we can ‘do good’ and outperform. This was a potent marketing cocktail – not backed by robust evidence – that created entirely fanciful expectations. It was just a matter of time before the backlash arrived.

The second catalyst was the pronounced style rotation in markets, which has seen high-growth companies (including many ESG darlings) fall back down to earth, whilst much-maligned resource stocks have surged. In financial markets it is performance that creates narratives (not the other way round). When something is underperforming it becomes open season for disapproval.

And much of the opprobrium has been warranted. Greenwashing is rife, trades-offs and difficult questions about fiduciary duty are roundly ignored and the industry is in danger of measuring everything and achieving nothing. Yet valid criticisms do not render the entire endeavour meaningless or defunct. It just means we need to step back from the noise and think clearly about what ESG investing is and why it matters.

How Should We Think about ESG Investing?

One of the central problems with ESG investing is its sheer complexity. Investors of all guises are inevitably discombobulated by a seemingly endless array of measures, metrics, initiatives, regulations, acronyms, initiatives, bodies, reporting requirements, pathways, targets and even genuine issues.  Amidst all this, it is easy to lose sight of its underlying purpose.

At its core, ESG investing is about three elements – values, value and valuations. Any ESG-based decision we make should consider these aspects:

Values: These are issues that we care about. What matters to us outside of pure financial considerations?

Value: These are factors that we believe impact the worth of a company. Do they create or destroy long-term business value? *

Valuation: This is how an ESG related factor or business is priced. Is it expensive or cheap?

With any ESG based judgment or decision, an investor should be asking – is this about values, value or valuation?

Let’s take each element in turn:

Values

Values are the ESG-related choices that we make because of our beliefs on the issues or subjects we care about. The most obvious example of a values-based ESG decision is a portfolio exclusion. For example, we decide that we do not wish to invest in tobacco stocks because of the harmful and addictive nature of the product.

The flip side of exclusions is investing in thematic ‘impact’ strategies – here we might wish to invest in companies that are engaged in activities that we believe are positive for society or the environment. Investing in such a way makes us feel good or at least better.

The distinguishing feature of a values-based choice is that we are agnostic about the return effect of such decisions. We are willing to accept a financial cost. Green bonds are a good example of where there is some evidence of investors accepting inferior returns (in the form of a lower spread / yield) to ‘directly’ fund certain types of activity with an expected positive environmental impact. Investing due to our personal values will not always result in a loss but we have to accept the possibility that it might.

The problems arise when investors are unclear about what is driving a decision. Most investors in heavily thematically tilted sustainable or ESG funds are not doing so under the apprehension that performance will be poor (despite the historic evidence of thematic fund performance). Asset managers also frequently muddy the water by applying minor exclusions at the margins of a fund (such as controversial weapons), but without being transparent about whether this is an investment view or values-based choice.

This is a messy and highly subjective area. Not only because of the personal and somewhat opaque nature of values, but also the different ways we might be willing to express them. Two investors with a similar set of values might behave in an entirely different way – one might exclude a certain industry; another might believe that engagement is a far more effective approach.

There are few right answers when it comes to values, but if we are making a values-based decision it is critical that we admit we are doing so and understand the potential implications.

The question that investors need to ask to ascertain whether an ESG-related decision is values based is – am I willing to accept a financial cost to make a decision that is consistent with my values?

If the answer is no, then we need to provide a coherent, evidence-based explanation as to why the decision is instead about value or valuation.

Value

Value is about the ESG issues that impact the value of a business. These will be specific to companies and industries, and should be considered alongside other relevant factors that impact the long-term worth of a business.**

The crucial point here – as Alex Edmans’ highlights in his excellent recent paper – is that if there are ESG issues that are vital to the value of a company then it should be a focus of all investors, not simply those running ESG or sustainability orientated strategies.[i] ESG factors and risks that are central to a business and will impact shareholder returns should be considered alongside a host of other aspects. The job of any fund manager or analyst is to understand the factors within a business that are likely to create or impair long-term shareholder value.

The logical extension to this idea is that there is no need for sustainable or ESG-orientated funds because all competent investors should be doing it anyway. There is some truth to this, and this is hopefully the direction in which the industry moves. There are, however, two caveats:

First, ESG funds may cater to certain investor values (as previously covered), but if this is the case then we should be willing to incur a potential cost. Second, ESG funds are likely to believe that these issues are more material than others and therefore weight them more highly in their analysis of a company’s worth. In such a scenario we need to be transparent that this is a stark investment view that will have meaningful implications – we are stating that most mainstream funds are neglecting the importance of ESG factors and underweighting them in their investment decisions. There is nothing wrong with holding this perspective – although it would be helpful to understand the evidence supporting it – but we need to be clear that it is a position that will have performance implications.

Even if we correctly identify the ESG issues that are relevant to a company and can assess their materiality, there is one other aspect to consider – valuation.

Valuation

Identifying the long-term drivers of value within a business is imperative for making sound investment decisions, but we cannot ignore how that business is priced. What we pay for a security or asset matters greatly to the returns that we receive.

Let’s assume we have identified an ESG factor that has a material impact on the creation of shareholder value and a company that scores particularly well on this metric (amongst many other non-ESG characteristics). Is it a good investment? It depends on the price. Positive ESG or non-ESG characteristics do not result in good investment outcomes if they are more than reflected in the price that we must pay for it. ***

There will almost inevitably be times when stocks with a particular set of ESG credentials become very expensive. What do we do in that situation? 1) Hold them for so long that the price paid pales into insignificance relative to cash flows and growth (few people have a time horizon of this length). 2) Become a values-based investor and say that we are willing to endure a lower return because of the positive ESG traits. 3) Not hold the companies because they are not attractively or even fairly priced. The third option seems the obvious one but becomes problematic if we had made commitments about the ESG metrics of our fund, which limits our flexibility. If we hold expensive assets to maintain some score or meet an ESG threshold – we become implicit values-based investors.

In the future we may see strategies that are explicitly willing to sacrifice potential returns by investing in companies with positive ESG characteristics irrespective of the price. But for most existing funds this creates question marks around fiduciary duty – this is a discussion that not many people want to have but will have to happen at some juncture.

For any ESG orientated investment decision we should be able to ask whether it is driven by values or value.  If the latter, there should be a significant evidence base supporting why it impacts the long-term value of the business. We can then consider how that company is priced relative to those attributes and all the many other facets that feed into an assessment of its valuation.

What about externalities?

If we think about ESG investing through a values, value and valuation lens, where does that leave negative externalities? Where and how do we incorporate a cost created by a company that is not fully borne by them? Let’s take an example.

Imagine there is a large social media company that we believe creates a profound societal cost due to its negative impact on the mental health of teenagers. How do we integrate that into a values, value and valuation framework?

If we believe that costs of this are not currently incurred by the company but may be in the future, we can absorb this into our valuation. Even though it is currently an externality we can price for its future internalisation. It is in such situations that engagement is likely to prove particularly powerful and can combine values and value effectively. (I care about the issue deeply and think the company value will increase if it alters its behaviour).

If we believe that either costs are unlikely to ever be fairly levied on the company, or that we simply find the activity of the company unpalatable then our decision (perhaps to exclude the company from our portfolio) will be a values-based choice.

The major difficulty with externalities is when we think from a portfolio perspective rather than how they impact an individual business. We may suffer the cost of the negative externalities of a company we hold because it has broader consequences on, for example, economic growth or asset class performance. A polluting company we own may benefit financially (particularly in the near term) from avoiding the full internalisation of external costs, but it could still be to the detriment of our overall, long-run returns (amongst other things).

If we make decisions based on the potential ‘universal’ impact on our investment returns it can still be considered value-led, just through a different lens. The critical aspect is to be open about how we arrive at such judgements.    

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Trying to simplify how we think about ESG by using a values, value and valuation framework doesn’t make a complex and subjective area easy. Being clear about the drivers of our ESG-influenced decisions will, however, help in both setting realistic expectations and allow for reasoned debate about the quality of our choices.   

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* This could also apply at a portfolio or market level.

** This is obviously messier and more complicated than it sounds. There will be (many) scenarios where company executives are incentivised based on short-term profitability / share price performance and rational behaviour for them may be to maximise this, perhaps at the expense of long-term shareholder value. Engagement should play a crucial role in such situations.

*** The reverse of this situation is a company that scores poorly on the ESG metrics that are relevant to it but is incredibly cheap. Here we can decide not to invest (which becomes a values-based decision) or look to invest and engage.

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[i] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4221990

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Imagine a young active fund manager is presented with a choice; over a twenty-year investing career the fund they manage can take one of two paths. In path A it delivers annualised outperformance of 3%, but it is a bumpy ride – there will be numerous years of sustained and substantial underperformance. In path B their fund underperforms the market by only 0.3% a year, but it is a far smoother journey – in some years returns are a little better than the benchmark, in some slightly worse, but never too far away. Which path would they choose?

For a client investing with the fund manager the choice seems relatively straightforward – path A leaves them with substantially more wealth and justifies their use of an active fund. Yet for the fund manager it is not an obvious decision at all, in fact it is probably rational for them to choose path B, even though it would leave their clients worse off over the long run. Why? Because in path A there is a high probability that they will be fired and never be able to deliver the long-run results promised; contrastingly, path B is more likely to lead to a lucrative career.

There is a major incentive problem at the heart of the asset management industry, where the interests of clients and the professional investors who run money for them are often poorly aligned.

The key to a ‘successful’ career as a fund manager is not long-term outperformance, it is survival. Making sure from quarter to quarter that your results are adequate so that you don’t find yourself in the firing line. If you can survive long enough then you might get promoted to head of team or another executive role, so you are no longer even directly responsible for investment decisions. The most lucrative choices you can make are those that help you to stay in the game.

The power of the incentive to keep your job and progress your career increases through time. As you earn more money, you adapt your lifestyle, take on a bigger mortgage and send your children to private school. This means the risk of short-term failure becomes even more acute.

The development of this type of incentive structure means that the active fund management industry has evolved to a point where making high conviction, long-term decisions is irrational behaviour for many participants. Even though it should be one of its primary purposes.  

This is not the fault of fund managers. The entire industry is complicit in the game of enabling their own short-term survival. Asset management companies trying to meet quarterly inflow targets, board and committee members worried about the reputational impact of something going wrong, consultants concerned about losing disgruntled clients. Even regulators are now enforcing judgements on “value” based on performance time horizons over which every strategy (no matter how capable) will fail at some juncture. Nobody is incentivised to make long-term investment decisions because doing so exposes you to profound personal and corporate risks. 

Most people are left spending their time engaging with largely meaningless short-term market noise and ensuring that they are safely ensconced within the pack.

What does this cultural backdrop mean for the structure of the active asset management industry? We are left with an unnecessarily large and amorphous blob of uninspiring funds stuck in the middle and doing enough to survive. Strategies taking higher conviction, longer-term decisions frequently succumb to the endemic short-termism that defines the industry (irrespective of whether they are skillful or lucky).

For the active management sector to successfully evolve not only does it have to become smaller and cheaper, but it must ensure that it creates an incentive structure and clear purpose that is properly aligned with the long-term interests of its clients.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Much of the focus on the dramatic and unprecedented sell-off in gilt markets this week has been centred on the technical factors that led to an intervention from the Bank of England, potentially worth £65bn. Whilst the tribulations of the Liability Driven Investment strategies used by pension schemes are both fascinating and concerning, these periods of extreme stress are not just about the technicalities – they also provide acute behavioural lessons:

Small sparks can lead to great damage in complex systems:

The catalyst for the dramatic rise in gilt yields was the new leadership’s ‘mini-budget’. Which precise part of Kwarteng’s proposal led investors in UK assets to panic? The removal of the highest rate of tax, the unfunded nature of the proposals or the lack of independent oversight from the Office for Budgetary Responsibility? Everything and nothing. It doesn’t matter. In deeply complex, interconnected systems small sparks can precipitate dramatic and destructive feedback loops.

Markets are about the behaviour of other investors:

Financial markets are about the decisions made by other people. Most investors do not assess new information about an asset based on how it impacts its cash flows and valuation, but how we believe other investors will respond to that same information. This creates vicious and virtuous circles. In periods of severe turbulence this feature of markets is taken to the extreme. Our decisions become driven by the fear and cost of being the wrong side of momentum shifts. We want to be in the herd during the stampede, not underneath it.

Predicting when things will happen is close to impossible:

The fact that complex systems can be compromised by small events doesn’t simply make them riskier than we might normally perceive. It makes them even more difficult to forecast than we realise. Even if a system has inherent fragilities, anticipating when these will be exposed (if ever) is an incredibly difficult, perhaps impossible, task. Investors should never try to predict when things will happen.

Both financial and mental models can break under stress:

It is inevitable that the scale and speed of the rise in gilt yields would have torn asunder many ‘worst case’ assumptions that have been made in financial models. Whether it be the stress tests or scenarios used to judge the appropriate collateral buffers in an LDI strategy or the predicted drawdown in cautious (but duration heavy) portfolios, some models will have been found wanting. This is to be expected – models are an abstraction, a simplified version of something too chaotic to replicate. Not only that, but the output of financial models is inexorably shaped by what has happened before. In a complex system, things tend to break in the future in a different way to how they broke in the past.

It is not just the limitations of financial models that leave us vulnerable, but the mental models that investors use. Inescapably, the mental models we apply to inform our investment decision making are framed by what we have experienced. For most that means years of tranquil market conditions, moribund inflation, and interest rates at close to zero. When the environment shifts it can leave us incredibly exposed.  

Short-term performance chasing sows the seeds of future pain:

One of the major casualties of the remarkable increase in yields has been defensive or cautious funds, some of which are nursing losses of more than 20% across the year. Many of these strategies have used a heavy allocation to long duration bonds to provide a ‘low volatility’ return stream and diversification alongside the growth assets held in a portfolio.

It is easy to now be critical of the unappealing ‘return free risk’ of owning long duration bonds with very low return prospects, but it is important to remember the context. Holding such assets had worked well for years (decades). Investors who came to find the combination of close to zero returns and (potentially) severe volatility unappealing likely found themselves underperforming their peers and benchmark. The more pressure investors feel about poor short-term performance – ‘being underweight duration led to underperformance again this quarter’ – the greater the temptation is to fold. Unfortunately, there is often a choice between keeping to our long-term investment principles or keeping our job and assets. We cannot always do both.

Market shocks leave scars:

The type of market shock we have witnessed in the past week will undoubtedly leave scars. Not simply in terms of unrealised and realised losses, but future behaviour. What will the consequences be? Changes to collateral buffer requirements for LDI strategies seems obvious (we have a new scenario to use in the risk model). What about cautious and defensive portfolios – are long duration assets now less palatable? (Ironically, they are far more attractive now than they have been in recent years). Will it now be more acceptable to hold high cash levels in a portfolio? The trend towards global bond and equity exposure at the expense of a domestic (UK) bias will almost certainly gain even further momentum.

The memories and consequences of stressful events unavoidably shape our future behaviour. Some changes will be an irrational reaction to an idiosyncratic occurrence, others might be more sensible. Some behaviour shifts will fade, others will prove long lasting.  

Our model for how things work has changed, and it will change again.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

In his new book on decision making, Ed Smith, who was responsible for the selection of the England Men’s cricket team between 2018 and 2021, discusses the challenges of innovative thinking.[i] He quotes poker player Caspar Berry:

“Whenever someone innovates in business or in life, they almost inevitably do so by accepting a negative metric that other people are unwilling to accept”.

Smith cites the dramatic increase in the number of 3-point shot attempts in the NBA in recent years – a revolution led by the then Houston Rockets General Manager Daryl Morey – as an example of pre-existing norms being broken because of a willingness to accept a negative metric (the increased failure rate when attempting the higher value shot).

It is not just in sport where this concept prevails. It matters for investors too. Whenever we attempt to make decisions with the aim of improving returns, we must also be willing to experience unpalatable negative metrics.

The simplest investing analogy that encapsulates the requirement to accept a negative metric is in active investing. Growth investors deviate from their benchmark because they have willingness to accept higher valuations; whilst (traditional) value investors may suffer from a portfolio with lower sales growth, weaker profitability, and potentially higher levels of debt.

Yet these simple figures miss the point. The critical aspect of a readiness to assume a negative metric is not the number itself, but the experience and consequences of deviating from what is expected. The cost to Daryl Morey of his team’s increasing propensity to take 3-point shots was not the lower successful shot percentage. It was the reputational risk, the anxiety of being the outlier, the threat of failure – all the stresses and pressures that come from diverging from the norm.

We can observe these trade-offs right across the investment landscape. Let’s take the equity risk premium, one compelling explanation for the long-run return advantage to equities is myopic loss aversion – higher returns are the compensation required for the pain of short-term losses. If we want to enjoy the benefits of long-term equity investing, we need to accept the behavioural pain and embrace the negative metrics.

On a more granular level, this is exactly the situation faced by active investors. Prolonged bouts of underperformance are inevitable – even if we happen to possess the ability to deliver long-run outperformance. It is pointless even having conversations about investor skill if we do not have the appetite or wherewithal to withstand the uncomfortable behavioural realities of active investing.

To make matters worse, negative metrics are not something that only appear on the road to success, it is also a feature of the path to failure. When we diverge from the crowd or consensus, we might accept negative metrics and still be wrong.

The most damaging situation for investors is where we take decisions with the intention of enhancing our performance, but don’t acknowledge or accept the negative aspects that we will have to endure to achieve it. If we invest in equities but don’t understand that gut wrenching bear markets are the price of admission, we will sell at the most inopportune time. If we invest in active funds and expect consistent outperformance over months, quarters and years we will pay the exorbitant tax of incessantly switching from near-term losers to yesterday’s winners.

Any investment decision comes with pain points and costs, failing to recognise and accept these will lead to consistently poor decisions.

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[i] Smith Ed (2022). Making Decisions: Putting the human back in the machine. William Collins

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Learning the skills required to become a good investor should be easy. There is plenty of information, decades of evidence and many willing teachers. Despite this it is anything but – we only need to look at the consistent and costly mistakes that we all make to acknowledge how tough it is. But what makes it quite so difficult? Terrible feedback loops. Effective feedback is critical to good learning, but in investing these feedback loops are as unhelpful as they could possibly be. Long, noisy and erratic.

The first time we put our hand on a hot stove, we quickly learn that it is a bad idea. Why is this? Because the feedback loop is short and direct. The immediate heat and pain provide an incredibly salient lesson in what not to do in the future. Unfortunately, not all feedback loops are this efficient.

If we break down the critical features of a useful learning feedback loop, we can see why investing is so problematic:

Feedback	Easier Learning	Harder Learning
Response	Short	Long
Results	Clear	Unclear
Impact	Minor	Major

Response: Rapid responses are vital in being able to understand immediately what a sensible course of action looks like. If we only felt pain in our hand two years after we put it on the stove, then the lesson really isn’t that valuable. If we want to make good decisions in the future, we need to receive good quality feedback as quickly as possible.

This is a real problem for investing. A long-term approach is critical for most successful investors, but – by definition – we only reap the rewards of this over time. We don’t get helpful instant feedback. We must wait and trust that we will get the right outcomes from the choices we make.

Results: Feedback is most useful when the link between our actions and results is clear. We have no doubt that the consequence of touching the stove is the burn on our hand. Things become much trickier when there is blurring between our choices and their outcomes.

Measured, sensible and evidence-backed investment decisions will often appear the opposite. They will frequently be outshone by investors engaging in ill-informed, wild speculation. This is particularly problematic over short time horizons, where meaningless noise dominates outcomes.

Imagine we are taking an exam. We know that nobody else in our class has studied, they barely even turned up to lessons. We have worked diligently and prepared to the best of our abilities. When the results come out, however, we find out that we are bottom of the class. We inevitably question why we bothered to work so hard and wonder whether we should follow the more relaxed approach of our classmates.

This is the situation faced by an investor trying to learn the craft. Good decisions will often receive feedback (in terms of short-term performance) that looks poor. So how can we be confident that we are doing the right thing?

Impact: Learning from short feedback loops only works if the impact from negative feedback is minor. Discovering that jumping from a tall building is a bad idea is excellent feedback, but the consequence is so severe that it is not that useful in the future.

Investors might receive valuable feedback on the dangers of concentration, the risk of leverage or the warning signs of investment fraud. These lessons are not so valuable if they come only after catastrophic losses.

The learning feedback loop for investment decisions is long, wildly erratic, and often too consequential.

How Do Investors Learn?

Investors learn in two ways. From our own experience and from the experience of others. It is often assumed that the most valuable form of learning is personal experience and whilst there is some truth to this – I have certainly learnt a great deal from my investing mistakes – it is not entirely accurate.

Our own personal sample size is simply too small. We will only have a narrow and particular set of experiences – and that just isn’t enough. It is far too easy to learn the wrong lessons. Imagine we are fortunate enough to begin investing in the early days of an investment bubble. We might go through years of learning about how valuations don’t matter, stories are everything and prices only go up. That is what our feedback has told us.

So, we must rely on others to learn how to make good investment decisions. Whilst this is better – it gives us a far more robust body of evidence – it is still challenging. Now we have so many samples to choose from we are easily confused – who and what should we pay attention to?

How to Learn Without Good Feedback Loops

Noisy and long feedback loops makes learning to make good investment decisions incredibly difficult. It means there will be times when we are likely to doubt even the most unimpeachable principles – such as the prudence of diversification. There are, however, several steps we can take to help address the problem:

Ignore near term feedback as much as possible: Unless we are short-term trading (good luck), then we need to ignore the random fluctuations of markets – even if there is a compelling story attached. It rarely tells us anything useful.

Decide what type of feedback is useful: Although disregarding short-term performance is vital for most investors, it is not reasonable to wait 40 years to judge whether you have made a sound decision. Instead, we need to consider what type of information would be helpful in assessing the quality of the decisions we have taken. For example, if the performance of our investments is wildly more volatile than we were expecting – this is probably helpful feedback. We should set some reasonable expectations to compare our results against.

Understand that our own experience is a very small and biased sample: We can learn from it, but it can also be deeply misleading.

Learn the right things from the right people: Learning from the experience of others is essential for investors, but it also leaves us vulnerable. From day traders posting their successes on Twitter to an outright snake oil salesman selling get rich quick trading schemes (to make themselves rich), there are more bad lessons out there for us than good ones – and, to make matters worse, the bad ones are more exciting.  Unlike school, in investing the best lessons are the boring ones. We should learn from those who have the right alignment of interests, similar objectives and plenty of experience.

Weigh evidence correctly: Not all evidence is created equal. The vast amount of information and noise around financial markets means that good learning involves being able to filter evidence that is robust (broad, long-time horizons, sound principles) from that which is flimsy (narrow, transitory and biased).

Focus on general principles rather than specific stories: Understanding principles that are likely to hold through time (the importance of valuation, the power of compounding or the benefits of diversification) is likely to be far more worthwhile than learning specific ideas about markets, assets or trading techniques, which will often prove fleeting. These principles can become models that we can apply across all types of investment decisions.

The feedback problem makes learning to become a good investor incredibly difficult, at times it can feel like learning to play the piano but where each time we hit the correct key the wrong note sounds. It is easy to become disenchanted.

Any useful feedback we receive will often be too late, either because something has gone badly wrong or because meaningful results only emerge over time. There is no easy solution to this. Investing is an exercise in dealing with short-term noise, deep uncertainty and profound behavioural challenges.  The best we can do is base our decisions on sound principles, always be willing to learn and understand that most short-term feedback can be happily ignored.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Selecting an active fund that will outperform its market capitalisation benchmark through time is an exacting challenge. We have all seen the bleak data regarding just how few funds deliver long-term excess returns in most (but not all) asset classes. It is, therefore, easy to make the argument that markets are simply too efficient and there are not sufficient opportunities for active investors to exploit, but this doesn’t hold water. Even if markets were efficient, we would expect a reasonably even distribution of outperformance and underperformance from active investors around this. Results would be random, but the probability of success would be somewhere near 50%. * In most cases, however, the odds of a positive outcome are far worse than this. But why?

There are three major issues that shift the probability of successful active fund selection from a 50 / 50 shot to something that can be close to zero: Fees, constraints, and behaviour. Any investor in active funds must manage these deliberately and well to give themselves a fighting chance:

Fees

Fees are the immutable, overwhelming impediment to successful active fund investing. They are a minor problem over any given year, but compound into a major, often insurmountable hurdle through time. The higher the fee level, the closer the probability of outperformance gets to zero.

People often misattribute the struggles of active management with efficient markets or incompetent professional investors, but this is generally not the case. The trouble is fees. Active funds are too expensive in aggregate, and this shifts our starting odds of success far lower than the 50% they would be before costs are considered.

In recent times there has been a conflation of two arguments: that low fees are incredibly beneficial to investors and that a market cap allocation approach is inherently superior to other methodologies. The first contention is true, the second is not. This mistaken thinking has arisen because most low-cost funds adopt a market cap indexing approach, and this methodology has enjoyed a prolonged period in the sun in many markets (the US in particular). There have been decades in the past where a market cap allocation has been inferior to other techniques (such as equal or fundamentally weighted).

The point is not that a market cap allocation is a poor strategy to adopt (it is perfectly sensible for most investors) but rather that the travails of active funds are more to do with the structural problem of high fees, rather than the cyclical issues of mega cap US companies making market cap indices hard to beat.

Staunch advocates of active fund investing often tend towards complacency on fees on the basis that certain managers are so skilful and will generate such a high level of alpha that the fee level isn’t a major concern. This is a dangerous mindset.

It is inconsistent to compare a certain cost with an uncertain benefit. If fees for an active fund are 1% and expected alpha is 2%, we need to haircut that forecasted outperformance for our own fallibility. We might be wrong that a manager has skill, or invest at an inopportune time (following a spell of stellar performance, for example). Active fund investors often talk about the hit rate required to be a successful fund manager (not much more than 50%), is it that different for fund investors? **

For active investors, reducing fees paid is the easiest lever to pull to improve the odds of success.

Constraints

Active fund investors must also seriously consider the constraints they encounter in their investment approach; these will substantially reduce their chances of delivering the desired outcomes.

The most obvious impediment is likely to be size. The larger the level of assets, the narrower the opportunity set and the more difficult it becomes to generate outperformance. Although (for obvious reasons) asset management companies do not like to acknowledge it, it is an inescapable fact that above a certain minimum viability threshold a rising level of assets impairs future returns. The extent of this hindrance will vary depending on the asset class involved but in almost all instances it is a major drawback.

It is not only size that serves to constrain active fund investors, but there is also a host of other implicit and explicit limitations that will impair returns and reduce the likelihood of success. ESG restrictions are an obvious area in the current climate, as are controls on variables such as tracking error or manager tenure. A requirement to recommend or own too many funds is also highly problematic (investment skill, if it exists, is scarce not abundant).

Some fund investors must even deal with disastrous constraints such as only holding funds that have delivered outperformance over certain historic periods (such as the last three years). This is the type of constraint that immediately puts the chances of long-run success at zero.

Anything that restricts the investable universe or limits the agency of the investor reduces the probability of successful active fund investing. It is critical that we know what these are before we start.

Behaviour

Even if we have skill in selecting active funds, manage fees prudently and face limited constraints, there is one thing that can make it all redundant – our behaviour. Active fund investors must be acutely aware of behavioural challenges (and be able to deal with them) if we are to have any hope of prolonged success.

The most significant behavioural challenge is related to time horizons. To invest in active funds there must be a willingness to not only hold for the long-term (we should be thinking ten years) but withstand the inescapable bouts of prolonged underperformance that will occur during these periods. Let’s be clear, on the time horizons and incentive structures of most fund investors, Warren Buffett would have been fired on numerous occasions.

An obsession with noise-laden short-term numbers – such as poring over quarterly results – or a bizarre fascination with the spurious idea of consistent calendar year outperformance are the type of traits that will eviscerate our chances of long-run success.

When owning an active fund for the long-term we will be regularly provided with reasons to sell. If an active fund manager has underperformed for three years, we will always be able to identify ‘process issues’ that have caused the underwhelming returns, and will not resist the urge of asking them “what are they doing?” to address their poor results (in most cases, hopefully nothing).

The added problem is that there will, of course, be times when selling is the correct course of action. Nobody said it was easy.

It is vital not to underestimate the harsh behavioural realities of active fund investing, but unless we are able to discard the rampant myopia and find ways to manage our preoccupation with short-run outcomes, we should be investing in index funds.

Improving the Odds of Success

This post has been somewhat negative as it has focused on those factors that make successful active fund investing so difficult, rather than address the positive steps that can be taken to improve the odds of success. Although I will cover this in another post in more detail, there are ways in which this can be done. Tilting towards empirically sound factors at a low cost (such as value, momentum and quality) should enhance long-term outcomes, identifying investors with skill is difficult but possible (it has little to do with past performance) and making counter-cyclical decisions (investing when valuations are cheap and performance is poor, rather than the reverse) is a painful but productive approach.

The problem is that the proactive measures we might take to improve our odds are irrelevant unless we first deal with high fees, burdensome constraints, and poor behaviour. These will conspire to overwhelm any other positive actions we might take. If we want to invest in active funds, we need to be clear about how we are going to address these three key issues. If we cannot then we really should not be doing it.

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*This is a deliberate simplification, which assumes no skew (lots of small funds outperform and a few large funds underperform, for example) and that active investors invest only in their defined market.

** It is, of course, not just a hit rate that matters but the win/loss ratio too.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Momentum investing has something of an image problem. It is not particularly sophisticated to say that we are buying a security because its price is going up or selling it because it is going down. It appears far superior to make investment decisions based on the elaborate fundamental analysis of a company or forensic due diligence of an actively managed fund. Despite a somewhat unattractive reputation, however, most of us are momentum investors. We just don’t want to admit it.   

What are the attractions of momentum investing?

In its most simple terms momentum investing is buying assets that are performing well, whilst abandoning the laggards. There are a range of reasons why investors find this secretly appealing:

1) It’s easy: Doing momentum investing badly is incredibly easy. It takes barely any effort to know which asset classes and securities are in-vogue. (Conversely, good momentum investing is difficult, particularly behaviourally).

2) It’s comfortable: Investing in things that are working right now and selling those that aren’t is incredibly comforting. It makes us feel good and worry less.

3) We extrapolate: We cannot help but think that what has happened recently will persist into the future.

4) We build stories around performance: When an asset is performing well, we create stories to justify it. Positive performance momentum leads us to form a compelling and persuasive investment narrative. A virtuous / vicious circle which increases our conviction.

5) We are comfortable in the crowd: Chasing momentum means following the crowd. Not only do we think that crowd behaviour provides us with information; taking a contrarian stance against it carries a host of unpleasant risks.  

6) Our career might depend on it: Momentum investing can be a useful survival strategy in the asset management industry, even if it destroys value over the long-term. Always telling clients how we are invested in the latest flavour of the month areas might just keep us from getting fired.  

Why don’t we admit to being momentum investors?

Despite the appeal of momentum investing, few of us admit to being profoundly influenced by it (excluding those who are running explicit momentum strategies). It is just too simple.

Although the majority of active fund investors chase performance, they rarely acknowledge it as the major influence on their decision making. Even when using a dreaded performance screen to filter a universe of funds (which ingrains momentum into the selection) this will be framed as a minor part of the process, before the more detailed research begins.

It is just not feasible to say to colleagues or clients: “we invested in this fund primarily because it was performing well”, even if this is the case. (We will also inevitably persuade ourselves that positive performance momentum wasn’t the significant driver of our decision).

Why doesn’t being an implicit momentum investor work?

There is a major problem with momentum being our implicit investment strategy – it doesn’t work. We are likely to be wildly inconsistent in our behaviour. Erratic, driven by noise, emotion and perverse incentives. We will be frequently whipsawed and often under-diversified.

Each time we make investment decisions that are implicitly driven by momentum it makes us feel better for a time; but what will feel like short-term wins, almost inevitably compound into painful, long-term losses.  

But momentum investing does work!

Why am I claiming that momentum investing doesn’t work, when it is one of the most empirically sound investment approaches to adopt? Momentum is everywhere.[i] It is because there are two types of momentum investing: implicit (the one we don’t like to admit) and explicit (which we find in academic literature and employed by various quant firms). Explicit momentum strategies are the polar opposite of their implicit counterpart. They are systematic, rules-based, unemotional, persistent and diversified. Everything implicit momentum strategies are not.

People often question why there is a premium for systematic momentum strategies. Perhaps because their profits are the other side of the losses made by ill-judged and widespread implicit momentum strategies. Bad momentum strategies feed good momentum strategies

Implicit momentum, or what we might call performance chasing, is endemic and entirely understandable. Not only are we hardwired to invest in assets that are performing well and sell those that are struggling, but the asset management industry also compels it – all our short-run incentives are aligned to behave in this way.  

There is nothing wrong with momentum investing, but there is plenty wrong with adopting an investment strategy that we won’t acknowledge to ourselves or anyone else.  

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[i] https://pages.stern.nyu.edu/~lpederse/papers/ValMomEverywhere.pdf

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

It is often said that a useful measure of happiness is the gap between reality and expectations. A similar approach can be adopted for identifying poor investment decisions. They tend to occur when our expectations of what we are capable of exceed the reality. This miscalibration leads us into activities and behaviours that we really should avoid.

Here are some of the most significant examples of what we think we can do, but probably can’t:

1. Time markets: Perhaps the most grievous example of investors overestimating skill is a belief in market timing. This is not just predicting what will happen, but when it will occur. The second part of this equation is even more difficult than the first. Forecasting with any precision the behaviour of a complex, adaptive and chaotic system is just not feasible.
   
   
2. Truly understand complex funds: Complex funds are alluring because they come with outlandish promises of high returns and low, differentiated risks. They also breach a cardinal rule of investing – don’t invest in things we don’t understand.
   
   
3. Predict inflation (or other macro variable): Our inability to accurately forecast macro economic variables seems to have no impact on our willingness to keep doing it.
   
   
4. Pick funds that consistently outperform: The greatest myth in fund investing is that any manager or strategy can consistently beat the market. Even a skilful fund manager will underperform for prolonged periods. When we fail to realise this we get trapped in a painful cycle of selling losing funds and buying yesterday’s winners.
   
   
5. Withstand poor performance: Spells of weak performance are inevitable for any strategy, fund or asset class. These are easy to deal with in theory, but the lived experience is an entirely different proposition. The stress, anxiety and doubts that occur during difficult periods will lead us to make poor decisions at just the wrong time.
   
   
6. Ignore a compelling story: Every bad investment comes with a beguiling story. We think that it is other people that will be taken in, but, one day, it will be us.
   
   
7. Be a long-term investor: The great rewards available for long-term investing only exist because it is so difficult to do. Doing very little feels like the easiest task in the world, but the temptation to act is so often overwhelming. Every day brings a new story, a new doubt, a new opportunity. A new reason to be a short-term investor.
   
   
8. Avoid dangerous extremes: Most of what we witness in financial markets is just noise, but extremes matter. When performance, sentiment and valuations are at extremes (either positive or negative) the opportunity is for investors to take the other side; unfortunately, the pressure to join the crowd will likely prove irresistible.
   
   
9. Overcome terrible odds: Investors frequently make decisions where the odds of success are incredibly poor. We think that we will be the person to actually make money from a thematic fund or invest in a star fund manager who keeps producing astronomical returns. We just cannot help ignoring the base rates.
   
   
10. Find the ‘one’ investment: Although investors are aware of the benefits of diversification, it is a little boring and an admission of our own limitations. We would prefer to find the ‘one’ investment that will transform our financial fortunes, whether it be a stock, theme, fund or ‘currency’. Such ambition does not tend to end well. 
    

Throughout my career I have heard people say that ego and a level of arrogance are a pre-requisite for a successful investor because there is a requirement to ‘stand out from the crowd’. This is nonsense. These are dangerous traits, not beneficial ones. Far more valuable is being humble about the challenges of financial markets and aware of our circle of competence. We need to avoid being our own worst enemy.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Since starting work in the investment industry in 2004, I have managed to accumulate a selection of pensions by virtue of having several different employers. Maintaining these was becoming increasingly cumbersome and inefficient, so I decided to consolidate them into a single account. As I probably have more than 20 years until retirement my pensions are close to 100% invested in equities; however, the process of moving them into a single scheme will mean that everything is sold. My pension will become 100% cash. I know the rational decision is to immediately reinvest the money back into equities, returning my pension to its former state, but I don’t want to do that – why?

Having studied and written about behaviour for many years, I feel reasonably well-versed in the dangers and pitfalls that lead to poor and costly decisions. The problem is that this doesn’t make me immune to them.

My reticence to immediately reinvest my pension into equities stems from my concern about the current environment; I can foresee a scenario where central banks hike rates into a recession with negative ramifications for equity markets. There could be a much better time for me to put the cash back to work.

There are, however, some very important caveats to this view:

1. I have no skill whatsoever in predicting short-term economic and market developments, in fact I do not believe that anyone does. The value of my views or feelings about the near-term prospects for markets is close to zero.
   
   
2. Everyone is bearish. Many indicators of investor pessimism are at maximum readings. Whenever all investors agree about the future we can guarantee one thing – something else is going to happen.
   
   
3. There are always reasons to be worried. There are very few occasions where it doesn’t feel like an uncomfortable time to invest; indeed, we should be more worried when we feel sanguine.
   
   
4. The only reason I am holding cash is because of an administration decision I have made; it has nothing to do with investment. If I had not attempted to streamline my pensions, I would not even be in this situation.
   

The behavioural predicament I find myself in is one of regret aversion. What if I invest the cash and equities fall another 30%? I will feel awful. I ‘knew’ this was going to happen and I didn’t do anything about it! Regret or the prospect of it is a very powerful influence on decision making.

So, what are the options?

I could hold cash until I identify a more opportune time to invest. This is an unequivocally terrible idea, which will likely have dire consequences and provoke the opposite type of regret.

The alternative is to gradually invest the cash into its desired end state – pound or dollar cost averaging. This will smooth out my entry price and ensure I mitigate the risk of investing at a single, untimely moment. It is also a sub-optimal approach.*

If I have a long-time horizon and a lump sum, investing it immediately into equity markets is the rational choice. Equity markets rise more often than they fall, and, therefore, making phased purchases is likely to reduce returns.

The advantage of pound / dollar cost averaging is that it is a regret minimisation strategy. If markets rise during the period of investment at least I have started to invest the cash and, if they fall, I can be glad that I didn’t go all in. Despite its limitations it is also a significantly better option than trying to guess the right time to invest, which is a fool’s errand.

I know that I cannot predict or time financial markets, and I am aware of what the rational, optimal course of action is. Yet it feels like the wrong thing to do. If I were to take the averaging in option, I would be paying a financial cost simply to limit the feeling of regret. Wilfully opting to pay a behavioural tax.

Humans are just not designed to make sensible investment decisions.   

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* The pound / dollar cost averaging described here is very different to the eminently sensible process of making regular investments into our pensions or savings account from our salary. These are actually small, incremental lump sum investments based on the cash we have available each period.  

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.