What will the Fed do next? How will conflict in the Middle East impact the oil price? What does a new bout of stimulus mean for the Chinese Equity market? Is the US economy heading into a recession or reflation? Investors are trapped in a vortex of noise. We are compelled to engage with and react to a rotating cast of inescapably prominent and impossibly complex issues. This constant state of flux is the lifeblood of the investment industry but poison for clients. For most investors 99%, of what we see, hear and feel in financial markets is not just irrelevant to what we are trying to achieve, it actively makes it harder to make good decisions and attain our goals. Why is noise so ubiquitous and what can we do about it?

Critical to the success of any investor is the ability to cancel out the noise that surrounds us and focus on the elements that will have a material influence on our outcomes. Given the sheer complexity and chaos inherent in financial markets this can seem like an impossible task – how can we figure out what is significant?

There are two key criteria we can apply to help us identify harmful noise in financial markets (which is the vast majority of what we encounter). For any issue or event, we should ask two questions:

– Does it matter?

– Is it knowable?

Unless we can answer both in the affirmative, we can classify it as unhelpful noise.

Let’s take each in turn:

– Does it matter? Here we are seeking to understand whether the subject we are focusing on will actually matter to what we are trying to achieve. Let’s assume I have a 20-year investment horizon, will the next decision by the Fed have any obvious impact on my investment goals? Absolutely not. The same can be said for whatever geopolitical issue is the focus of our attention at any given point in time. If something is likely to have either no effect or a random influence on us meeting our investment objectives, then it is just noise. Spending time thinking about it is likely to leave us worse off. 

Even if something does matter – we are confident that some variable or topic will have a material impact on our investments over the time horizons that matter to us – it can still be noise, because it also must be knowable.

– Is it knowable? Being confident that something actually matters is a pretty high hurdle for investment information, but even that is not sufficient. For it not to be noise, it must be knowable or predictable. Why? Well, let’s say I was certain that the near-term decisions of the Fed or the latest geopolitical issue would have an impact on meeting my investment objectives – this is only meaningful if I know or can predict the outcome of these things. I need to know both that the Fed decision matters and believe that I can predict it, otherwise, what am I going to do about it?

If that isn’t tough enough, there is another problem. We often need to know two things – both what is going to happen and how it will impact financial markets. Many wonderful (lucky) predictions about a particular event have been rendered worthless because someone got the second part wrong. Forecasting any future occurrence is usually a herculean task, adding on a prediction of how it will then influence something else (alongside all the other unforeseeable things that might also impact it) is getting us pretty close to impossible.

So, how can we tell what matters and what is knowable? Well, we can apply some simple tests.

Does it matter?

Test: If I had a crystal ball and knew something would occur in advance, would it change my investment decision making?

This is a useful test for long-term investors because most things really should not influence our choices. There is a danger, however, of being overconfident and believing that certain pieces of information will move markets in an obvious way. Imagine having some foresight of 2020 ‘Covid’ economic data and making investment decisions based on that – it probably would have ended badly.

Is it knowable?

Test: Is the information already known or is there evidence that people can accurately predict it?

The most obvious piece of information that is in some way knowable is the valuation of an asset. For example, when bond yields were close to zero we didn’t need to make predictions about future returns being low – we knew this. Unfortunately, most financial market relevant activity isn’t knowable, it is instead reliant on making bold predictions about the future, which in complex adaptive systems is quite the ask.

Bringing these aspects together creates a simple framework for addressing the issue of noise in financial markets and the many problems it causes investors: 

Does it matter?	Is it knowable?	What to do about it?
Yes	Yes	Use the information
Yes	No	Diversify
No	No	Ignore

When people talk about current hot topics in financial markets – usually in wildly overconfident ways – we should be trying to apply this framework before anything else. Ask does the thing being discussed have any relevance based on my objectives and horizon, and if it does, is it reasonable to believe that it is in anyway knowable or predictable? The vast majority of things we can ignore, some things matter but are unpredictable so we diversify our portfolios, and a select few things really matter and should inform the investment decisions we make.

It is fair to say that what matters depends on the individual investor and what they are trying to achieve. So, for short-term traders many more events and occurrences will seem to matter because they are trying to judge near-term changes in sentiment. It is expected that they will interact with the market more than those with a longer horizon. The problem for investors taking such short-run perspectives is that most of the variables that might matter for them are not predictable in any reasonable or consistent way.

Using this framework leaves something of a puzzle, however. Most investors have long-term objectives, yet almost everyone seems to be obsessed with perpetuating short-term noise – constantly talking about things that don’t matter and / or are unknown and unpredictable. What causes such a dynamic? There are many, many factors at play, but here are a few ideas:

We want to reduce uncertainty: As humans we abhor uncertainty, and there are few things more uncertain than short-term financial market fluctuations. Engaging with what is happening and listening to people who confidently explain it (and predict how it will develop) is incredibly comforting. The sense of security it gives us is entirely false, but it feels real.   

We react to what is in front of us: Even if we try to avoid it, we are surrounded by news of what is unfolding right now and cannot help but think that what is happening in the moment is more important than anything else. 

We want to sound smart:  Talking about financial markets makes us sound smart. We can quite easily be wrong about how every major financial market event unfolds yet still sound credible and intelligent whilst doing it. The alternative is to say “I don’t know” or “it probably doesn’t matter” and that doesn’t do wonders for our conversations or career.

We don’t want to look negligent: One of the real challenges faced when trying not to engage with market noise, is that there will always be some events that will have an impact and matter (particularly in the short-run). We won’t know what these are beforehand, but after they occur everyone will act as if they were obvious and inevitable. We cannot risk looking negligent, so it is safer to treat everything as if it might be vital.

We avoid feedback: Does anybody genuinely keep track of the views they have on market events and short-term market moves? Almost certainly not. Everyone knows why this is, but it doesn’t matter because everyone carries on in the same fashion. ‘I was wrong yesterday and the day before that, but I will be right tomorrow.’

We focus on what matters to others: Unfortunately, it is not the things that matter to our long-term outcomes that are most important, but what other people think matters. If everyone else in the industry treats certain events or issues with the utmost significance, it is almost impossible to be an outlier. The industry acts as if these things are important, so clients think they are important, and it is rational to conform.

We want to sell something: Everything always in the end comes down to incentives. Noise, news flow and the conveyor belt of market events grease the wheels of almost everything that happens in the industry. It is in the interests of everyone to join in (apart from the clients).

We are bored: The willingness of investors to engage with market noise always reminds me of a social psychology experiment where participants were left alone in a room for fifteen minutes. They could either sit and think, or press a button that would give them an electric shock. 67% of men chose to electrocute themselves. Long-term investing is usually dull, embracing the noise of financial markets might be painful, but at least it stops us being bored.

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I often wonder whether the majority of people involved in the investment industry know that much of what is discussed and debated on a day-to-day basis is often irrelevant and almost always unpredictable, and just play along with the game, or if they actually believe that they stand apart from everyone else in their ability to make sense of the cacophony. Whatever the case, noise is a real problem for most investors and one that can lead to poor long-term outcomes unless we find ways to drown it out.

The next time you get drawn into a conversation about the latest market event try stopping yourself and first asking – does this matter and is it knowable? The answer will usually be no. 

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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).

One of the best moments of being a football (soccer) fan is when your team scores from long range. Although a goal built from an intricate passing move is undeniably pleasing, nothing quite beats a 25-yard rocket into the top corner. That’s why when a player finds themselves in space outside of the opposition penalty area the crowd will inevitably encourage an effort on goal with the dull roar of ‘shooot’. This is a mistake. The probability of scoring from distance is poor. It is typically a much better idea to try to work the ball closer to the goal. Shots from distance in football are like short-term investing – it feels right, but the odds of success are terrible. It is much better to do something else.

In his book on the use of data and analytics in football, Ian Graham (who played a major role in the success of Liverpool over recent years) highlighted work that showed while one-third of shots from inside the six-yard box are converted into goals, this falls to just 4% once outside the penalty area. There are several caveats to place around such numbers, but the general point holds –  shooting while being a considerable distance from goal is not usually a great decision.*

Why does this have anything to do with short-term investing? Well, trying to predict how markets might move over any brief time period (1 month, 1 year…) is another activity that we seem inescapably drawn towards despite it having little chance of success and being detrimental to what we are trying to achieve.

But why do we believe that long range shots and short-term investing are better ideas than they really are? Because of the influence of some of our most impactful behavioural foibles:

– We remember the wrong things: Our judgement of probability is inextricably linked to how available something is in our mind. Goals from long range shots don’t seem anywhere near as rare as they are because they are salient and we see them repeated continually, much more so than those that fail to hit the back of the net. Similarly, it is far easier to remember those short-term market calls that we got right, than the many we got wrong.

– We want a near-term fix: We prefer things that are exciting and give us a reward as soon as possible. Long range shots and short-term investing are far more stimulating than their alternatives, both of which require a great deal more patience and are just a little more dull.

– We want to be part of the crowd: Most people in a football crowd will urge the player to take the long shot, why would we not want to be part of this? Likewise, most people in the investment industry want us to engage with short-term market activity, so most of us do. Norms matter.

—

There are situations where taking a long shot might be a prudent option. For example, a weaker team playing against a much stronger team my not get that close to their opponent’s goal so an effort from distance is their best chance. Yet even here the the similarities with investing are stark – speculation can only be justified when our objectives are speculative.

The further we are from goal when taking a shot the greater the uncertainty, the more other variables will get in the way and the lower the probability of success.   

The shorter our investing time horizon the greater the uncertainty, the more other variables will get in the way and the lower the probability of success.

Enjoying and encouraging a shot from long distance in football is entirely understandable and perhaps desirable. Football is entertainment – it is about moments and feelings – ignoring what the data tells us is fine, it might even make the game better. Most of us don’t invest for fun and, unless we do, we should avoid the long shot of being short-term.

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* These numbers are a simple representation of what the data tells us. There are a range of other factors that will impact the probability of scoring from various parts of the pitch, such as the relative strength of the teams involved, the player taking the shot, how easy it is to get the ball closer to the goal etc.. Such things are always noisy, but the point about long shots being overrated (from a data if not enjoyment perspective) still stands. There has been a reduction in long range shooting in high level football in recent years no doubt in part due to the increasing use of analytics.

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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 the latest episode of Decision Nerds, Paul Richards and I talk with Professor Alex Edmans of London Business School. Alex recently published a book, ‘May Contain Lies’, which discusses our vulnerability to the misuse of evidence, statistics and stories, and how we can get better at deciphering the information that we consume.

Alex talks us through his ‘Ladder of Misinference’, which is a great framework for understanding how we might be mistaken when in receipt of information, and what we can do about it.

As part of the discussion we also cover areas including:

– How to help people move beyond black-and-white thinking and engage with complexity – getting the right mix of data and stories

– Why do bad ideas stick – do you still ‘Power Pose’?

– Changing minds – the power of good questions (there’s a great experiment on pianos and toilets that you can try at home).

– Trading off the short and long-term – why he chose the most critical agent to help him publish his book.

– Understanding neurological carrots and sticks – what happens when we put people in a brain scanner and give them statements they like and don’t?

– The state of debate around ESG and DEI – ideology, identity and pressures to conform.

I hope you enjoy the conversation, which covers a range of subjects that feel increasingly important.

You can listen to the episode in the usual places, or from the link below.

May Contain Lies

In his book on the concept of ergodicity, Luca Dellanna writes of his cousin who was a highly talented skier in his youth, but had a potential future in the sport cut short by a succession of injuries.[i] The lesson that Dellanna draws from this is that it is not the fastest skier that wins the race, but the quickest of those who reach the finish line. The risk of irreversible losses is integral to long-term success. Investors may think that maximising returns is their primary goal, but it isn’t. Survival comes first, and survival comes in several guises.

Diversifying Disaster

The most obvious case of the survival imperative is in the avoidance of catastrophic losses. These tend to stem from some form of concentration but are often complemented by leverage and complexity.  Although this might seem a simple risk to mitigate it is not, primarily because it is easy to be negligent about how susceptible to concentration we are. Just because a portfolio looks diversified – it holds lots of stocks, funds or asset classes – doesn’t mean it is.

Although diversification can be critical to survival, investors don’t really like it. When we diversify it says that we are uncertain about the future rather than confident, it also means that – after the fact – our portfolio has always performed worse than it might have done. Why didn’t we hold more of the asset that produced the strongest returns?

The danger of this is that we have only ‘line-item diversification’ – we hold a long list of names in the portfolio because it is deemed to be the prudent thing to do, but they are all exposed to very similar risks. When we do this we are prioritising return maximisation over survival, which is an incredibly dangerous approach.

Wrong on Average

One of the primary causes of survival neglect is looking at the wrong type of average. Investors can be susceptible to thinking about the average return of an asset class at a group level (XYZ hedge fund category has produced a 7.8% return over the past decade), but really we should care at least as much about the individual paths taken by the funds within that grouping (5% of the funds in XYZ hedge fund category lost more than 50%). The second piece of information feels more important than the first.

Humans can think in this way. When we buy home insurance, we (hopefully) don’t spend too much time considering the average loss experienced by all home insurance buyers (we know insurance companies should make a profit), we instead focus on the consequences of a bad outcome in our own personal experience.  Of course, as investors we cannot make decisions based on the worst possible result, but with any decision we make we must consider the potential adverse paths it might leads us down and whether we can survive them.

Salient Survivors

What investors really want is to identify investment strategies that survive and generate stellar returns. How do we go about finding these? Often by looking at individuals and teams that have achieved just that.

Although survivorship bias seems to be one of the most high-profile behavioural foibles that we encounter, this awareness doesn’t seem to provide much protection against it. High risk, highly fragile investment strategies – whether they be complex, leveraged hedge funds or concentrated equity portfolios – are constantly lauded when they produce extraordinary returns with rarely a mention of the many, many other similar strategies that were carrying similar risks but failed to survive.

Why is it so easy to fall into this trap? In part because of the salience of high-profile survivors – they become incredibly prominent and identifiable, far more so than the long, unmemorable list of those that no longer exist (notwithstanding the select group of notable failures) – but also because of our difficulty in accepting the consequences of high risk and good fortune. The successful survivors have inevitably enjoyed incredible luck, but it is our tendency to ascribe those outcomes to agency and skill rather than a dice roll.   

Surviving Ourselves

It is very easy to think about investment survival purely in terms of avoiding disastrous outcomes from the assets themselves, but although this is critical it is far from the only relevant aspect.  As important are the decisions we make through the life of an investment.

Any investment is only as good as our ability not to make bad choices while we own it.  

Poor decisions at the wrong time – selling at a market trough or following a prolonged spell of underperformance – is another survival problem. It doesn’t matter if the asset recovers from its difficulties if we have acted to crystallise the losses through our own actions.

The challenge is that it is incredibly tough to avoid such mistakes. When a fund is going through a poor spell of performance, we will desperately want to sell it and move on. And the longer the trend persists, the stronger the urge will become. The narratives will be overwhelming and the emotional toll heavy.

Every investor overestimates their aptitude for making smart decisions in the face of poor returns, yet every investment will go through spells of disappointing performance. Few of us seem prepared for this painful reality.   

To benefit from the power of compounding returns over the long-term, we need to survive the temptation to make poor decisions along the way.

Surviving our Environment

The lessons about the challenges of dealing with our own behaviour applies to private and professional investors alike, but for professional investors not only do they have to worry about themselves, they have to worry about their environment. This means not only considering their own behaviour, but also the decision making of their clients and their employer.  It is no good making a great investment decision if you might lose your assets or job before it comes to fruition.

Imagine you are a fund manager responsible for asset allocation decisions and happen upon a (functioning) crystal ball that means that you are sure that a particular asset class will generate the highest returns over the next decade. Would it make sense to own as much of the asset as you can within the parameters of the portfolio you are running? No, it wouldn’t, because the path will matter. You need to survive for the next ten years – what if the asset class that will win over the decade underperforms significantly for the next three years? Do you still have a job?

For a professional investor there is a requirement to make decisions where they can survive the weakest link in the chain. It might be their investments; it might be their own psychology, or it might be their environment.

For any investor to be successful there must be an alignment between their investment approach and the environment in which they make investment decisions. If there is conflict, the environment will win.

There is often a lot of cynicism about fund managers running ‘closet trackers’ or making decisions that seem to be designed for managing their own career risk. While such choices might not look compelling from an investment perspective, it is a rational activity for an individual looking to survive their environment.  

How to Survive

Long-term investing has many benefits, but to enjoy them we need to find a way of reaching the long-term. All investors need to think as much about surviving as they do about performance.  

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[i] Ergodicity, Luca Dellanna

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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).

Improving our investment behaviour is difficult. Our choices have a messy confluence of influences ranging from the explicit (financial incentives) to the implicit (our own psychological wiring). It is impossible to ever understand precisely why we made a particular decision – it is just too complex. This doesn’t mean, however, that we are helpless bystanders. In fact there are many seemingly innocuous areas that we can change to improve the chances that we might make sound judgements. Foremost of these is what we pay attention to – our investment decisions are inextricably linked to what we see and the impact it has on us.

A useful activity for any investor is to note down the major financial market issues that are in focus each week. After a year or so we can review these and realise how unworthy of our attention they were. As an added bonus, we might also want to make a prediction about how these issues will unfold so – on the rare occasion they are meaningful – we can see how lousy we were in forecasting them. This might seem glib, but it is not.  As investors, what we pay attention to dominates our decision making. We are bombarded with information (noise) that encourages costly choices at the expense of our long-term goals.

Our attention is drawn towards things that are available (easily accessible) and salient (provoke some form of emotional response). For investors this means whatever narrative thread is being weaved around random and unpredictable fluctuations in market prices. This is a major problem as the things we are being constantly exposed to are exactly the things that most of us should be ignoring.

For the majority of investors – those who invest over the long-term for profits, dividends and coupons – there is no need to have six screens providing a plethora of real time financial market information, knowing what equity markets did yesterday is an irrelevance and it is okay to ignore the latest hot topic. Even the areas that the industry treats as the most important thing in the world – such as what the Fed will do at its next meeting – just don’t matter that much to fundamentally driven investors with long-run horizons.

The asset management industry compels us to engage with all of these distractions, when the route to better decision making is finding ways to avoid them.

The problem, of course, is that avoiding them is incredibly difficult. Not only are we designed to care about what is happening right in front of our eyes, but everyone else behaves as if every move in markets is based on a vital new piece of information. Looking one way while the crowd looks in the opposite direction takes incredible resolve.

Is there anything we can do to stop us paying attention to the wrong things?

The first step is to separate the investment industry machine with its ‘9 seconds until markets open’ or ‘German equities were down 1.2% over the month after weak industrial production numbers’ from actual investing. In most cases, the incessant cacophony of financial market newsflow is nothing more than advertising – it is designed to grab our eyeballs, our clicks or our money in one form or another – it is an irrelevance to the real reason most of us are investing. Treat it for what it is – interesting but meaningless at best, a damaging distraction at worst.

Next, we need to clearly and explicitly define what we should be paying attention to. Based on our goals, what are the things that are worthy of our focus and attention? What are the aspects that really matter to meeting our objectives? These will be specific to each individual but will inevitably be stable and boring, and come with no requirement to care that the US ten year treasury yield fell by 7bps last week.

Asset managers – who are inevitably heavily complicit in this chronic attention challenge faced by investors  –  will say that financial markets are constantly in motion and that it is not feasible to simply act as if nothing is happening. Clients would be left uncertain, anxious and prone to even worse decisions. Although this sounds credible, it doesn’t really hold water. There is not a choice between adding to the gobbledegook or saying nothing at all. How about putting short-term financial market fluctuations in their appropriate context and explaining why it is rarely that worthy of our attention or action?

Talking about topics also bestows credibility to them. If asset managers spend time discussing monthly market fluctuations and performance, they shouldn’t be surprised if clients consider it to be important. Professional investors should always be asking themselves – how is what I am saying likely to influence the behaviour of my clients?

What we pay attention to tends to drive the decisions we make, and investors are persistently exposed to meaningless noise masquerading as meaningful information. We tend to perceive investment acumen in those individuals with an intimate knowledge of these daily market gyrations, but we have this entirely backwards – the ones with real skill are those who find ways to ignore it.

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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).

Back in January 2022, I wrote the following about the fervour for ESG investing:

‘What happens when stocks and funds with positive ESG characteristics start to underperform? Investors are likely to move on to the next outperforming trend, particularly as we told them to focus on the performance prospects.‘

That this scenario has unfolded does, unfortunately, not reflect some remarkable prescience on my part; it is just the grimly inevitable denouement that occurs after a compelling story is combined with unsustainable performance and ferocious asset manager marketing to create wholly unrealistic investor expectations. When the industry has its next big idea, investor disappointment often follows.

This has nothing to do with ESG as a concept. There are plenty of positive and worthwhile elements attached to ESG investing, but unfortunately many of them were forgotten because of the zeal that came to define it. The question here is not about the validity of ESG, but rather why such cycles of investor obsession occur.

There are three important observations about big ideas in investing:

1) Past performance dominates investor behaviour: Past performance is the overwhelming force driving investor decision making – it consumes everything we do, whether it be a private investor or the committee of an endowment. We might not like to admit it, but our views and decisions are indelibly shaped by recent returns. No matter how committed we might be to an investment approach, style or asset class, two or three years of underwhelming returns will be more than enough to shake us out of it. Strong performance fuels the big idea as surely as weak performance kills it.

2) Substantial inflows erode future returns: One of the most perverse elements of investors ploughing assets into the next big idea is the apparent ignorance that the flows must almost certainly push valuations higher and future long-term returns lower. We are attracted to robust recent performance despite it dragging returns from the future into the past. The next big idea always comes with wholly illogical performance assumptions.

3) Asset managers will sell things that benefit them and sell them aggressively: If asset managers are fanning the flames of the latest big idea then there is a very high probability that it is better for them than it is for us. This is an issue that has been made more acute by the rise of index funds and compression in active fund volume and margins. Good businesses solve client problems, bad businesses try to solve their own. 

So, now that some of the froth that came to surround ESG investing has subsided, what’s the next big idea? It is difficult to be sure – something related to AI must be a strong contender – but perhaps private markets are the obvious candidate. The combination of high fees, long-term lock-ins, performance opacity and limited direct competition from passives makes them a perfect solution to many of the threats that asset managers are facing. It is unclear whether the benefits to clients are quite so significant.   

It is not that big ideas are necessarily bad ones. Many of the tenets of ESG continue to bring welcome attention to important and neglected areas, and it is by no means unreasonable for an investor to hold an allocation to private markets as part of a diversified portfolio. The problem is when these ideas are taken to extremes. They tend to become ubiquitous, impervious to challenge and saddled with wildly irrational expectations. To make matters worse, any genuine underlying benefits from the initial idea get lost amidst the excitement and inevitable comedown.

So, where does the rise of index fund investing sit in all of this? Is that another problematic big idea? No, it is not the same. The key difference being that it is an evolution that has largely been resisted rather than embraced (for obvious reasons). It has succeeded despite it being against the interests of the industry. That being said as investors we are always complacent about concepts that are performing well and underestimate how we will react if the environment changes. Index funds will not be immune to this behavioural reality and we should not be complacent about it. 

The simple truth is that the asset management industry needs big ideas more than investors do. All most of us need is small, simple ideas, consistently applied.

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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).

So, what was it that caused the sell-off in risky assets and sharp increase in volatility? The Fed? The Bank of Japan? The end of an AI bubble? A soft employment number? The yen carry trade unwinding? All of the above? Something else entirely? Who knows? The truth is that financial markets are a complex, chaotic and deeply intertwined beast, which makes both predictions and explanations impossibly difficult. Not that this stops us attempting both. For most investors a rationalisation of events doesn’t even matter – markets are volatile; sometimes uncomfortable and inexplicable things occur. What’s more important is what happens to us during bouts of market turbulence. This is where the real damage is done.

Here are a few things to bear in mind:

– The fact that people are scrambling around to decipher what happened in recent days should be a salutary lesson in the folly of market predictions. We can’t even give confident explanations for events after they have occurred, what makes us think we can do it before!?

– When an unpredictable event occurs it unfortunately makes us increasingly susceptible to forecasts. We feel anxious and uncertain, so become even more desperate than usual for a comforting guide to the future.

– People who didn’t predict the market sell-off will confidently foresee what is to come: “I didn’t see this coming, I cannot explain what caused it, but I am going to tell you what happens next.”

– Trading around market / economic events is unbelievably hard. We only need to look at the wildly varying expectations for Fed policy through 2024 to see how fiendishly tough it is to do well.

– Everyone will start to say that “uncertainty has increased”. This cannot be true. It makes no sense to claim that we were more certain about things before an unpredictable occurrence. Markets are always uncertain, sometimes we are complacent.

– Living through periods of market tumult is always challenging, even over short horizons. It is far easier to deal with such spells in theory than in practice.

– A new market narrative will take hold incredibly quickly and everyone will start using a fresh set of buzzwords that are consistent with the current set of events.

– We will forget all of our prior market pontifications no matter how recently made. Nobody will remember panicking about stagflation / a rebound in inflation after some hot data prints a few months’ back.

– Everything seems obvious after the event. Of course US employment was weakening, of course the Mag 7 would come under pressure, of course the yen carry trade was a tinderbox.

– What is happening right now will be the most important thing, and we will easily and quickly extrapolate into the future.

– The present value of future cash flows from Japanese companies is not changing by 10% a day.

– This might turn into something more substantial, or we might be talking about something else next month. Usually it is the latter, sometimes it is the former.

Living through periods of turbulence is taxing. It is easy to talk about the long-term, staying invested, and compounding returns when markets are going up. It is an entirely different story when the reverse is true, but these are the times when behaviour really counts.

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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).

Hendrik Bessembinder’s latest paper asks the question – which US stock has generated the highest long-term returns?[i] The answer is Altria Group (formerly known as Philip Morris). Over 98 years the tobacco company produced a cumulative return of 265 million percent! Based on this it would be easy to write about how lucrative it can be to sell addictive products, particularly when there are negative externalities involved, but there is something more important for investors to take away from the research – the power of compounding over the passage of time.

The cumulative total return of Altria seems astonishing, yet it equates to an annualised return of ‘only’ 16.3%.  On a standalone basis the figure does not seem remarkable, it is only when you apply time to it – long periods of time – that the dramatic impact of compounding takes hold.

Investors are inevitably drawn to high short-term returns (far higher than the 16.3% per annum produced by Altria), but these are inevitably unsustainable. That’s not an opinion, it is a mathematical reality. There is an inescapable gravitational pull as both time and size drags astronomical performance back toward normality.

Most investors neglect the power of time and the monumental advantage it bestows upon those with a sufficiently long horizon. We behave as if we are attempting to generate the highest possible return in the shortest possible time. Instead of compounding solid returns, we become destined to compound a succession of poor decisions with painful long-term consequences.  

It is not surprising that investors act in this fashion. We are wired to worry about and act on short-term risks and opportunities – it is a great strategy for evolutionary survival, just a terrible one for long-term investing. But it is more than that. The entire industry wants us to be impatient – whether it be selling the next great product or attracting our attention with the next alarming article.

Everything within us and around us seems designed to interrupt the positive force of compounding.

Investors who understand their time horizon, build a sensible portfolio and rarely make changes will be far better off than most. The trick is understanding ourselves and our environment well enough so that we avoid the temptation to veer from that course.  

Despite it being the best strategy for most investors, doing nothing (or at least very little) has a very bad reputation, so maybe it needs a rebrand. Instead, from now on, let’s call it: ‘Letting compounding do its work’.

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[i] Bessembinder, H. (2024). Which US Stocks Generated the Highest Long-Term Returns?. Available at SSRN.

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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)

Investors love talking about ‘skin in the game’. It has become something of a truism that a fund manager with substantial sums of their own money invested in their strategy will make better decisions. Not only is this a dubious generalisation but it also overly simplifies what can be quite a messy incentive problem. Skin in the game is an important idea but also one we can get wrong by misjudging where it exists, what it is telling us and when it might be a problem.

Incentives drive behaviour. If we could only know one piece of information to predict how someone would behave in a given situation, it would be their incentives. The idea of having skin in the game is a form of incentive alignment, it means that people directly experience the consequence (or risks) of their actions, not simply enjoy the benefits.

The decisions that we make will be heavily influenced by the distribution of potential outcomes that we face. An individual who bears all of the upside but none of the downside in a given situation, will make different choices to someone who faces the reverse.

It is too simplistic to say that having skin in the game leads people to make better decisions, but rather that the shape of incentive structures can profoundly impact our behaviour.   

Skin in the game is a critical concept, but one which investors can easily misjudge. Here are three examples:

Our skin in their game – The most obvious and frustrating scenario is where we believe that our interests are aligned with an investor that we are allocating money to, when in fact the structure is horribly asymmetric. Here we bear the majority of the downside risk, but the fund manager captures a disproportionate amount of the upside. The classic case of this is traditional hedge fund performance fees, where client capital is put at risk and large performance fees can be generated (and crystallised) for fleeting periods of outperformance.

The worst aspect of these fee structures is that they are often framed as better aligning incentives – “we have skin in the game – when our performance is poor, our profits suffer”, but this is a sleight of hand that ignores the inherent asymmetry. If things go badly wrong who bears the majority of the painful costs? If things go right who can generate transformational wealth? The answer to these questions should be the same, and it is not.

From a utility maximising, risk / reward perspective asset managers will always want to structure fees and incentives in ways such as this (this is not just a hedge fund issue, hello private equity), but it is a terrible structure for clients and not ‘skin in the game’ in any beneficial way.

Skin in the game as a negative signal – Now for an unpopular view. What if a fund manager investing heavily in their own strategy was a sign that they were not a good investor, but rather an overconfident and imprudent risk taker? What if having skin in the game was a useful signal for which fund managers to avoid?

This is an exaggeration for effect here, but it is not clear to me that a fund manager holding a significant portion of their net worth in their own strategy is always a positive, nor likely to encourage better decisions.

I am quite keen on investors who are humble, understand probabilities and are aware of the prudence of diversification. Such investors may be less likely to invest most of their wealth into their own investment strategy – the same one on which their career is reliant upon.

Aside from this issue there are other questions, such as: How does a fund manager having a large portion of their wealth invested in a strategy impact the choices they make? Are their objectives and risk tolerance aligned with our own? Given that fund managers have been known to be infected with a slight dose of hubris – should we be emboldened by their own (over)confidence in their strategy, or worried by it?

People seem to confuse it being ‘right’ that a fund manager invests in their own strategy (which it may be), with it necessarily being a positive indicator. In some circumstances it might be, in others perhaps not. It is a complex and nuanced area, not a useful heuristic.

Skin in different games – The final area is one where we tend to ignore issues around skin in the game and incentive structures: group decision making. Somewhat bizarrely little attention is paid to how groups of people make judgements – the behavioural literature is focused on the individual – despite most of our choices being made as part of a collective.

One of the primary reasons that boards and committees are so often dysfunctional is because they suffer from profound incentive misalignment problems. There is no meaningful, unified skin in the game because everyone is playing entirely different games. Often everyone around the room will have different incentive structures, time horizons and metrics that they are measured against, which will dominate their behaviour.

The CEO worried about share price performance, CIO focused on investment returns, the CFO trained on controlling costs and the independent Non-Executive hoping nothing blows up in their tenure. This is not a recipe for aligned, high quality decision making, but individuals with their risk and rewards attached to very different things. It shouldn’t be surprising that group decisions are defined by frustration, procrastination and uneasy compromise. Internal politics are generally about trade-offs between individuals with divergent incentives.

This is not just true of boards, most group structures face this problem, but never realise or acknowledge it – they just assume that everyone has a consistent set of objectives. Our assumption should always be that a group of people put together to make a decision do not have alignment of incentives or share skin in the game, unless an express effort is made to make it so.

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Incentives are almost certainly the most important driver of human behaviour and sometimes they are incredibly easy to observe, but, as the notion of skin in the game shows, they can be a little more complex than they might first appear.  

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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).

Humans are prediction machines. We have to be. Every decision we make is based on predicting something. Whether it is the sun rising tomorrow morning, our car slowing down when we press on the brake pedal or the bank we use remaining solvent. Every choice we make is built on assumptions about the future. Despite this, I spend plenty of time annoying people by talking about how pointless (or worse) most financial market predictions are. So, are they essential or worthless? Well, it depends.

It depends because the types of prediction that investors make are wildly different – some are fiendishly complex and dynamic, whilst others are simple and stable. Before comparing some examples, let’s think about the factors that are likely to moderate the challenge posed by an investment forecast.

Our basic approach to any prediction should be Bayesian. This means that we have a set of potential outcomes that we apply probabilities to based on some starting assumptions or prior beliefs. Crucially, when we receive new and relevant information we update our priors and probabilities.

Let’s take a simplified example. I believe that there is a 70% chance that US equities will outperform European equities over the next twelve months because of stronger earnings growth (this is not true, I have no idea). Now, if US company earnings are surprisingly weak in the next quarter, I may revise down my probability.

Sounds simple, but there is a problem. While a Bayesian method is the best way to approach this scenario, it doesn’t mean it leads to good or helpful answers from an investment perspective. This is due to the forecast itself being just too difficult.

What makes a forecast hard? There are three key questions:

1) Can we define the variables that matter to our forecast? We need to be able to identify the factors that will influence the outcome of the thing we are forecasting.

The list of variables that could impact the relative performance of US equities and European equities over the next twelve months is huge and includes things that we know (such as earnings) and things that we don’t (unexpected events).

2) Is the group of variables that matter stable? The more the factors that matter change, the harder it is to make good predictions.

It is not just that the list of variables that matter is long and unknowable, but the relative importance of them is not constant. Maybe earnings will matter this year, maybe a pandemic the next.

3) How predictable are those variables? It is one thing identifying what the variables of importance are, but we still need to be able to predict them with some level of accuracy.

We don’t just need to define the factors that will influence the relative performance, we need to be able to predict them. Even if earnings growth was the most important variable in any given year, we would still need to forecast it well.

This type of forecasting is exceptionally tough, even if we take a sensible, measured approach.

All our investment decisions are a type of forecast – does this mean they are all equally problematic? No, they are not. Let’s take another example that seems similar at face value, but is an entirely different proposition.

Imagine we have thirty years to retirement and invest the majority of our long-term savings into equities. We are making a forecast here – that investing in the stock market is the best way to grow our wealth over time. What assumptions are we making in this instance?

– That economies will grow in real terms.

– That corporate earnings growth will be closely linked to economic fundamentals.

– That shareholder rights will be upheld.

Now, we might want to expand this list a little or be more nuanced, but in basic terms these are the elements that will impact our forecast. Over the long-run these are likely to be the aspects that matter, they are unlikely to change and we can predict them with reasonable confidence.

There are, of course, no guarantees. There is by no means a 100% probability that equities are the right place to be even over thirty-years – there are all sorts of remote but not impossible adverse scenarios – but the likelihood we should attach to this being accurate is far, far higher than our one-year market conjecture.

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As much as I dislike admitting in, we are constantly making forecasts about financial markets – it is inescapable. That doesn’t mean, however, that we cannot differentiate between predictions that are necessary and reasonable, and those that are impossibly difficult and almost certainly damaging.

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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).