I have brought you to this post under false pretences because I don’t have any fund or stock picks for the year ahead; but if you have read this blog before you may have already guessed that. Recommendations for individual stocks and funds are a persistent feature of the investment landscape, but are particularly prevalent at the start of the year. Unfortunately, these are a terrible idea for investors and encourage the most harmful behaviours. They should be added to the ever-increasing list of ‘stuff to ignore’.

The recommendation of specific stocks is the most egregious practice. Any single stock is a highly risky investment and has a huge range of potential outcomes; most investors do not need to be dabbling in such areas. It is also incredibly difficult to do well – even for dedicated, experienced professionals. We know that the success rate of most active equity fund managers is low and that those that are successful rarely get many more than 50% of their decisions right – why would it ever be a good idea to think that focusing on one or two companies would be prudent?

Advocating certain funds is somewhat less heinous than stocks because of the inherent diversification and ongoing stewardship, but still entirely unnecessary. Often recommendations are for flavour of the month areas, or in niche, high risk segments of the market offering the false allure of stratospheric returns.

Even if the individual suggesting the stock or fund ideas has some skill (which is impossible to know) the time horizons involved renders this irrelevant. Over a 12-month period nobody knows which stocks or funds will outperform, the amount of noise and randomness involved is overwhelming. But that doesn’t matter because next year there will be a fresh set of recommendations and the current ones will be a dim and distant memory (apart from those that have done well, which may just get a mention).

This type of endorsement leaves investors incredibly exposed. What happens if we follow a stock or fund pick and two months down the line there is a negative development? What do we do if the stock has an earnings disappointment, or a fund manager departs? There is often no recourse or requirement to update the view – we are on our own from the moment the proposal is made.

There is also no accountability. We have no meaningful way of knowing whether the person making the suggestions has expertise (not that it really matters), nor do they have any skin in the game regarding the consequences of the choices that are made.

Perhaps the most damaging aspect of such stock and fund picks is that they are typically devoid of context. What is the situation and disposition of the individual reading the article? How might this recommendation fit within a wider portfolio? Do they understand the risks involved? Individual fund and stock picks are a bad idea for us all but can be terrible for some.     

These recommendations often do little more than perpetuate a dangerous short-term mindset – offering persuasive and captivating ways of making more money and making it quickly. In truth, investors should not be focusing on any individual stock or fund, nor believe that anybody has a clue about what will perform well over the next year.

Such guidance is good for commissions and clicks, but bad for investors.

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

Financial markets are enjoying an exceptionally strong finish to 2023. At the time of writing, equities in the US were up over 10% and aggregate bonds 5%. Balanced investors have experienced a very healthy annual return in under three months. Although it is pleasing to close the year with portfolios increasing in value; it is perhaps more useful to think about what such periods tell us about the oddities of financial markets and our own behaviour:

– Predicting the short-term fluctuations of markets is incredibly difficult to do well and enormously damaging when done badly. It’s best to avoid it. 

– Although it might make us feel good right now, the high returns of this quarter means that long-term, regular savers will be investing at more expensive valuations and lower yields.

– Financial assets behave a little like a Veblen good – demand for them tends to increase as the ‘price’ increases. Or, to put it another way, as expected returns fall, demand rises.

– The movement in asset prices over the fourth quarter of 2023 has little to do with the valuation of long-term cash flows but a lot to do with momentum.

– Most investors (certainly those making shorter horizon decisions) are simply engaged in a circle game of predicting how other people like them will react to certain market / economic developments. (If the Fed do X, other investors will do Y, so I will do Y, and so it continues).

– Price performance creates market narratives, not the other way around. Most stories are a persuasive post-hoc rationalisation of events. Financial market movements are typically a mystery before the fact and obvious after.  

– When we enjoy periods of strong performance, we should apply a mirror and ask how we would feel if we were experiencing losses of similar magnitude.  

– Periods of extreme are dangerous for investors in both directions – they create unduly ebullient or pessimistic expectations and lure us into irrational extrapolations. Bad decisions get made at extremes.

– What has happened recently carries far more weight in our thinking than it really should.

– The fear of missing out (markets up) or the fear of being involved (markets down) are most acute during periods of abnormally positive or weak performance.

– Short run equity returns are volatile and unpredictable. If they weren’t, their long-run returns would be much lower.

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Investors should try to treat periods of unusual performance with equanimity. Over the long-run they are unlikely to matter that much; unless, of course, they lure us into poor decisions.

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

Paul Richards and I downed some eggnog and decided to record an impromptu ‘Decision Nerds’ Christmas special. In the pod, we chat about how insights from behavioural science might help the holidays proceed more smoothly. This includes:

– Why I am worried that my Christmas gifts might make me look like an ‘egotistical a*&hole’.

– Why Paul sets very low expectations for Christmas.

– The nudges that retailers use to get us to buy.

– Gift cards or cash as a present – to constrain or not to constrain?

– Do New Year’s resolutions get a bad rap and how can we structure them to give a better chance of success?

Our favourite Christmas movie as a metaphor for decision-making and a gift that helps people understand their value to the world. (It’s not Die Hard).

Wherever you are, however you celebrate (or don’t), we hope that you have some high-quality time with family and friends over the festive period.

Available from all your favourite pod places, or below.

Christmas Behaviour

It is that time again when many investment professionals make predictions about how equity markets will perform over the coming 12 months. The only purpose of which seems to be allowing us to look back in a year’s time and comment on how pointless such endeavours are. Although it can be viewed as a harmless diversion, the pervasive culture of forecasting the unforecastable perpetuates damaging investor behaviour.

When setting expectations for equity markets for the year ahead, it is important to understand what it is actually being done. In simple terms, equity returns have three drivers – changes in valuation, dividend payments and earnings growth. Over short horizons it is often valuation changes (or what we might also call fluctuating sentiment) that dominate; whilst as the horizon extends it is cash flows and their growth that matters.

When we forecast the year ahead in equity markets, it is largely an exercise in anticipating changes in sentiment. In essence we are asking – how will the market (other investors) react to future events? Which is quite tricky.

If we are attempting to forecast equity market performance in 2024, we need to do three things:

1) Identify known issues or developments that will influence investor sentiment in 2024 and accurately predict them. (For example, we would need to know both that the action of The Fed will be influential and how they will behave).

2) Identify unknown issues that will influence investor sentiment in 2024 and correctly forecast them. (This is, by definition, impossible).

3) Foresee how markets will react to these known unknowns and unknown unknowns. (We don’t need to just get the events right, but the market’s reaction to them).

Although this may seem glib, it is not. It is exactly what is required to make such a forecast. It is a prediction of the market’s reaction to unpredictable events and events we haven’t even thought about.  

Given the improbability of meeting this challenge, why do so many people do it?

– It’s expected: Unfortunately, the most persuasive reason is that such short-termism is an unshakeable industry standard. I have worked in investment markets for twenty years and when people ask me about what I expect ‘the market’ to do next year I feel embarrassed saying “I have no idea”, even though it should be more embarrassing actually offering a confident forecast.

– It’s their job: For many people it is simply their job to produce such forecasts, whether they believe it has value or not.

– They believe it: Presumably some people believe there is merit in such forecasts, which I can only put down to overconfidence.

– It’s fun: Predicting short-term equity market performance is enjoyable and engaging. People want to keep doing things that are interesting and might keep doing them even if it destroys value over the long-run.

But what if we had to forecast equity market performance in 2024? What would be the ‘right’ way to do it? Probably by looking at some base rates of historic one year returns and perhaps adjusting those to reflect starting valuations. The final step would be to put some extraordinarily wide confidence intervals around the prediction, immediately rendering it pointless.

The truth is most people owning equities should be doing so to capture long-run returns by investing in a collection of companies generating a rising stream of real cash flows through time. Attempts to predict how the market might be pricing those cash flows over any given year is entirely fruitless and counterproductive. *

This is not simply a case of more wildly inaccurate forecasts in financial markets, but another example of the incessant implicit encouragement of damaging investor behaviour. The more we see these types of predictions, the more people think that equity markets are somehow stable rather than noisy, and that investing is about making short-run estimates of impossibly complex things.

We need to spend less time on spurious forecasts and more time on educating investors about what really matters.

How will equity markets perform in 2024? I have no idea.

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* Even if we knew the ‘fair value’ of equity markets, there is no reason to believe that markets are ever attempting to ‘find’ this price. Why Should Equities Be Fairly Valued?

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

Being an investor is like walking into a casino and seeing everyone crowded around a table playing the game with the worst odds of success. We seem inexplicably drawn towards activities – such as timing the short-term fluctuations of markets or taking aggressive, concentrated bets – where the chances of positive outcomes are poor, yet we carry on regardless. Why can’t we resist playing what seem like the wrong games?

– We don’t know the odds of the game: We can either be oblivious to or wilfully ignorant of the probabilities attached to the activity we are undertaking. Although this is undoubtedly common, it shouldn’t be. Understanding the base rates of success should be the first thing we do.

– We have unusual skill in the game: Assuming we are playing for more than just entertainment, the only reason to engage in a game where the odds for the average player are poor is if we are uncommonly skilful.

– We are overconfident in our own abilities: The problem with believing that we are remarkably talented is that we probably aren’t. We are far more likely to have an unjustified, inflated view of our own capabilities and erroneously believe that the odds do not apply to us.

– The game is exciting and fun to play: We play games where there is a high chance of failure if they are enjoyable, entertaining and engaging. The challenge for investors is that it is the boring stuff that works. And nobody wants to play a dull game.

– Lots of people are playing the game: If everyone else is involved in the game then we might as well join in. Not only is social proof important here (there is validation and comfort in doing the same as other people); but there becomes an expectation that we should be doing the same – we are an oddity if we don’t do it.

– We get paid to play the game: If we are paid just for playing then the odds of success matter less.

– The outcomes are asymmetric: Low probability games are attractive to play where we are able to capture a significant portion of the upside payoff, whilst other people bear the downside. (See hedge fund performance fees without clawbacks).

– There are more tables for this game: If a casino has 25 tables of low probability games that are fun to play, noisy and enticing, and a single table with a boring, quiet game with better odds of success – which one will we play? Almost certainly the former.

– We see other people winning at this game: We judge probabilities based not on the actual statistics – but what is available and salient. Huge coverage is granted to those fortunate enough to win big at low probability games and it makes us think that we can do it too. They make films and write books about the outliers and survivors in investing, not the average. 

As investors we spend far too much time focusing on how to win the game we are playing, rather than understanding the reasons we are playing at all.

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

I have no idea what happened in financial markets in the second quarter of 2019. I think it is safe to assume that not many people do. The problem is that when we were living through it, it would have felt like the most important thing. As if the ‘information’ we were engaging with would have a profound impact on our investment outcomes. Yet now we cannot even remember it. Our obsession with dealing with what is right in front of us may well be an effective evolutionary adaption, but it is a terrible affliction for most investors with long-term goals.  

Human attention tends to be drawn towards two things – salience and availability. Salience is where something is particularly noticeable (often due to some emotional resonance), and availability is how easily something comes to mind (typically because it is recent). The lure of the day-to-day gyrations of financial markets is strong.

Unfortunately, it is not only an issue of attention, but importance. We are prone to hugely overweight the relevance of what is happening in the moment, as Daniel Kahneman noted:

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

In the general sense this is not irrational human behaviour. If something is happening or changing in the current instant, then it can make absolute sense to focus on it and deal with it immediately. Taking the time to accurately calculate the probability of whether that movement you spotted on the savannah is actually the head of a lion is probably not a smart strategy. The issue is that rationality is context dependent. What is good for human survival is often terrible for long-term investing.

The problems that stem from this behavioural wiring are twofold. First, we are likely to neglect information that is genuinely important in favour of what we are currently experiencing. Second, we are almost certain to trade too much as we get stuck in the cycle of continually reacting to the next set of salient and available information, or what we might instead call the prevailing market narrative.

That most investors are caught in this behaviourally satisfying but return-eroding loop is reflected in the lack of introspection or reflection around past decisions and opinions. Nobody looks back at all the predictions that were made in our market outlooks for 2019 because it would be embarrassing to acknowledge how wrong we were and how attentively we focused on matters that were either irrelevant or unpredictable. It is better for everyone if we all just keep looking forward.

Escaping this damaging obsession with the present is not simply about overcoming our own behavioural limitations but acting in a manner that is contrary to expectations. It is not just us who feels that we must do something about what is happening right now. Everyone does. Even if we don’t think it is important it makes sense to act as if it is. In this instance taking action is still about survival, but not from the lion, in our job.

There are inevitably periods in time when there are market developments that matter for our long-term prospects. These might be fundamental (such as some significant change in valuations or expected returns) or behavioural (dealing with these challenges of bear markets and bubbles), but will be dramatically outweighed by things that are either unimportant or unforecastable. 

When we are living with markets in each moment it is almost impossible to separate signal from noise because of the undue status we place on the present. Aside from entirely ignoring the vacillations of markets (which for many is impossible), the only conceivable way to deal with this is to define in advance what aspects are important and then attempt to ignore the rest. This is the price of admission for the advantages provided by a long-term investing approach. Nobody said it was easy.

Attempting to be a long-term investor while obsessing over the short-term fluctuations of financial markets is like starting a diet but filling your kitchen with chocolates and cakes; you might still achieve your goals but you are really making it hard for yourself. 

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

Harry Markowitz is reported to have said that “diversification is the only free lunch in investing”. This is the notion that holding a broader range of assets can result in better returns without assuming more risk. Over the decades this has become accepted wisdom – but it is not true. Diversification isn’t free; it is painful and difficult to achieve.

Diversification is a vital concept for investors. It is an acceptance that the future is inherently unknowable and can take many different directions. If done well it provides protection against both uncertainty and hubris. The best indicator of an investor’s overconfidence is how concentrated their portfolio is. If we could accurately predict the future, then we would only own one security.

Given this, why is diversification a problem?

Because it is behaviourally difficult. To be appropriately diversified not only means holding assets that will be a disappointment, but where we actively want them to disappoint in advance.

If everything is performing well and in concert, our portfolios are probably not diversified.

If we are appropriately diversified, we will look at our portfolio and see a collection of strong performers and laggards. Rather than be comfortable with this as an inevitable feature of diversification however, we will have the urge to make changes. Removing the struggling positions and adding more to those that have produced stellar results.

It is far more comfortable for our portfolios to be focused on the top performing assets rather than be genuinely diversified. It will feel like there is nothing to worry about – everything is working well. Although we are drawn towards this type of situation, it is merely a short-term complacency that will foster almost certain long-term pain.

Diversification is constantly put in jeopardy by our behavioural failings. For the assets that are outperforming in our portfolios, the prevailing market narratives will persuade us that this environment will persist forever. Conversely, the stories around the stragglers will make us believe that they will never deliver again.

When we are reviewing the performance of our portfolio, diversification often feels like a bad idea – because we could have always held more of the assets that provided the highest returns.

Hindsight makes diversification look unnecessary.  

Given that maintaining appropriate levels of diversification is likely to prove a constant challenge for investors, there are two crucial concepts to place at the forefront of our thinking:

– Things will be different in the future: Markets are constantly adapting, things will be different in the future in ways that we are unable to predict.

– Things could have been different in the past: When we look at the performance of our portfolios, we assume that it was inescapable that this particular course had been charted, but, of course, this is never the case. In a chaotic, complex system, entirely different outcomes could have come to pass.

Diversification requires us to own positions that haven’t performed well and we don’t expect to always perform well. That doesn’t mean we should naively hold any asset irrespective of its fundamental characteristics, but we must accept that to be well-diversified requires us to have relative slackers in our portfolios at all points in time.

Nothing that works in investing provides a free lunch, it always comes with some behavioural pain. For diversification it is the acute sense of regret about how much better things could have been.  

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

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

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

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

There are two major reasons for this behaviour:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And much more in-between.

You can listen here: Seeing the Future

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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