A Little Bit of Friction Can Make Us Better Long-Term Investors

One of the most effective methods for changing our behaviour is to alter the level of friction we face when making a decision. If we want to encourage an action, make it simple. If we want to restrict it, put up obstacles. We use this method intuitively in our everyday life – when we are trying to eat healthily we know it’s best not to have chocolate readily accessible in the fridge – but we tend to understate how the introduction of small amounts of friction can have profound consequences for the choices we make.

Take the case of paracetamol.  It is estimated that after the UK introduced limits on the number of tablets contained in a single packet, overdose deaths fell by 43%[i]*.  It seems absurd to believe that the implementation of a seemingly slight change could materially influence a decision of unparalleled consequence, but it can.  When behaviours are driven by emotion and moments, even minor amounts of friction can exhibit incredible leverage. This is a concept that matters a great deal for investors.

Technological developments have profoundly changed the decision-making experience of both professional and private investors in recent decades.  We are awash with information (noise) and stimulus; and have the freedom to transact at any given moment. Technology has made investing seamless.  It has removed the friction.

The greater transparency and control investors enjoy is regularly lauded, and it has brought us a wave of benefits; but it also comes with a major shortcoming.  The absence of friction allows us to easily take decisions based on how we feel at a given point in time.  It makes the most pernicious investing behaviours – performance chasing / market timing / panic selling – easy, and the most important – adopting a long-term approach – more difficult.

Friction in investment has a bad image.  We tend to think of it slowing our decision making.  Rendering us unable to access opportunities as they arise and suppressing our best instincts.  This view is illogical.  For most investors, the ability to exploit near-term opportunities or react rapidly to changing market dynamics is a danger not an advantage.  Whilst a very select group will attempt such activity for most of us it is a damaging distraction or at best an irrelevance.  We tend to perceive friction as a hindrance, but it can quell some of our worst dispositions and promote long-term investing.

It is important to differentiate friction in decision making from outright prohibition.  Friction does not prevent us from taking a particular path entirely, it simply slows the process.  It introduces time and reflection.  Although there may be some investing activities where a complete block might be prudent; in most cases the simple introduction of some level of difficulty or delay is likely to have significant ramifications for our decision making.

For private investors, the notion of friction is often allied to being trapped in poorly performing, expensive funds where extricating yourself from them is seen as too painful, costly or complicated to be worthwhile.  This is an undoubted negative friction. Freedom and ease of movement here is essential.  Yet a consequence of removing such friction is the ability it gives us to lurch between in-vogue investments and make judgements based on ever-dwindling time horizons.   

To counter this, we can introduce our own inhibitors.  Part of our long-term investment plan should be specifying limits on how frequently we check our investments (the most effective way to reduce volatility is to review your portfolio less) or put restrictions on the amounts of trades we place.  Setting the password for your account to something you are unlikely to remember might have an even greater impact.

It would also be helpful if the investment platforms that we use allowed us to apply our own restrictions when setting-up an account – creating frictions in a cold state that will prevent us making poor decisions in a hot one.  For example, there could be a feature where your ability to place trades online is switched off, unless you make a request (which might take 7 days to be approved).  Not removing the choice, but introducing a pause.

Even for professional investors, the use of friction can be beneficial.  It is typical to pour scorn on ‘committee-led’ decision making and any element of an investment process that seems to undermine the unadulterated views of a fund manager.  But they are not immune to short-term thinking or the pressure to react to the prevailing market narrative.  Frictions in the process can allow them to be more faithful to their investment objectives, rather than act as an impediment. 

Long-term investing has never been more difficult. The freedom, transparency and choice now available to investors which has brought many benefits, also increases the opportunity to make poor decisions.  Doing less and enjoying the power of compounding sounds simple but it is far from easy.  The more we engage with markets, the greater the temptation is to make choices that feel good now, that we later come to regret.

Taking a long-term approach takes effort and requires assistance.  A little bit of friction can go a long way.


* Not all of these will be suicides, and there are several confounding variables that mean that there is significant uncertainty around the 43% figure.  There is general agreement, however, that there has been a meaningful impact.

[i] https://www.nhs.uk/news/medication/smaller-paracetamol-packs-may-have-reduced-deaths/

How Much Conviction Do You Hold in Your Investment Views?

I recently read War and Chance by Jeffrey A. Friedman, which considers how foreign policy specialists deal with the uncertainty that surrounds their high stakes decisions.  Friedman focuses on an historic reticence to explicitly discuss either probabilities or confidence levels when making subjective judgements.  Whilst the impact of decisions made around the whereabouts of Osama bin Laden or the presence of WMD in Iraq have consequences that are far more profound, it struck me that the challenges and concerns highlighted by Friedman are also relevant to how we make investment decisions. In particular, the struggle we have in articulating how much conviction we hold in a position or opinion. 

The conviction that we express in any investment view reflects our expectations around the likelihood of certain outcomes.  We are constantly making judgements that are founded on our subjective belief about probabilities and our confidence in the available evidence. Despite this we seem unwilling to talk in these terms.  Instead, there is a tendency to frame investment positions in a definitive fashion – I believe X will happen because of Y.  The absence of nuance entirely belies both our own fallibility and the sheer uncertainty of the environment in which we operate. Ignoring these factors not only impacts the type and size of risks we take, but materially inhibits our ability to change our mind and learn from past decisions.

Why don’t we talk about probabilities?

In a similar fashion to foreign policy, the reluctance to address uncertainty and be specific around our probability judgements is driven by several factors.  Many people recoil at the spurious accuracy that appears to exist when numeric probabilities are expressed – how can you be 67% sure of something?  But this misses the point.  We are making this judgement whether we are transparent about it or not.  It is better to offer some level of clarity rather than not mention it at all or cloak it in vague language that will be interpreted differently by everyone who sees it.

The even greater impediment to being clear about probabilities when expressing an investment view is the value that the investment industry places on confidence. The conclusion we reach will either be right or wrong, and therefore there is a desire for our rationale to be consistent with that. It is all or nothing.  This is a meaningful decision and therefore we want it to appear as if it is an objective one (even though we know that this is an impossibility). 

When we discuss uncertainty and probability, we are admitting how much we do not and cannot know.  This jars with the fact that we are being paid for our investment acumen, and it is rarely a prudent marketing strategy to highlight your limitations. Particularly as everyone else seems more certain than we do.   

The value placed on (illusory) certainty and (over) confidence is vividly apparent in the categorical fashion in which we discuss our investment views. For example,  if I take the position that the dominant, large tech / consumer stocks in the US are overvalued and will underperform over the next five years, most of my time will be spent justifying why this perspective is correct and other theories are false.  If presented with a counter argument – such as certain names in this space becoming virtual monopolies that will not see their excess returns competed away as quickly as in ‘traditional’ industries – my instinct is to debunk this point to validate my own position. Yet if I accept uncertainty and a range of potential outcomes, I should not be discrediting all other scenarios, but rather acknowledging that there are other plausible paths. Albeit ones I ascribe a lower probability to than my central view. 

Disentangling confidence and probability

A crucial distinction that Friedman makes is between probability and confidence, which are often conflated.  Probability is based on the likelihood that something is true, whilst confidence is based on our belief in the robustness of the evidence supporting that view.  I believe that the chances of a single fair coin flip coming up tails is 50%; I also consider the chances of value stocks outperforming growth over the next 12 months to be 50%.  The probability I have ascribed to both outcomes is identical, but my confidence in my coin flip view is far greater than in the value versus growth call.  In the first case my 50% forecast is based on what I do know, the second case is based on what I do not know.  Expressing conviction is about both probabilities and confidence.  

Friedman states that the confidence we hold in our own analysis has three distinct components: i) The reliability of the evidence, ii) the breadth of reasonable views around a judgement, and iii) the extent to which fresh information could alter our perspective. 

Overtly utilising such a framework is crucial for a robust decision-making process and for understanding the level of conviction we should hold.  A cynic might suggest that financial markets are too noisy to distil confidence in this fashion, but if that is the case then it simply means we do not have sufficient confidence to take a view – which is perfectly reasonable. Also, when making an investment decision these three aspects are always implicit in the conviction we possess; it is far better to be open about these assumptions, particularly if we want to encourage consistency in our decision making and have the ability to learn from mistakes.

The benefits of probabilistic thinking 

Being clear about the probabilities we ascribe to potential outcomes and our own confidence in our views can be incredibly important to our investment decision making; especially when informing our level of conviction.  There are at least five clear benefits: 

1) Clarity of view:  Investment views tend to be either absolute or obscured (sometimes deliberately) by vague and ambiguous language. This means that they are either negligent of uncertainty or useless.  Addressing this by being more specific – by using numeric probabilities, for example – provides far more transparency around what we believe.     

2) Realism:  All investment decisions are made amidst uncertainty, although most of us behave as if that is not the case.  As soon as we employ probabilities in a consistent manner, we open ourselves to alternate scenarios.  It is crucial to concede the uncertainty both of an event and our own ability to foresee it. 

3) Ability to change our mind:  Moving away from categorical views makes it far easier to change our mind and update our thinking.  If we predict something will happen, we invariably become committed to that position, and often defined by it. Utilising a more nuanced approach that acknowledges other possible outcomes affords us the freedom to adapt and update as we receive new information. 

4) Ability to learn: All investors will be wrong and wrong frequently.  We cannot hope to improve our decision making unless we are consistent in how we record and convey our views.  If we are clear about probabilities and our level confidence at the point a decision is made; it becomes possible to review this in the future and understand the flaws in our judgements when we err. It allows us to become better calibrated. 

5) Consistency and comparability:  Given that investors will be expressing numerous views at any given point in time (and through time) the ability to treat them consistently and compare them equitably is paramount to effective decision making.  If our conviction differs between views, what is causing that? Why are we happy to take more risk in position A than position B? We can only answer such questions if we have a clear framework to understand probabilities and confidence levels.  

Don’t forget the magnitude 

Whilst our conviction should be driven by probabilities and confidence, that is not all that is required. We must always consider the magnitude of potential outcomes. The most significant example being situations where there is something unpleasant lurking in the tail of the distribution.  A bet with a 99% chance of a favourable outcome, may be unappealing if there is a 1% risk of ruin.  In such a scenario we might have an incredibly high conviction in our view, but still decline the ‘bet’ or at least size it in a manner that seems optically inconsistent with the strength of our beliefs.  Being more open to considering probabilities offers some protection against being ignorant of such tail risks because we are explicitly incorporating other possible scenarios in our thinking. 

Embracing uncertainty

Uncertainty is uncomfortable and unappealing, but it is also the reality of financial markets. The unequivocal investment opinions that we so often hear, and offer, feel bold and informed but are incongruous with the environment in which we make decisions.

Whether we acknowledge it or not, the conviction or strength of belief we hold in our investment views must be based on assumptions around probabilities and confidence.  Yet we rarely discuss our investments in this manner.   This is a problem not simply because it is hard to understand how much weight to give to other peoples’ opinions, but it also impairs our own decision making.  If we are to formulate, compare, scale and adjust our investment views appropriately we need to be clear not only about what we believe and why, but how much we believe it.

Friedman, J. A. (2019). War and chance: Assessing uncertainty in international politics. Oxford University Press.


Active Management has Become a Game of Musical Chairs

An often heard lament in recent years has been how the torrent of flows into passive strategies is distorting financial markets.  Although this is an inevitable angle for much maligned active managers to take, it is also somewhat absurd.  What is a broad, market cap index if not a reflection of the decisions of other ‘active’ investors?  Passive investors will replicate the prevailing weights of the target index; active investors will move those weights*.  The opprobrium directed at the rise of passive investing is mostly misguided.  Indeed, it is a sharp irony that the major impact of increased indexing has been for active investors to become more benchmark aware and myopic.  Their attempts to insulate themselves from the threat actually weakens the case for using them.

In an ideal world a market capitalisation index should be a reflection of the behaviour of other investors – a simple derivative outcome.  Unfortunately,  the market cap index or benchmark is now far more than that .  It has become the lodestar for the majority of active managers.  Not only is it a yardstick to evaluate quality over increasingly short and meaningless time horizons, but it has become the foundation of many investment processes. This is not because there is a widespread, philosophical belief that this is the correct approach to adopt; but because of skewed incentives and the management of business and career risk.

Active managers are under severe competitive pressure.  If they don’t perform they will be removed and the money will go to a passive option, or at least an outperforming peer.  Therefore their desire to take significant risk away from the benchmark is low.  Active management has become like a game of musical chairs where it makes sense to hover close to the chairs at all times, rather than risk being at the other side of the room when one is pulled away. 

Allied to this defensive behaviour is the closely related problem of increased short-term thinking.  The threat that most active managers face of being fired tomorrow has profound implications for decision making, both for individual managers and their employers.  Is there any purpose in making a long-term investment decision if there is little chance you will be around to witness it come to fruition?  Indeed, making such farsighted decisions may well hasten your departure.  Investing is a long-term endeavour,  active management has become a short-term game.

Success in this game is based on the measurement of performance over increasingly contracted time horizons.  Investors in active funds and managers of them consistently talk about results in terms of days, weeks and months.  This is nonsense.  Financial markets are hugely unpredictable and chaotic, and discerning skill is incredibly difficult.  Over short-time horizons it is impossible. 

Although suggesting so is often met with derision, judging investment quality by performance alone is deeply flawed.  In a system where there can be profound randomness in outcomes, it is crucial to focus on decision quality rather than results.  Performance outcomes (particularly over short horizons) are incredibly noisy.  There will inevitably be periods where the skilful (or just sensible) will appear inept and the lucky will appear to be sagacious.

Judging decision quality in financial markets is fraught with difficulty, and it is far easier to use the shorthand of relative performance instead.  Replace a difficult question with an easy one.  More importantly, however, if everyone else cares about short-term performance outcomes, then you have to as well.  There is no point playing in a game where your idea of winning is different to the other players.

Our investment behaviours pose major agency problems for active management.  Listed asset manager share price performance is driven by asset flows, which are led by short-term performance .  Executives at these firms are incentivised to raise assets under management  and therefore become focused on near-term results.  Although underlying investors are unlikely to be well-served by such myopia, the structure of the system means that executives and fund managers have to play a different game where the pay-offs arrive at a different point in time.  What is rational for the manager or business, may not always be rational for the client. 

We therefore exist in an environment where underperforming active fund managers are sacked, lose assets, forced to collapse their unrewarded risks and review their processes.  Even if you are a talented long-term investor you might not make it through your inevitable barren spell in-tact.  The result of all of these aspects is more money flowing into areas that have been ‘working’, exacerbating any perceived market distortions . Passive strategies reflect this, active strategies cause it.

Frustrated active managers will often complain that fundamentals don’t matter any longer.  They do, they are just not important in the game being played.  The desperation of active managers to ward off the threat posed by passive investments is leading to less differentiation and more short-term performance chasing, which only makes the case for passives more compelling.  Time for a rethink.


*In this context we can think about passives as exposure to broad, market capitalisation indices. Of course, securities not captured in these can be more impacted by increasing flows into passive strategies.

Financial Markets Are No More Uncertain Today Than They Were Last Year

One of the most common statements since the outbreak of the coronavirus pandemic is that the economic and market outlook has become more uncertain.  Given that the future is inherently difficult to predict with any level of confidence and we are generally terrible forecasters can it really be true that the world is now more uncertain?

The environment unquestionably feels more unstable.  There are a range of imponderables around the development of the virus itself that none of us can hope to anticipate.  From the potential of a ‘second wave’ to the production of a viable vaccine.  We have also experienced an unprecedented economic ‘stop’, and credible cases can be made for an inflationary or deflationary future. 

Yet before accepting the ‘greater uncertainty’ idea at face value, it is worth deconstructing the meaning of such a claim.  What we are really saying is:

“I was much more confident in predicting the future of the economy and financial markets before that unexpected event occurred”.

Which can be expanded to:

“I was much more confident in predicting the future of the economy and financial markets before that unexpected event occurred, and showed that my level of certainty was exaggerated.”

It seems paradoxical to suggest that things were more certain before something we hadn’t expected happened and upended our prior beliefs. 

When we say things are now more uncertain we are usually implying that something has altered which has meant that the future has become increasingly difficult to predict.  It has not.  It was unpredictable before and it remains unpredictable now.  Rather than making the world more uncertain, unanticipated events serve to show us that we were understating how uncertain things were before. When claiming greater uncertainty in the future, we actually get it backwards.

Although we should not conflate greater uncertainty with changes in the forecastability of the world, this does not mean that the notion is meaningless; it just needs to be considered in a different way.  What we perceive to be an increase in uncertainty is really a change in the frame through which we view the world.  We have taken a particular path and now face a different distribution of possible outcomes. 

Let’s take a simple example.  My range of potential future personal outcomes involves me losing my job tomorrow.  This is (hopefully) a tail risk, yet it is a possibility.  If I am made redundant tomorrow then my life has taken that specific course.  My future is still unknowable, but the routes and their likelihood from this starting point have changed.  Although it feels like my life is more uncertain now I am without a job or salary, it is nonsensical to suggest that my life was more certain before it was struck by a remote risk that I failed to predict. 

If my life following a job loss hasn’t become more uncertain, then what has it become?  More fragile. When we discuss greater uncertainty following a particular event,  we often focus on how the shock has left us more vulnerable to future negative events.  Since losing my job I am now more susceptible to failing to pay my mortgage and losing my house.  There are a range of unpleasant scenarios that are now more likely.  This is the same for many businesses through the current recession.  The probability of ruin has changed.  Our certainty in predicting the future hasn’t.

The perception of greater uncertainty is not just about fragility, but how we make sense of the world.  When we perceive  a sharp rise in uncertainty it is a case of the narratives we use to explain the world becoming untethered.  The cause and effect stories we weave help give us some comfort navigating the randomness and chaotic nature of life.  If there is an occurrence that dramatically alters the environment then the threads that hold together our own explanatory narratives quickly break apart.  

The world has not become any harder to predict, but rather the stories we previously used to explain it are no longer valid.  If we cannot construct a coherent narrative things begin to feel distinctly uncomfortable.  To address this we will create new stories, or simply adjust our previous ones.  Restoring our prior (misplaced) sense of confidence and control

The very occurrence of the coronavirus pandemic means that any certainty we may have held before was unfounded.  We never know what will happen tomorrow.  We should act accordingly.

Do Fund Investors Prefer Lower Fees or Strong Past Performance?

Performance chasing is endemic in mutual fund selection.   Despite the randomness and luck involved,  the decisions that we make and narratives we weave are inextricably influenced by historic returns.  Although we may only spend a fraction of our time considering performance, it has an overwhelming impact on the judgements we make.

Supporting the results of previous studies in this area, a new piece of research by Leonardo Weiss-Cohen, Philip W.S. Newall and Peter Ayton shows individuals using  strong past performance to inform their fund choices rather than lower fees.

The researchers devised a task where investors had to select between one high fee (0.7%) and one low fee fund (0.1%) over 60 periods (months).  Both funds generated returns which were index plus random noise.  The mean of the random noise was set at zero, so the only long-term performance differential was the fee load.  For the first selection participants were shown a 12 month historic return for each fund and asked to make an initial choice.  At the end of each subsequent period they were shown the performance of both funds and again selected between the two options.  The compensation participants received for taking part in the study was in part based on the wealth they managed to accumulate through the game.

There were two separate experiments.  The first featured subjects (400) who had previous investment experience, and two conditions – one where they received a standard disclaimer: “Past performance does not guarantee future results” and one without this disclaimer.  The second experiment recruited subjects (596) without investing experience.  Here there was a third condition – a ‘social disclaimer’ stating:  “Some people invest based on past performance, but funds with low fees have the highest future results.”.  All participants also took a test to grade their level of financial literacy.

The were a number of informative results:

– Performance chasing behaviour was evident across all trials, in both initial and subsequent fund selections. The fund with the highest returns in the last trial was selected with greater regularity.  Recent performance was more influential than fees.

– The standard performance disclaimer had limited impact on reducing performance chasing behaviour and led to worse outcomes for those with low financial literacy and no experience.

– In the second experiment participants chose the low fee option more often when they had been shown the ‘social disclaimer’.

– Participants with lower financial literacy and no investment experience actually chose the expensive fund more frequently when they received the standard disclosure: “Past performance does not guarantee future returns”.

– Participants were more likely to choose the low fee option as the trials progressed, but the overall effect of this was modest.

Of course such ‘lab’ studies are imperfect and never a substitute for natural experiments. Furthermore, the paper does not provide full details on the exact scenarios faced by the participants or a granular breakdown of the results achieved .  These issues notwithstanding there are a range of insights that are worthy of greater research and consideration:

-It is fascinating that participants tended to favour highly uncertain (indeed random) future performance at the expense of the certain performance advantage of a cheaper fund.  Their decisions were made absent any information about the forthcoming returns of the funds meaning choices were guided only by fees or previous results.  This could be an example of our struggle to accept randomness and tendency to see information in noise (the outperforming fund must have some advantage).  Or, as the authors suggests, higher fees can be associated with quality.

– In the real world, performance chasing behaviour is typically intertwined by some form of narrative.  A story that validates why past performance will indeed be a prelude to future excess returns – it could be the exceptional skill of a certain fund manager or the wonderful prospects of a particular economy.  In this experiment there was no story to tell just the numbers, and individuals still tended to be led by them.

– As suggested by the authors, one of the potential issues with recurring fees is that because they can be small relative to the volatility in performance, investors may neglect to attend to them, or fail to understand the huge influence they can have when compounded over the long-term.

– Those with low financial literacy performed worse in the task, which goes to reaffirm that it is individuals in such groups who require the most protection and direction.

– Perhaps the most fascinating aspect of the study is the role of the disclaimers. The “Past performance does not guarantee future results” wording has always seemed a woefully ineffective message because if offers no meaningful guidance.  The social disclaimer provides a clear nudge by directly stating that lower fee funds achieve better outcomes than higher fee funds. Whilst this wording is not without its own problems – fees alone are not sufficient to make an investment decision –  it does suggest that such disclaimers could be re-worded in a manner which genuinely helps investors, particularly those with less experience and knowledge.

Although it is no surprise to observe performance chasing behaviour;  it is particularly interesting to see it play out in a sterile, artificial environment absent the narratives, newsflow and incentives that contribute greatly to performance chasing in the real world.  The structure of the research also allows for a clear distinction to be made between past performance and fee levels as a decision driver, which are otherwise impossible to isolate.  The study provides further support to the idea that past performance and neglect of costs are real problems for investors, and behavioural interventions – such as changing disclaimer wordings – might be part of a solution.


Why is Extrapolation so Dangerous for Investors?

At the start of the last decade everyone was bullish on emerging market equities.  It is hard to recall now, but it was the consensus trade.  You couldn’t attend a meeting or conference without being told how many people there were in China or how underwhelming the growth prospects were for developed economies compared to their emerging counterparts.  The irresistible optimism was to prove unfounded as the asset class delivered a prolonged spell of underwhelming performance.  This disappointment is merely one prominent example of perhaps the most common (and often damaging) investor behaviour; we take past performance, combine it with a persuasive story and extrapolate into the future.

Dealing with uncertainty

 Our desire to extrapolate is an understandable reaction to the uncertainty of financial markets.  If we cannot predict the future then our best approach may be to assume a continuation of previous trends.  It is not, however, simply a case of presuming performance patterns will persist; the power of extrapolation comes from the narrative that we use to explain what has happened in the past.  The stories we tell are what make us believe that things will continue.

When themes or narratives are discussed regarding investment decisions; it is often done in such a way that suggests that the story is driving the price.  This is misleading.  On many occasions the reverse is true – our inability to explain complex, chaotic markets means that we wrap a compelling narrative around the performance after it has occurred.  Extrapolation in investment is driven by a circular relationship between these two elements.  Performance creates story creates performance.

These post-hoc rationalisations are hugely problematic however.  Whilst the futility of market forecasts and predictions about future market movements is often discussed, this doesn’t go far enough.  On most occasions it is difficult to provide robust and complete explanations for market movements even after the event.  If markets are largely chaotic and random then simply observing outcomes does not mean you can then draw a straight line of cause and effect.

We cannot confidently explain the past in financial markets, let alone predict the future.  Given this, how do we construct narratives that support our desire to extrapolate?  We simplify.  Let’s take the argument that reinforced the extrapolation of emerging market outperformance in 2010; fundamentally, it can be distilled to this: economic growth in emerging markets will be higher than in developed markets in the future.

Although a naive and fragile argument; from an extrapolation perspective it is incredibly powerful because it is easy and ‘feels’ right – of course you want to invest in higher growth markets.  Also, crucially, there was evidence to support it.  By evidence, I mean that in the prior decade emerging market equities hugely outperformed and emerging market economic growth was higher than developed markets.  Whether the relationship between these two variables is strong or not (it’s not) is immaterial – what matters is whether the story is a convincing explanation of performance.  Once the link is forged between narrative and price, it becomes hard to break.  Any attempts to refute it are met with puzzlement – “of course it is right, haven’t you seen the performance?”

Creating a simple, powerful story to describe historic performance is ineffective and illusory, but it is also relatively harmless if all we are doing is explaining the past.  Unfortunately, that is not all we are doing.  The narratives we create don’t just help us decipher yesterday; they set our expectations for tomorrow.  We believe that if our story still holds, then performance will persist.

Extrapolation in three easy steps

 Extrapolation is an exercise in simplifying things that are uncertain or unknowable in order to make some form of prediction.  The process for extrapolation in investment contains three crucial steps:

1)      Take a significant performance pattern: Performance needs to be meaningful and sustained – a convincing narrative is hard to forge if returns are noisy or absent a convincing trend.

2)      Construct simple explanatory narrative:  Markets are too complex to understand or define the precise drivers of previous performance.  With a great deal of effort we can make educated guesses, but it is far easier to simplify the task by creating a straightforward explanation that is understandable, convincing and difficult to refute.

3)      Consider whether the narrative holds into the future:  Our desire to weave simple, intuitive and optically powerful explanations often means that we assume the performance trend will continue provided the narrative explanation holds.  If emerging markets grow faster than developed markets their equity markets will continue to outperform, if rates stay low quality will outperform value etc…

We create a compelling narrative to justify why past performance has been particularly strong or weak.  We then use that same narrative to predict its continuation.

The problem with extrapolation

Investors can and do make money from the propensity of other investors to extrapolate, but whilst it creates opportunities; it also causes a host of problems:

–         Extrapolation is an exercise in simple forecasting:    Our explanation for what happened in the past quickly becomes our prediction for the future.  This is dangerous because we cannot accurately explain the past let alone predict the future.  Even in the event that we are correct in our diagnosis of the drivers of previous returns; it is unlikely that they will persist unchecked.

–          We often imply structural changes when extrapolating:  Although much market behaviour is inherently cyclical, when we extrapolate it often tends toward being a structural pronouncement.  Things are either in a new paradigm or dead, rather than be in some form of natural cyclical decline or boom.  This is because when we extrapolate we do so in perpetual terms – this will continue indefinitely.

–          Stories are often wrong and missing key variables:  The narratives we utilise are almost always too simplistic to be meaningful or even close to comprehensive.  Sometimes they are entirely wrong.  Yet when it comes to stories it is not the validity that matters but the coherence.  There will be some occasions in financial markets when Occam’s razor does apply – and a simple explanation does fit – but it has to be supported by robust evidence, not just be a convincing yarn.

–          Extrapolation can leave us concentrated and overconfident: The longer a performance trend persists and the more investors participate, the more the underpinning narrative is bolstered.  Our growing assurance can leave us unable to see any other environment prevailing; indeed, doing anything but following the dominant trend probably comes at a cost.  It is at these times when we are most vulnerable to abandoning sensible investment disciplines such as diversification.  After all, the more certain you are about the future, the less you need to diversify.

Extrapolation is simple.  If something has worked well in the past you don’t have to expend any energy explaining why it will work in the future – the evidence is in front of you.  It is easy to convince yourself and it is easy to sell to other people (try marketing an investment strategy that hasn’t worked for the last five years).  As investors we use it persistently; whether it is thinking about asset class returns, building a portfolio or selecting active managers.

Extrapolation can be effective.  Performance trends in markets can and do persist for prolonged periods.  Yet exploiting these trends is more about understanding the behaviour of other investors (the Keynesian beauty contest), than it is ‘knowing’ the fundamental drivers of market performance (past or future) or telling an accurate story.

The central problem with our tendency to extrapolate is that when we do so we are implicitly making unjustifiable assumptions about financial markets: that they are predictable, that there are simple explanations and that things won’t change.  Holding such beliefs rarely ends well.   Yet despite the pitfalls when performance and narrative align it is hard to imagine that the prevailing trend will ever cease.

Investment Risk is about the Extreme and the Unseen

When an event such as the coronavirus pandemic hits markets, investor attention is inevitably drawn to the damage that can be wrought by high impact, unpredictable episodes. This is understandable as such occurrences can have disastrous financial consequences.  I touched upon managing the risk of ruin in my post on ergodicity[i], and Morgan Housel recently addressed the tail-end consequences of risk in typically eloquent fashion[ii].  Yet whilst it is important for investors to prepare ourselves as best we can for such scenarios; we should not focus solely on the extreme, arresting, outlier happenings.  There are investment risks that we face that are small, slow and creeping – often going unnoticed –  but compound to result in unnecessarily poor outcomes.

The tail risks investors face are problematic both because of the scale of their impact and their unpredictability.  We know that they are inevitable but we are never entirely certain what form they will take.  Most of us prepare for the next ‘extreme’ market event by taking steps that would have protected us from the previous one.   Whilst incredibly painful when they occur, a combination of appropriate time horizons, sensible investment disciplines and measured behaviour means that investors can withstand most extreme events.

At the opposite end of the spectrum from these conspicuous, striking risks are those risks that cause harm through time because we are prone to ignore their deleterious impact.  This can be because they are small and incremental; taking time to grow into something material – if we ever realise, it is too late.  Or they can be risks where we are making a temporal trade-off.  We carry out actions that make us feel better now, but increase the risks faced by our future self.

Risks that we don’t notice:  The most obvious example of an often unseen risk is high investment fees. In any given day, month or year high fees are likely to seem inconsequential, if they are noticed at all.  Yet the compound impact over a lifetime of investing can be staggering.  This is far from a dramatic, extreme event but more like a slow water torture.  The risk here is that we fail to meet our investment objectives, or are materially worse off than we could have otherwise have been.  It is not dramatic, or eye-catching, and many will not perceive it as a risk during or even after its realisation.  This does not mean that it cannot be profound.

Risks that make us feel good in the present, but at a great future cost:  There is a vast array of investment activities that can fall within this category.  Perhaps the most material is a failure to begin our long-term savings early enough.  Here we are liable to make our lives better now (by having more disposable income), but worse in the future because we diminish the influence of compounding.  This risk of undersaving in our younger years is one which we may either not realise at all or fail to appreciate its magnitude.  It is particularly pernicious because assuming the risk (either knowingly or unknowingly) makes our life more enjoyable in the present.

Another prominent ‘feel good today / repent later’ risk is overtrading.  Whenever we trade in our portfolios it is likely to make us feel better; very few investors are comfortable transacting in a way that causes immediate discomfort (value investors being a notable exception).  Whether we are chasing the latest momentum trade, switching to a flavour of the month active manager or raising cash in a period of market turmoil; we are probably doing things we feel good about in that specific moment.  Yet if we work on the safe assumption that most of us are terrible traders; the aggregate impact of all those trades is likely to leave us materially worse off.  Of course, we don’t perceive this to be a risk to our long-term outcomes because with each trade we think we are improving our situation (otherwise we wouldn’t be doing it).  The risk here is not about a single large trade blowing up our portfolios (which falls into the extreme category), but the compound impact of the performance chasing, the market timing and the costs incurred.  How many of us will look back and say: “I would have been better off if I had just left it alone”?

Exposure to catastrophic incidents is certainly a crucial consideration for all investors – whether they be the general (e.g. financial crises) or the specific (e.g. frauds) – but is not only the extremes that should concern investors.  Risks that seem small and inconsequential at any given point in time, can compound to have ramifications that are just as significant.

[i] https://behaviouralinvestment.com/2020/05/13/we-need-to-talk-about-ergodicity/

[ii] https://www.collaborativefund.com/blog/the-three-sides-of-risk/

We Need To Talk About Ergodicity

You have a gun which holds six bullets, but only has one in the chamber.  You use it to play a game of Russian roulette with a group of 19 other people.  Each of you takes one turn in spinning the chamber, holding the gun to your temple and pulling the trigger.  If you are successful you win £1m, if not, well, then you die. Whilst this may not be an appealing proposition, your chance of death is relatively low (17%), and potential for becoming a millionaire high (83%).  It is also far more attractive than an alternative version of the game where instead of playing with a group, you play on your own.  In this instance there are still 20 turns but each time the gun is directed at your head.  The odds on the outcome for you in this instance are not so favourable.

These contrasting approaches to Russian roulette are a typical example of ergodicity[i] [ii]. A system is deemed ergodic if the expected value of an activity performed by a group is the same as for an individual carrying out the same action over time.  Rolling a dice is an example of an ergodic system.  If 500 people roll a fair six-sided dice once, the expected value is the same as if I alone roll a fair six-sided dice 500 times.

The Russian roulette example is a non-ergodic system.  The expected value of the group differs sharply to the average of an individual carrying out the action through time.  In the group situation the average outcome is to live and become wealthy.  As an individual performing the activity through time – on average – I am dead.  In a non-ergodic system the group expected value is deeply misleading as it pertains to individual experience.

Although these may seem like somewhat frivolous examples, the concept of ergodicity is incredibly important.  Much of classical economics assumes about human behaviour is founded on the expected average outcome of the group (see Expected Utility Theory).  This works under the assumption that most environments or situations are ergodic, when in fact this is not the case.  The best starting point for understanding ergodicity economics is this article in Nature, by Ole Peters[iii].

Given the implications for classical economics, the idea of ergodicity is also incredibly important for behavioural economics.  Many of the ‘biases’ identified in this field are expressed as violations of the assumptions made in classical economics and therefore deemed irrational.  Yet what if the starting assumptions are incorrect in the first place? What if much of what classical economics says about decision making is based on the average outcome of a group; when my ‘rationality’ is best judged by considering my individual experience through time?

Ergodicity is not the most intuitive concept, so let’s take another example – home insurance. If we assume that insurance companies make a profit from selling us insurance on our houses, then surely it doesn’t make sense for anyone to buy insurance for their home?  The insurance company is making a profit, those buying insurance must be making a loss.  Yet this negative expected loss applies to the group average, the situation is different for the individual.  The experience of the group is irrelevant to me as an individual.  What I care about is the impact on my wealth through time – there is only one of me.  The risk of ruin from my house burning down is what matters.

The concept of ergodicity is also critical when thinking about major issues such as inequality. Let’s take the standard economic measure of economic growth – GDP – what does that tell us about individual experience? Very little[iv]. GDP is a group measure.  Therefore we have another situation where the average outcome of the group can be very different to any individual’s experience.  We could therefore enter a situation where economic growth numbers (measured by GDP) appear impressive, but they mask the fact that inequality is burgeoning – wealth is accumulating to a select, small group, whilst more individuals suffer (surely this couldn’t actually happen!?).  Focusing on extreme cases of success in non-ergodic systems can be incredibly deceptive.

Ergodicity and Behavioural Economics

Given the subject matter of this blog, it is perhaps worthwhile exploring a couple of examples of where the concept of ergodicity has implications for ideas in behavioural economics.  One of these was explored by Jason Collins.  In his blog[v] he looked at the following scenario, which draws on work from Ole Peters and colleagues:

“Suppose you have $100 and are offered a gamble involving a series of coin flips. For each flip, heads will increase your wealth by 50%. Tails will decrease it by 40%. Flip 100 times.”

This type of bet is often rejected by individuals, despite the expected gain being 5% of wealth at each flip.  Declining this type of bet is often put down to risk aversion.  But is turning down a bet with a positive expected value such a bad idea?

Collins ran a simulation of 10,000 individuals flipping the coin 100 times each. Whilst the average wealth reached $16,000, the median was only 51 cents. 86% of the population saw their wealth decline.

A bet that looked good on average actually led to catastrophic outcomes for most, whilst a select, fortunate few made huge amounts of money.  Again, the average outcome of the group was meaningless to most people.  And, as Collins goes on to explain, if you increase the number of coin tosses eventually everyone will end up financially ruined.

There is inevitably a lesson here for investors about the destructive power of negative compounding. And from a behavioural economics perspective there is also a valuable insight into why seemingly irrational decisions (turning down a bet with a positive value on average) can be viewed as rational when considering the experience of a given individual over time.

Probability Weighting 

Ergodicity can also matter when we consider how we ‘weight’ probabilities when making decisions.  In a recent paper Ole Peters and colleagues[vi] explored a key tenet of cumulative prospect theory – that people overweight the probability of rare events with extreme outcomes.

The authors argue that far from being an error of judgement, a propensity to ‘exaggerate’ the likelihood of low probability extreme events is a reflection of greater uncertainty.  Individuals have less information about uncommon events (their historic frequency is low) and therefore a greater potential for error in their assumptions.  This feature allied to the risk of ruin from an extreme event means that adopting a cautious approach to such likelihoods is prudent.

The idea of increased uncertainty about probabilities for rare, ruinous events is a compelling argument as to why a seeming overstatement of probabilities may not be an error of judgement.  There are, however, other pertinent issues to consider around how individuals gauge probabilities.  Rather than simply overstate the likelihood of extreme events, there is evidence that in certain circumstances individuals ignore certain high impact risks, seemingly applying a zero probability weighting to them.  Kunreuther’s work on insurance showed that individuals often don’t buy disaster insurance until after they have experienced a loss from such an event[vii].  My contention would be that an individual’s judgement about the probability of a low likelihood, high impact event is intertwined with its salience and availability.  We are less likely to ‘overstate’ the probability of an event if we have never observed it, or if it lacks any emotive qualities.  Our perception of risk needs to be over some ‘threshold’ for us to consider it at all.  We can’t worry about everything.

What Are the Implications for Investment Decisions?

There are a range of areas where considering ergodicity could influence investment making; not least in the sizing of ‘bets’ and the potential use of the Kelly Criterion, but that will be for future posts.  A simple example of where ergodicity might be important is in portfolio construction.  Let’s assume we are allocating to ‘alternatives’ in our portfolio and have modelled them on the basis of them delivering a 4% annualized return with 7% volatility (remember this is hypothetical).  Is the average expected return of a group of hedge funds that meaningful?  Not really.  This is a non-ergodic system – we are interested in the path of returns for the individual funds that we select; the average result of the group might match our forecasts (unlikely), but we could still end up with very poor results.

Concluding Thoughts

Given that the field of behavioural economics was forged on the identification of limitations in the assumptions of classical economics; it seems reasonable that ideas central to the amorphous field of ‘behavioural economics / science / finance’ should also be held up to scrutiny.  Whilst we should always be cautious about attempting to identify ‘one big idea’ that explains everything; the concept of ergodicity is crucial lens through which we should be observing decision making.  We need to talk about it more.

[i] https://medium.com/incerto/the-logic-of-risk-taking-107bf41029d3

[ii] https://taylorpearson.me/ergodicity/

[iii] https://www.nature.com/articles/s41567-019-0732-

[iv] https://ergodicityeconomics.com/2020/02/26/democratic-domestic-product/

[v] https://jasoncollins.blog/2020/01/22/ergodicity-economics-a-primer/

[vi] https://econpapers.repec.org/paper/arxpapers/2005.00056.htm

[vii] https://publicpolicy.wharton.upenn.edu/issue-brief/v4n7.php

What Lessons Should Investors Learn from the Coronavirus Bear Market? (Part One)

Although it feels like painful events such as bear markets are an unpleasant reality best quickly forgotten, they are incredibly important for investors.  Our decision making during such difficult periods can easily define our long-term outcomes.  Whilst our present inclination might be to focus on the specifics of the coronavirus we should instead consider how we can learn the right lessons about both our investments and our own behaviour during periods of severe market stress.  We can then be better prepared for the next bear market, whenever it may arrive.

Here are some lessons I think are important.

In a low interest rate environment we will have a love / hate relationship with cash: When rates are on the floor, very few people are comfortable holding cash.  For most investors it generates a low nominal return and often a negative real return, plus a fee is levied for the pleasure of owning it.  These paltry or negative returns become even more painful when all other assets are delivering strong performance.  In times of true market stress however, cash can become the only asset that investors want to hold.  This will make us start to question why we and others weren’t holding more of it.

This presents something of a conundrum.  In a low rate world, cash is likely to prove a material drag on returns, and the longer a bull market persists the more unpalatable holding it will become.  Yet it is incredibly valuable in times of extreme market dislocation.  So what is the answer? Well, we could just hold low cash when the market is rising and then increase our exposure before the market falls (this is a joke).  The only option is to have a sensible long-term view on its role in a portfolio (given its risk profile) and be content with that.  If we want to own a meaningful level of cash permanently, then we can’t complain when our portfolio lags in a bull market. Conversely, if we believe it will be of long-term detriment to own exposure to an asset that may produce a negative real return then that is likely to leave our investments more vulnerable in markets like those we have seen for spells of 2020.

Investment returns are not normally distributed, and prolonged periods of subdued volatility do not mean it is a good idea to increase your exposure to risk assets: These seem like obvious points to make but they are often ignored during a bull market.  Investment results come with more periods of sharply negative observations than one would assume from a normally distributed set of returns.  Irrespective of how low realised volatility has been there will always be wretched bouts of performance, which render any ‘information’ gleaned from periods of below average volatility meaningless.

The related issue regarding volatility (I have written about its use as a measure of risk here) is that during sustained spells of depressed realised volatility, there is often an overwhelming temptation to hold more risky assets.  Whilst a low volatility backdrop persists this can be an effective means of increasing returns and also looks fine when run through a backward-looking risk model; but can suddenly become incredibly problematic when volatility erupts.

Drawdowns are an inevitable feature of long-term investing:  Investing in any form of risky asset (above cash) involves drawdown risk. An extended period with few material drawdowns does not mean that this risk has been extinguished.  As a rule of thumb, I would say that for a diversified portfolio of liquid traditional assets the absolute minimum expected drawdown over a market cycle should be 2x the expected long-term volatility.  This is a base level because, as mentioned earlier, returns are not normally distributed – there is a negative skew – 3x volatility is probably a more reasonable expectation, depending on the assets / strategies involved.  My sense is that we tend to underestimate the potential for drawdowns in our portfolios so it is crucial to be realistic about this from the outset.  To generate strong long-term returns and enjoy the benefits of compounding we need to be financially and behaviourally disposed to bearing such risks.

Illiquidity is not diversification:  Just because something doesn’t price, does not mean it is providing diversification to a portfolio.  As I (and others) have mentioned before, the major advantage of illiquid assets is that the inability to trade limits our propensity to make bad short-term decisions. This is a behavioural premium created by structurally compelling us to be long-term investors (obviously with the caveat that a bad investment is still a bad investment).  Ignore anyone saying that their private equity holdings have ‘held up well’ during a market sell-off. 

Some alternatives are not that alternative: Low bond yields have pushed more investors into ‘alternative’ asset classes and strategies in order to ‘enhance’ portfolio diversification.  The market downturn has highlighted three crucial aspects around this for investors to consider: i) Some apparent diversification is just a different pricing methodology.  ii) Some strategies appear diversifying until a severe bout of market / economic weakness arrives and diversification disappears just when you need it. iii) Even if assets are genuinely distinctive from other traditional assets, when there is a stampede for cash, everything can get trampled. 

We need to have a plan:  Making plans for torrid market conditions is a crucial element of prudent long-term investing.  It is probably the only thing that will protect us from the confluence of newsflow, negativity, anxiety and stress, which lures us toward poor choices.  Of course, we cannot prepare for specific eventualities – here is what I will do in a global pandemic – but we do know that severe declines in asset prices will occur at some unpredictable juncture.  Even acknowledging this (and writing it down) can help.

We need to have a plan we can stick to:  Investment plans are incredibly important, but also fiendishly difficult to follow.  In a bull market it is easy to say: “when valuations become more attractive (markets fall) I will increase my exposure to equities”.  The problem is that when we make such commitments we neglect to consider how it will actually feel at the time it happens.  Markets will be declining for a reason.  News will be uniformly terrible. Are we sure that our plan was sensible? Hasn’t everything changed? Sticking to our plan will be the last thing we want to do. Plans need to be clear, specific, realistic and, as far as possible, systematic.  Make the decision before it happens. 

Base rates are ignored even more than usual in periods of stress:  During the recent market turbulence high yield spreads moved to 1000 over.  Historically, this has been a good time to own lower quality credit for the long-term, and on a five year view has typically led to strong returns.  We can call this the base rate or our outside view.  Despite the importance of this information we are prone to ignore it, particularly in times of stress.  Rather than consider the relationship between starting valuations and future long-term returns; we focus on specific, salient issues (the inside view) – the virus, the default rate, the energy sector travails.  It is not that this information is irrelevant, but that we weigh it too heavily in our long-term considerations. 

We should always start with the base rate / outside view (spreads being wide is good for long-term returns) and make any adjustments we feel are prudent based on the prevailing backdrop.  Instead, we start with the inside view – the particulars of the current scenario – and the salience and availability of that tends to overwhelm any consideration of base rates, or the things that are likely to matter more over the long-term.

It is hard to make good long-term decisions:  Our obsession with the present makes it close to impossible to implement sensible long-term decisions.  Time horizons contract dramatically and savagely during market declines.  The quality of the choices that we make will be judged over the next week or month (rather than the usual quarter).

People will want action!  As uncertainty increases and markets fall there will be an inevitable clamour for activity.  Things are happening – what are we doing about it?  Whether or not what we are doing is likely to be beneficial in the long-term or is even part of our investment process is likely to fade into insignificance.

For the vast majority of investors sitting on our hands, or making very modest adjustments based on pre-existing plans is the right thing to do.  The problem is nobody else thinks it is, and it might see you out of a job. 

Some people will look stupid, some will look smart:  Most of it is luck and randomness.  When recessions and bear markets arrive there are always heroes and villains.  Some will be lauded for their foresight (and perhaps have books and movies produced about them) others will be castigated for their folly.  Outcome bias grips us hard.  There will always be a few skilful exceptions, but even then we don’t know if the individuals involved will repeat such feats (history would suggest not).  If you work on the assumption that most investor results during such periods are the result of luck and sheer chance, you will have the odds on your side.

Recessions will happen, and for reasons we have not predicted:  There are plenty of things that people ‘know’ are a waste of time in the investment industry but keep on doing anyway – one is speculating about recessions.  Experts cannot predict when they will develop or what the cause will be.  We shouldn’t waste our time trying to forecast the next one. (I am assuming that nobody leaving their homes for months means that we are in one now, but I am no economist). 

It is difficult to tell whether changing market structure, or the nature of the pandemic caused the pace and severity of the asset price decline:  The speed and severity of decline in risky assets was likely in part due to changes in market structure, but not all arguments are equally valid.  A reduced willingness for investment banks to warehouse risk seems likely to be a contributory factor; the growth in low cost index investing wasn’t.

Whilst the structural arguments have some merit, the nature of the market drop was also due to an unprecedented economic stop and huge uncertainty around a global pandemic.  There were (are) some deeply negative economic consequences from the coronavirus outbreak and nobody had (has) any confidence about what probability to ascribe to them.  Does the recent decline provide information about how market bear markets may occur in the future?  Yes.  Will they all look like this one? No.

We are not epidemiologists. Even if we were, we still wouldn’t be able to time markets:  Let’s be clear about short-term market calls in this environment.  It means taking a view on the progression of the virus, the fiscal / monetary response, the economic impact of that response, the prospects for businesses, the reaction of individuals, and, crucially, the behaviour of other investors.  Good luck.

The virus and its consequences will be used to support everyone’s pre-existing beliefs:
 The virus will change the beliefs and behaviours of very few people.  When I say ‘very few’, I really mean nobody.  Growth investors will tell you that societal changes following the virus will bolster the prospects of tech companies.  Value investors will say the fiscal response means that inflation and rate rises are inevitable providing a catalyst for the long awaited resurgence.  MMT advocates will say their ideas have been validated, naysayers will forecast the coming inflationary reckoning.  Active investors will say dispersion is high and the time is right; passive investors will say they held up just fine in a bear market.  Everyone has an angle and everyone will use the same information to bolster their own contradictory views. 

Decisions we make in periods of stress will have profound implications for our long-term results:  If an investment decision makes you feel good immediately, it will probably make you feel bad in the long-term.  In periods of market weakness, the temptation to do what will make you feel better now can be overwhelming.

Things will happen that we had never seriously considered:  An economic shutdown / negative oil prices. These weren’t in forecasts or captured in risk models. 

Depending on the progression of the virus and its market / economic impact, there may or may not be a part 2 of this post (hopefully not). 

10 Questions ESG Investors Must Consider

The coronavirus outbreak has diverted attention away from the drive towards ESG-focused investing that had become the dominant narrative in the asset management industry.  Yet whilst its prominence may have temporarily dimmed; it will almost certainly be one of the defining issues for investors over the next decade.

Although I am supportive of the determination to make ESG factors critical to investment decision making; I worry that professional investors have become focused on the outcome (achieving some form of ESG badge) rather than the process required to get there.  Asset managers frequently proclaim that ESG is ‘in their DNA’ whilst keeping a straight face and fail to acknowledge that it is one of the only routes they have to maintain high margin active management business (alongside private markets).  Every investment process now ‘integrates’ ESG because they have to, even if it is unclear what influence these factors really have.  In many cases ESG has become a tick box or a label. This is a disservice to the complexity of the subject and what the core principles of ESG investing are designed to achieve.

 Whilst the issues to consider are myriad, below are some of the most important questions around ESG investment philosophy that need to be considered by all involved:

Are you willing to sacrifice investment returns? Although it is wonderful to work on the assumption that you can ‘do good’ and improve your financial returns this should not be the founding principle of any ESG-focused investment.  When applying portfolio restrictions that constrain choice you must be reducing your ex-ante return expectations – otherwise they would not be a constraint (of course it might turn out that they improved returns after the event).  Whilst ESG investment is about far more than limits and restrictions; even if we move towards ‘Sustainable’ and ‘Impact’ strategies there is not an insignificant probability that investing in a manner that has material environmental and societal benefits may diminish your investment return.

Every investor in this area needs to ask how they would feel if their investment strategy underperformed a broad market benchmark for a sustained period.  At its core making a decision to invest with an ESG mindset should be based on the notion that you care about more than simple financial results and understand the possible consequences of that from a return perspective.  Three years of underperformance from ESG factors should not lead you to recant your beliefs.  Part of accepting a broader definition of what ‘returns’ means is being able to understand the positive non-investment outcomes that your portfolio might deliver. 

Do any ESG elements constitute a risk premia? It is possible, but there is nowhere near sufficient evidence to prove it.  The strongest case to be made is that within the governance component there are elements that are intertwined with the quality factor, which can be considered a risk premia.  Broadly, however, it would seem a stretch to assume that ESG factors deliver excess return for their level of risk, and provide some form of external societal and environmental benefit in addition.  Of course, in specific cases this might be true, but it is unlikely to be broadly applicable.  Furthermore, as ESG factors become an increasingly vital element of investment decision making it is likely that investors will be willing to hold certain securities at higher valuations, and therefore with lower expected investment returns.

Should ESG assessments be absolute or relative? It is important to understand the heterogeneous nature of ESG scoring and assessment.  One of the most critical is the distinction between absolute and relative.  Are you comfortable investing in companies that are the best in their industry, even if the industry is poor in certain ESG aspects – the best airline, for example?  Or do you think about ESG in absolute terms – how strong is a potential company on ESG factors relative to everything else?  The latter option offers a level of ‘purity’ to an ESG philosophy but brings with it a cost in terms of a lack of diversification.

Should you worry about where a company is now, or where it is going? Another crucial consideration is around what could be referred to as ESG momentum.  Should you focus on companies that rate highly from an ESG perspective now; or also incorporate those companies that may fare poorly at present, but are showing signs of positive change?  If a key aim of ESG investing is to bring about a broader shift in corporate behaviour, then giving some reward to positive change seems prudent.

Should you divest or engage?  This requires careful thought. Of course, there are certain companies that you may wish to avoid from a pure values perspective – controversial weapons, for example – but is it always best to relinquish investments that are deeply questionable from an ESG perspective, and what do you achieve by doing so?  My initial thinking on this was that divestment could be an effective means of bringing about change, primarily on the basis that if carried out in significant magnitude it could materially increase the cost of capital to that business.  However, as Izabella Kaminska at FT Alphaville eloquently argued[i]by divesting you lose all influence and any chance of bringing about material change.  Furthermore, you allow other investors (perhaps those with purely financial motives) to invest with more attractive return prospects, and tacitly permit the company to continue absent any shareholder pressure to alter its activities.  The question therefore should not simply be to divest or not, but if I remain invested what influence can I exert (alongside others) and how might this change the business.?  Also, if I don’t invest, who does?  The problem with this last question is that it provides a get out of jail free card, which allows anyone to own anything.  Therefore it is crucial that you are able to justify and evidence your ability to influence a company. 

Is active or passive the best approach?  Although a perennial favourite for ESG deliberations, it is a false dichotomy.  The real question is about whether a rules-based decision making approach (such as an ESG index) is sufficient or do you require additional qualitative judgement to run an ESG oriented strategy?  Even this distinction is limited by the fact that ESG indices will involve qualitative assessments both in the construction of the benchmark and the underlying scores that inform it.  Unlike in broad asset class decisions a simple active versus passive choice doesn’t exist; it depends on your objectives and requirements.

Are the multiple ratings services a problem? We are likely all well-versed in the fact that the major firms in ESG ratings adopt significantly different approaches in their company assessments resulting in a worryingly low correlation between scores from different providers.  The same portfolio could have positive or negative ESG characteristics depending on the lens through which you choose to analyse them. The problems with this lack of consistency are often highlighted as a profound weakness of ESG investing; but we should also consider an alternative scenario where one firm held the ability to define what represented ‘good’ from an ESG ratings perspective.  The idea of being beholden to a single judge in this regard is equally unappealing. There is at least some benefit to the diversity of thought embedded in numerous ESG ratings services, and there is far more subjectivity in defining ESG quality than credit quality, for example, so this divergence is likely a feature rather than a bug.  Clearly it is important for investors to understand the different methodologies and assumptions, and also use their own.

The other issue with ESG ratings is the spectre of Goodhart’s law – when a measure becomes a target it ceases to be a good measure.  Whilst ESG scoring will likely encourage companies to improve and potentially lower their cost of capital there will inevitably be gaming.  Firms will look at what is being measured and almost certainly target specific areas to improve their ratings.  Although companies seeking to increase their ESG score is a positive; a close eye will need to be kept on loopholes in the ratings, and situations where optics supersede substance.  One indirect benefit of the aforementioned issue of multiple scoring approaches is that it reduces the ability to game or target specific metrics – because of the very inconsistency.  

Is ESG investing in a bubble? An investment bubble needs a compelling narrative, widespread participation and a complete disregard for valuation. ESG has momentum and a compelling story, but not the broad and complete disregard for valuation and future returns.  The danger for ESG investing is that because it is about more than financial returns there can be a tendency to make valuation subordinate to other issues.  Furthermore, flows into ESG can create a self-reinforcing problem, where strong appetite for positive ESG stocks encourages more investors to convert because past performance is appealing.

The fact, however, that ESG is such a nebulous term and the ratings highly subjective means that a widespread bubble is unlikely and actually very difficult to define – what would a bubble in ESG look like?  More possible is that there will be certain areas of the market captured in the drive towards ESG that will (and have already) moved to unsustainably lofty valuation levels.  The other potential ramification is an increasing valuation gap between positive ESG stocks and those that are uniformly excluded or commonly score poorly.  I did think for a time that things could not get much worse for value investing, but the move to ESG is another potential headwind*.

How do you balance principles and diversification? Your ESG philosophy will have a significant bearing on the level of diversification you are able to achieve in your portfolio, and it is important to be clear about the sacrifices you are willing to make.  For example, in a multi-asset fund are you willing to own sovereign bonds?  In an equity fund are you comfortable excluding swathes of the market and being narrowly exposed to certain styles, sectors and industries?  There are trade-offs to be made and you need to be acutely aware of the investment implications of these.

What matters and how much does it matter? Implicit in any ESG score or rating will be assumptions about what issues are important and how important they are.  An overall ESG score will incorporate a hugely disparate group of factors, from carbon intensity to board level gender diversity, which are almost impossible to compare in any reasonable fashion.  Furthermore, judgements are being made about the relative importance (or weighting) of each factor at an E, S and G level, and also regarding the underlying metrics that fuel the headline scores. 

The use of the ESG definition as a coverall term for such a diverse group of factors and issues is almost certainly a net positive as it brings focus and direction to a movement that could otherwise be unwieldy and disparate.  It also offers welcome simplicity to a horribly complex and subjective area that could leave many afflicted by decision paralysis.  Those benefits notwithstanding, we should be aware of the implicit assumptions and judgements we might be making. 

It is easy to be cynical and critical about aspects of the growth in ESG investing and the motives of some involved in it.  Yet whilst it should be held up to scrutiny, there is also the possibility that we allow perfect to become the enemy of the good.  For all of its faults and limitations the move towards ESG influenced investment decision making in recent years is very likely to be of long-term benefit to us all.  For it to continue to evolve and improve it is important that we are realistic about the investment implications of any ESG approaches we adopt, and ensure that we are willing to understand what underlies simple definitions, scores and labels.

* Or opportunity, depending on your time horizon.

[i] https://ftalphaville.ft.com/2020/02/19/1582111795000/Climate-activists-would-be-better-off-buying-BP/