It will not have escaped anyone’s attention that 2024 is a significant political year. Over 50 countries – home to somewhere near half of the world’s population – will hold elections. This – in particular the US presidential vote – is currently exercising financial markets. There is much talk of rising uncertainty* and a frenzy of predictions about results and their consequences. Given this backdrop, investors have every right to be worried, but perhaps not for the expected reasons. We should be focusing less on the specifics of the elections and more on avoiding the poor decisions we are likely to make because of them.

A US election is fertile ground for market forecasters. They can speculate both about the result of a significant occurrence and the market’s response to it. The prognostications typically involve either predicting the short-term reaction of market participants (how other people doing the same thing as them will act), or specifying some longer-term structural shifts that might occur as a consequence (what happens to the US dollar? Which industries stand to benefit?)

Should we act based on either of these types of predictions? Our strong default should be no. These are highly unpredictable, impossibly complex and chaotic subjects that we are understandably not very good at judging. Will some market soothsayers be right? Probably. Do we have any idea who will have that honour this time around? Probably not.

It is not just that it is incredibly difficult to make forecasts or to know whose forecasts to follow, but for most investors the thing we are anxious about will matter much less in meeting our specific goals than we think.

The challenge is that the industry compels action – it generates far more heat than light. It wants us to trade, to switch funds and to pay for critical insights. Even investors who really don’t want to engage with these issues are forced to simply because everyone else is – otherwise we risk seeming negligent.

There are two critical questions to consider when ‘significant’ market events are looming, or we are tempted to trade because of some noteworthy development:

1) Is it important to achieving our goals? Generally, events are far less critical to investors and our long-run returns than we perceive them to be.

2) Can we predict the event and the market’s reaction to it? Almost always the answer to this question is no.

It remains fascinating how investors face an incessant bombardment of evidence about how bad we are at making predictions and timing markets, yet we continue to persist with a punishing indefatigability. We were wrong yesterday but will be right today.

Major events – such as elections – are particularly pernicious because their prominence means that the urge to act can prove irresistible. As humans we are wired to deal with what is right in front us. The more salient and available an issue, the more we are likely to act. Far better to do something destructive than to be a bystander.

As difficult as it is, as investors we would be well-placed to reframe our approach. Rather than respond to each major event or period of ‘increased uncertainty’, we should instead try to move our focus to managing behavioural risk. That is identifying environments where we are likely to make poor investment decisions that damage our long-term returns, such scenarios might be:

– Significant market / macro events (elections / recessions / wars)

– Periods of extreme performance (bubbles and busts)

– Paradigm shifts (the next new transformative market narrative)

In these environments – where the behavioural risk gauge is flashing red – it will be the poor decisions we make because events are happening, rather than the events themselves, that will be of greater consequence.

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* I am always slightly sceptical of the warnings of rising market uncertainty. Both because markets are always uncertain but more because it suggests that we were more certain about markets before they became uncertain (which means we were wrong to be more certain in the first place!)

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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).

It is so tempting to get lost in the noise and intrigue of financial markets that we can easily forget what type of investor we are. Although the investing community can at times appear something of an amorphous blob attached to the latest in-vogue topic; groups of participants are engaged in wildly different activities that – at anything but a cursory level – are barely related. To have any chance of success it is critical to understand the realities of our own approach and avoid playing somebody else’s game.

In broad terms, I think there are four investor types:

Trader

A trader operates with ultra-short time horizons (intra-day to weeks) and is typically engaged in the prediction of price movements based on historic patterns or the expected market reactions to certain events (if X happens, prices will do Y). Asset class valuations and fundamentals are largely irrelevant, and the focus is on forecasting the response function of other investors.

This is staggeringly difficult to do consistently well, which is why profits often seem to accrue to the people who teach trading to others rather than do it themselves.

Price-Based Investor

Almost certainly the most common active investment approach. Price-based investors have short time horizons (ranging from three months to perhaps three years) and tend to engage in one of two related activities:

1) Predicting future market / macro factors and how other investors will respond to them. “We believe that the Fed will be more accommodative than the market expects, which will support US equities.”

or

2) Predicting how other investors will react to realised market / macro factors. “The Fed is far more dovish than the market expected, therefore we have increased our exposure to US equities.”

The common factor in both of these closely related methods is that investors are guessing how other investors will behave. This is similar to trading, but the horizons are extended (though still what I would class as short-term). In essence it is an attempt to capture anticipated price trends.

Valuations and fundamentals matter somewhat for this group, but only insofar as they are useful for understanding the positioning and future decisions of other people like them.  

This is probably the most comfortable style of investing from a behavioural perspective as it caters to plenty of our biases – our desire to be active, to be part of the herd, to tell stories. For similar reasons, it is also likely to prove the most prudent survival strategy for professional investors.  

The problem is that it is incredibly challenging to get these types of calls right (or even more right than not).

Valuation-Based Investor

This type of investor is focused on the fundamental attributes of an asset and will look to make some assessment of expected return or fair value based on analysis of starting price and future cash flows. Given that price fluctuations dominate short-term asset class performance, a long view is essential.

It is important not to confuse a valuation-based approach with value investing, which is only a subset of it. Valuation-based investors are seeking to identify asset mispricings – these might occur because the level of growth is underappreciated, or high returns on capital will persist. The key distinction is that the focus is on the returns produced by the asset rather than how other investors might trade it.

Given that market movements over short and medium horizons often bear little relationship with the fundamental features of an asset class, a valuation-led approach is undoubtedly the most behaviourally taxing. This group will inevitably spend a great deal of time appearing out of touch and idiotic, even if they are right, and they might end up waiting years for validation that never arrives (taking a valuation-led approach doesn’t mean that you will necessarily be correct in the end).

Relative to a price-based investor they are more likely to be successful in their investment decision making, but also more likely to lose their job.  

Passive Investor

Although there is no purely passive portfolio, this group seeks to invest in a fashion that can be considered a broadly neutral representation of the relevant asset class opportunity set (by size). While passive investors are inherently agnostic on valuation, they do care about the fundamental features of the assets in which they invest, but specifically in regard to the ultra-long run, or structural, expected risk and return.

A passive investor may not believe that markets are efficiently priced, but simply there is no reasonable and consistent way of capturing any inefficiencies (certainly relative to the effort or behavioural stress required), particularly after costs.

Although a long-term, passive approach appears simple it is not without behavioural challenges – doing nothing is tough and rarely lucrative.  There will also be incessant speculation around how some profound change in asset class behaviour will soon render a passive approach defunct. 

But perhaps a more credible problem is that a purely passive style requires investors to be ambivalent about extreme asset class overvaluation – passive investors are fully / increasingly exposed to equities trading at 100x PE or bonds yielding zero – even if the evidence suggests this will lead to derisory future returns. It is reasonable to suggest that this is a known cost and one which still leaves it superior to other strategies. It should not, however, be ignored.

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These categories are not quite as discrete as I have made out, but the overall point holds. Defining our own approach and understanding its realities and limitations is absolutely critical for any investor. This requires setting realistic expectations, knowing the information that matters and what should be ignored, and preparing for the specific behavioural issues we will encounter. Failure to do this will mean we will inevitably become part of that amorphous blob.

All investors should be asking who they are and what it means.

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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).

It doesn’t matter whether we are an experienced or novice investor, we will all face plenty of situations where our decisions go awry and investments fail to meet our expectations or goals. It is easy to say that we should all spend more time thinking about and learning from our errors, but it is not quite that simple. Although it might seem obvious, it is not always clear what an investing mistake is. Are poor short-term returns from a long-term position a fault or meaningless noise? What about underperformance from holdings in a diversified portfolio that would have fared well in a different future? Misdiagnosing what a mistake is may well be as damaging as simply being ignorant to them. To avoid this, it is helpful to think about investment mistakes in three ways – those related to beliefs, processes and outcomes:

Belief Mistakes

Almost certainly the most commonplace, but least appreciated, cause of investing disappointment are mistakes of belief. This is where our foundational belief or philosophy is flawed.

Let’s take an example. We adopt an investment approach that is designed to tactically allocate across asset classes based on a three-month view. After a period of implementing this strategy, it is very likely that our performance will have been underwhelming. Our instinct will be to try to remedy the situation by adjusting the process – refining the inputs and our implementation – but the process isn’t the issue, rather it is the idea that asset class performance is predictable over such short horizons. If our beliefs are wrong from the outset, adjusting the process is not going to provide a solution.

Mistakes of belief occur when we incorrectly believe that what we are trying to achieve is reasonable and feasible. This leads to us engage in investment activities where the probability of success is extremely low. Why do we do this? The obvious answers are overconfidence and perverse incentives. We either hugely overstate our ability to succeed in an activity, or we are paid for it, so we do it even if we realise that it is not a good idea.

The real challenge of erroneous beliefs is that they are so difficult to change. When we alter our investment process it can be regarded as a welcome evolution or refinement – we are taking a positive step to get better. When we change our investment beliefs we risk tarnishing our reputation and identity (which is why it so rarely happens).

Process Mistakes

Even if our investment beliefs are credible and sound we can still err.  A process mistake is where there is some flaw in the way in which we implement our beliefs.  
The typical cause of bad outcomes from a mistake of process is technical. Here there is a weakness in our analysis of the information or use of it. What we believe is true, we just have failed to implement it well.

It may be perfectly reasonable to believe that we can lose 10lbs over the next 6 months, but if we have no idea how to design a sensible diet and exercise strategy, we are probably not going to achieve it. There is a belief and process gap.

The other type of process mistake is behavioural. This is about our ability to enact and maintain a plan. This is a serious problem for investors. We can have a sound set of foundational beliefs and a robust process but fail because we have underestimated our own behavioural limitations. This is not just an issue for individuals, but also for institutions who spend a great deal of time refining processes but seemingly little on whether the decision-making environment is supportive of the desired approach.

We have the perfect plan for losing 10lbs, but have entirely ignored the behavioural challenge of going to the gym or not eating that cake.

Outcome Mistakes

One of the toughest parts of being an investor is that there is no clean and consistent link between our beliefs and processes, and the outcomes we receive. We can make smart, evidence-based decisions and end up looking clueless; or appear to be a genius from making an ill-educated punt. Financial markets are fickle and unpredictable; talented investors will experience plenty of bad luck and see lots of things that look like mistakes but really aren’t.

The key danger of outcome mistakes is that they can lead us to give up on an investment strategy that works because we either misinterpret the results or struggle to accept the reality that good long-term investing comes with plenty of pain. There are four types of outcome mistake where we do the right things, but get the wrong results:

1) Bad luck: We simply suffer from misfortune. The more chaotic and unstable an environment, the more things can transpire against us. 

2) Goal mismatch: A frequent issue for investors is where we compare our results against something that we were not even targeting. The most common example is worrying about short-term performance when we have long-tern objectives. This is akin to running a marathon and judging our success after the first mile.

3) Cost of sensible diversification: Well-judged diversification means being positioned for a range of different outcomes, not trying to maximise returns based on a single vision of the future. Being diversified requires holding positions that look like mistakes.

4) Natural failure rate: Even if we have solid beliefs and an incredible process it is likely to have an element of failure built into it. If we can score 90% of our penalty kicks or covert 75% of our 50+ yard field goals then we are delivering exceptional results punctuated with the occasional failure. The more difficult an activity, the more good operators have to accept mistakes, and, crucially, avoid overhauling their approach when they occur. 

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If there is randomness and uncertainty in an endeavour, identifying and dealing with mistakes will always be difficult. For investors, a perceived failure could be the result of a profound flaw in our thinking or simply an inevitable feature of a sensible investment approach. So, what can we do about it?

We should begin by defining what it is we believe and setting reasonable expectations; these are the foundations of any investing approach and without them we really don’t have much of a hope. With these in-place we must make sure we record and review our decision making through time. This means detailing and maintaining a clear rationale for our choices at the point at which we make them; and crucially avoiding the trap of judging past decisions through the horribly biased lens of hindsight. 

It is easy to believe that investors are prone to ignore thinking about their mistakes because it is too psychologically painful, while this notion certainly has merit the truth is far more complicated. Our starting point shouldn’t be trying to identify our own mistakes, but defining what mistakes actually are.

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

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

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

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

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

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

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

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

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

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

—

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

– Why Paul sets very low expectations for Christmas.

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

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

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

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

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

Available from all your favourite pod places, or below.

Christmas Behaviour

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Given this, why is diversification a problem?

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

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

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

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

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

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

Hindsight makes diversification look unnecessary.  

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

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

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

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

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

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