When you buy a stock, what drives your decision-making? In a new study, academics ran a series of AI-driven interviews with over 1,500 investors from across the world about their stock-picking choices, and found 13 different factors (or what the paper calls “recurrent mechanisms”) that motivate decisions to invest in a particular company. Although there were some notable distinctions across regions and cultures, Fundamental Strength and Growth / Innovation proved to be far more common reasons than Valuation / Mispricing and Momentum. [i]

The researchers employed AI to conduct field interviews with a large group of investors situated in several countries (including the US, UK, India, and South Korea). There was also a broad spread of investable assets, with 42% of the sample between $1,000 and $499,999, 29% between $500,000 and $999,999, and 29% above $1m.

Participants engaged in open-ended, AI-led conversations designed to explore their rationale for stock purchases. A GPT model was then used to assess the responses and define “recurring decision patterns” or, in simple terms, the reasons why investors were buying stocks.

The process led to the identification of 13 mechanisms that commonly described the choices made by investors around individual company investments. They were ranked as follows:

1. Fundamental Strength (40.5%)*
2. Growth Innovation (37.6%)
3. Familiarity / Brand Effect (28.4%)
4. Blue Chip Comfort (28.1%)
5. Authority / Follow (18.6%)
6. Momentum (17.9%)
7. Confluence (14.6%)
8. Dividends (14.0%)
9. Social Copy (13.6%)
10. Valuation / Mispricing (13.6%)
11. Buy the Dip (12.5%)
12. ESG / Values (10.3%)
13. Technical Analysis (6.8%)

(The numbers in parentheses show the proportion of responses where a specific mechanism or rationale was identified.)

This is a fascinating study that I would recommend taking the time to read. I have some initial observations on the results:

Investors like to own stocks that are performing well right now:

If you had asked me, prior to reading the study, to predict its findings, I probably would have said that investors like to buy stocks that have good current profitability and positive sentiment around its prospects – consistent with Fundamental Strength. This plays into so many of our behavioural biases – most notably our desire to extrapolate, our focus on recent outcomes, and susceptibility to salient stories. What is more attractive to an investor than a high-profile stock with good recent results and a captivating narrative?

In addition to this result being unsurprising, it is also worrying that so many investors implicitly believe that they have an edge in judging the prospects of these types of companies.

Investors can’t resist a good growth story:

It is also unsurprising that investors have a preference for growth and innovation. While this may be somewhat exaggerated by market conditions in recent years, the desire to invest in innovative companies with the potential for abnormally high payoffs predates the more recent success of technology and AI-related names.

Investors are comfortable with what they know:

Investors like companies that have an established history and those which they may have personal experience with. There are some powerful heuristics at play here, both in the view that a long-established company may be lower risk, and in the tendency for people to judge a company’s prospects by how positive their own experience is with the product or service it offers. I would expect this factor to be far more common among private investors, where the depth and breadth of knowledge of the universe of stocks is very likely to be limited compared to professional investors.

There is good news for value investors:

Value investors will probably have mixed emotions reading this study – both despondent that Valuation / Mispricing does not rank highly among the reasons people buy stocks, and delighted at the opportunities that may arise because valuation does not rank highly. Value investing works (over time) because it is behaviourally difficult, and because we are predisposed to care more about other things (valuation only scores as highly as copying other people).

There is probably a stigma around momentum investing:

Momentum as a standalone factor only ranks sixth, but I think this understates how important recent returns are to investor decision-making. Performance momentum is inevitably deeply intertwined with Fundamental Strength, and I have a strong suspicion that people are likely to justify performance-chasing decisions as being driven by strong fundamentals. It sounds more compelling and robust to say that you have invested because of a company’s improving operational prospects, rather than because its price has gone up a lot recently.

There are significant cultural / regional differences:

There are some fascinating regional and cultural differences in the study. For example, Fundamental Strength is stronger in Japan (60%) than in the US (30%). Also, close to half of the responses in Japan were assessed to have Familiarity / Brand Effect as a meaningful contributor to stock decisions. The extent to which these are entrenched differences or reflective of more recent, localised market performance is
unclear, but it is undoubtedly interesting.

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Why are certain factors so influential in what stocks investors buy?

If we look through the underlying mechanisms described, there is a heavy behavioural influence on the largest contributors to stock picks – Fundamental Strength (extrapolation, outcome bias), Growth Innovation (lottery-ticket pay-offs, stories), and Brand Effect (familiarity). This seems to outweigh the influence of factors that have somewhat more evidence supporting them (such as Valuation / Mispricing and Momentum).

Of course, it is impossible to know with any level of confidence what drives our behaviour and this study only goes so far as to seek to identify the stated reasons for a stock purchase. This raises two intriguing questions:

– How significant is the gap between the stated reasons and the ‘real’ drivers of our investing behaviour?

– If the stated reasons are a fair reflection of the factors influencing our stock purchasing decisions, why do investors choose those factors? (Why is Fundamental Strength more important to us than Valuation? What is the appeal of dividends?)

Questions for another post.

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* The definition of Fundamental Strength is as follows: “Investors buy stocks when audited financial information indicates robust current performance, which, to investors invoking this mechanism, also signals high expected future returns.” Definitions for each of the mechanisms are provided in the full study.

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^[i] How Investors Pick Stocks: Global Evidence from 1,540 AI-Driven Field Interviews

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

It is that most wonderful time when asset managers publish their expectations for the coming year, so I have decided to lightly update my 2025 version of what all of these will say:

Here goes:

– There is no AI bubble (2026 special): Nobody is going to tell clients there is an equity market bubble, but the importance of being selective will be emphasised.

– Uncertainty will persist, diversification is critical: This will be framed as being particular to the year ahead, but is always true.

– Investors need to be nimble: This is the asset allocators’ version of ‘a stock picker’s market’.

– Investors need to be discerning: A stock picker’s market.

– The traditional approach to portfolio management might not work anymore: Just in case a reader is investing in an old fashioned, unsophisticated way. Yes, the 60/40 is still dead.

– Economic growth will be fine (but with some downside risks): This must be the case because 1: Economic growth is usually solid in any given year and 2: It is not a great idea to tell clients that there is a recession looming.   

– Prevailing performance trends are likely to continue but could change: The safest bet is always to say that what has been working recently will continue to perform well next year This makes readers feel comfortable and plays on the propensity of markets to trend / people to extrapolate. It is important, however, to mention something about the potential for a ‘broadening out’ or ‘reversal’ – just in case.

– Alternative asset classes look attractive: Coincidentally, they also happen to have high fees and are difficult to replicate passively.

– A current key structural theme will profoundly impact markets: AI is incredibly important, but look beyond the obvious winners.

– We are at a critical turning point. Something significant is changing in the world order / investment landscape – you need our help to navigate it safely. Whatever you do, don’t be complacent. (Probably AI, again). 

– We should be worried about a loosely-specified tail risk that the market is obsessing over: There is always some tail risk that is concerning investors – it needs to be mentioned even if nobody is quite sure if it is a genuine risk or what to do about it (fiscal sustainability for the second year running).

– Equities will perform well: This is both likely to be true in any given year and avoids panicking readers. (Adjust as appropriate for fixed income / private market outlooks).

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These annual documents are generally a good, tangible reminder that we are hopeless at forecasting and that financial markets are always a rotating cast of salient topics that feel urgent in the moment but have little predictable bearing on long-term outcomes.

To the extent that short-term issues matter at all, it will be the ones that nobody is expecting that will have a significant market impact.

If read for what they are – a gentle sales pitch with some interesting financial market observations – they are harmless enough, particularly if they, somewhat inadvertently, encourage readers to stay invested over the long-term. But we certainly don’t need to be acting on them and rest assured nobody will remember anything that is being foretold now in 12 months’ time.

—

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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

There has been a lot of talk recently about whether there is a bubble in certain parts of the market, but this might be the wrong question. Perhaps we should instead be asking what we would do about it if there was one. Imagine if you – and only you – knew for certain that there was a bubble in US equities. What action would you take?

Let’s define some terms. You are managing a traditional multi-asset portfolio holding a globally diversified mix of assets for long-term growth. Through an unexpected dose of divinity, you know without any doubt that US equities are in the midst of an investment bubble – that is, valuations are unsustainably high relative to underlying fundamentals and will aggressively revert at some point.*

There is a catch, however. Your ability to see the future does not extend to timing. So, while you know a bubble exists, you have no idea when it will pop.

You know something will happen, but you don’t know when.

How would you adjust your asset allocation?**

For your personal portfolio the answer is probably straightforward: you remove most, if not all, of your US equity exposure and are comfortable being patient (perhaps you simply invest in non-US equity markets).

If, however, you manage money professionally for others, the answer is likely to be very different.

When a professional investor assesses an investment opportunity and decides how to size it, they think primarily about four things (or at least they should):

• The potential payoffs – the future returns in different scenarios.
  
• The probability of each payoff – how likely each return outcome is.
  
• The cost of being wrong – the impact if the assumed payoffs and probabilities prove incorrect.
  
• The need to survive – how much underperformance we can bear.

The final element – survival – is about understanding that being right isn’t always enough. It is about our ability to withstand the path to validation. It asks:

How can I size a position so that I don’t lose most of my assets, or my job, if it temporarily goes against me?

Drawdowns, whether in absolute terms or relative to a benchmark, are incredibly challenging. And it is not just their depth that matters, but their duration.

If you don’t scale your position for survival through time, then whether you are correct can become an irrelevance. That is why, for professional investors, even the enormous advantage of knowing without any doubt that US equities are in a dangerous bubble would not make allocation decisions easy — unless you also knew the timing.

Imagine you take the bold choice to reduce your exposure to US equities by three-quarters because of your bubble prescience. What if the US market outperforms for the next four years? You will appear completely wrong and probably lose a lot of clients, even though you possess an exceptionally valuable piece of foresight.

When managing a portfolio, sizing is all about survival or gauging your ‘portfolio pain threshold’ – for how long and by how much could you bear a decision appearing wrong, even if it is ultimately right?

This reality of professional investing can lead to behaviours that seem irrational — such as holding an asset you know is in a bubble — but are in fact ultra-rational within the context of surviving the unpredictable nature of markets.

This dynamic makes it essential that professional investors ensure their clients have clear expectations about the approach being adopting and the performance realities that come with it.

Unfortunately, no investor has advance warning of what will happen in the future. We must contend not only with the pain of short-term underperformance when we are right, but also with the uncomfortable truth that we could be completely wrong.

It doesn’t matter how confident we are in our investment thesis: if we don’t consider survival and understand our tolerance for portfolio pain, we might not be around to benefit even if we are ultimately vindicated.

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*This is not a view, just an example for the sake of the post.

** No options or instruments with convex pay-offs are allowed, as that spoils the game. The question is – how would you adjust your allocations in a simple fashion?

This is an excellent piece from alpha architect on why seeing the future wouldn’t stop an active manager getting fired.

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Following the evidence has become an increasingly important idea in investing in recent years. If we want to make informed decisions, it makes sense to understand what the evidence tells us. Unfortunately, following the evidence will not lead us to a definitive, correct answer – financial markets are far too messy and capricious for that. What evidence we choose to use and how we apply it is highly subjective and involves a host of trade-offs, which can lead reasonable people to disagree.  

Of course, not all evidence is created equal, some is robust and compelling – fees matter a lot to long-term returns and trying to time markets is a bad idea – but much of it is imperfect. A robust piece of evidence may directly contradict another equally strong argument. Investment decision making is about understanding what we are trying to achieve, assessing the available evidence and drawing a necessarily uncertain conclusion. 

To give a sense of how difficult it is to just ‘follow the evidence’, I wanted to give some examples of how the inescapable complexity of financial markets means that investors are perennially forced to make a whole host of subjective calls:

Static asset allocation versus valuation sensitivity: There is plenty of evidence that holding a static 60/40 portfolio allocation is an approach that is hard to beat over time. This idea, however, is probably outweighed by the evidence that valuations are a crucial driver of long-term return and risk. If we are following the evidence, what should we do? If we decide on fixed allocations, we ignore the evidence on valuations, if we make allocation adjustments over time based on changing valuations we ignore the evidence on the cost of taking active views. It is possible to argue either side and cite strong evidence – and this means we need to take a view.

Market cap equity versus equal weight equity: In 2013, a group of academics published a paper looking at alternatives to market cap weighting in equity indices and they found that doing ‘anything’ was better than a cap weighted approach – including portfolios ‘selected by monkeys’. At the time of publication, someone following the evidence could have quite justifiably preferred an equal weighted equity index fund compared to a traditional market cap weighted index fund. If they had done so, their relative performance would have been absolutely trounced in the years that followed. A lovely reward for taking heed of the evidence available. 

Not only would following the evidence have cost them, but the consensus now would be that market cap is superior to other approaches. So, with the benefit of hindsight, it would look like we were not guided by the evidence at all.

Global allocation and private markets: Many long-term investors reasonably take the view that the most prudent approach is to own something akin to the ‘global market portfolio’ and tailor it to their risk appetite. Given that private markets are a decent slice of the investable universe and more feasible access routes are emerging, does that mean these investors should now incorporate such strategies? Maybe. Or perhaps they should consider the evidence that expensive and complex products tend to come at a cost to clients over the long-run. There is an explicit choice to be made.

The small cap effect: On reading Fama and French’s seminal 1992 paper, an evidence-minded investor may have titled their equity portfolio towards smaller firms. The problem is that the evidence since publication has suggested that the size effect is only present in micro-caps, that it only works if you control for quality, or may not exist at all. Not only might seemingly compelling evidence be unreliable, it can also change based on better methods or new information. If you still believe in a small cap premium you are underweighting more recent evidence – which is fine – but it is an active choice that needs to be justified. 

Domestic bias: What does the evidence say about holding a domestic bias in our portfolios? It is a bad idea for most people, unless you happen to live in the US – then it looks like a great one. If I am in the US, should I rely more on the general rule about the cost and risk of a domestic bias, or the specific case of being a US investor? I have an opinion on this, but there will be plenty of people who disagree because of the evidence they choose to use. 

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There are many more examples of this I could give but the broad point is that very few things are simple or easy in the world of investing. The evidence about the investment decisions we should make is opaque, changeable and often conflicting. Even if we have all the relevant information to hand, it still requires us to have opinions and own them. We will never alight upon the right answer, just the one we think makes the most sense to us based on what we observe and who we are.

I am worried that by writing this I am giving a charter to make poor decisions and justify them by saying that because the evidence is incomplete anything goes. This is not the case. It is critical to filter out the nonsense and noise as best we can (and there is a lot of it). Even when we do, however, and are left with only high-quality information, we still have to discard or underweight some parts and emphasise others.

Judging the quality of the evidence available is not just a challenge due to the sheer scale of material available, but the fact that it changes (or at least can appear to).  Does twenty years of data that conflicts with the prior eighty years overwhelm it? When have markets sufficiently changed so that certain information is no longer valid? How valid is that 120-year data set today? Are we in a different regime now? Not only is it difficult to know what evidence should really matter, it is difficult to stick with something that is well-supported by the evidence available because – inevitably – there will be spells when it looks utterly incorrect.

Taking the time to assess the evidence and incorporate it into our decision making is crucial and the key underpinning of any investment process. It doesn’t, however, guarantee that it will lead to positive results – even if we do it well. We should, of course, still try, but we will need a little dose of good luck as well. All we can try to do is get the odds on our side.

I have focused here on the complexity and noisiness of financial market evidence. I have not started to touch upon the way in which we as individuals source, interpret and employ evidence – incentives, experience, temperament, environment and many other factors will all have a huge influence on how we engage with it. We are as muddled as the information we use.

Using evidence well is integral to good investment decision making but, unfortunately, there is not only one way to do it nor only one sensible answer to find. 

—

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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

What does a difficult decision look like? One where there are lots of moving parts, a constant stream of new information, plenty of emotional stimulus, and nothing to stop us reacting to it all.

This is exactly the type of choice investors have to deal with – with one small addition. We have to make the decision over and over again.

Every interaction we have with financial markets creates a new decision point. We are constantly receiving new ‘information’ (I use this word loosely) and, implicitly, asking ourselves the question: “Do I need to change my portfolio?” *

Whenever we check our portfolio valuation, or even read a financial news article, it is shifting the way we think or feel about our investments. What we do about this will depend on how emotive or compelling whatever we are engaging with is.

To make matters worse, our choices are also unavoidably affected by entirely superfluous factors. If we are having a bad day, it will influence the type of investment decision we might make.

Unfortunately, we live in a world where we are increasingly bombarded by ‘investment stimulus’, and technological progress means that we can act on this immediately. Using one device and a few swipes or clicks, we can read a concerning article, check our declining portfolio valuation, and switch assets, all in the space of sixty seconds.

To have any chance of being a successful long-term investor, we need to make decisions that are consistent, slow, and infrequent. What does this mean?

• Consistent: Follow a process where we are clear about what our aim is and what information matters.
  
• Slow: Consider any new information carefully and never when in a hot, emotional state.
  
• Infrequent: Trade rarely. Doing nothing must be the strong default.

The problem investors face is twofold: 1) We are naturally disposed to be highly alert to new information, acutely sensitive to short-term risks, and responsive to what our emotions are telling us. 2) Technological and investment-industry developments mean that the environment is increasingly encouraging the exact behaviours that are likely to harm our chances of good long-term outcomes.

From an investment-industry perspective, the focus should never be on whether a piece of investment communication is a ‘good article’ or whether a rollout of platform technology represents ‘positive progress’. Rather, it should be asking: “Is what we are doing likely to help someone make good investment decisions over time?”

The job of industry participants should be to improve the odds of their clients meeting their objectives. To do this, understanding how what they do is likely to impact client behaviour is paramount, but often seems to be an afterthought.

Investment decisions are incredibly complex and difficult; it is very hard to achieve good long-term outcomes if we are forced to make them every day.

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* Very probably not.

–

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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Performance fees are one of the more puzzling aspects of the fund industry. They are often hailed as a way of best aligning the incentives of fund manager and client yet, in reality, frequently benefit the former at the expense of the latter. Often in an egregious manner. 

Let’s imagine a hypothetical conversation between a professional investor and a potential client:

Investor: “I have developed this fantastic new strategy that can deliver high, uncorrelated returns. The backtests are incredible. All I need is some capital to put to work”.

Client: “That sounds interesting, what would it cost?”

Investor: “I would want to keep 20% of any performance above cash.”

Client: “Okay. What about the cost of providing the capital?”

Investor: “That would be 1.5% a year.”

Client: “So you will pay me 1.5% to gain an economic interest in my large pool of assets?”

Investor: “Err…no. You will pay me 1.5% for it.”

Client: “Right. And what if the strategy goes wrong?”

Investor: “I am afraid that’s all on you.”

Client: “Sounds great, where do I sign?”

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If we developed our own high conviction investment strategy and sought to make it as lucrative as possible (for ourselves), we would want access to a large pot of assets (ideally somebody else’s) and to participate directly in its performance.* Getting paid a healthy annual retainer would be the cherry on the cake.

Is it unreasonable to suggest that fund managers levying performance fees should actually be paying clients for gaining access to sizeable asset pools? Perhaps, or maybe it is just unrealistic (the lights need to stay on). Clients are, however, providing the necessary capital, bearing the vast majority of downside risk and often paying out fees for volatility. Hardly a textbook example of incentive alignment.

While there has been some evolution in how performance fees are structured, the pace of positive change is slow and certain areas seem to be moving in the opposite direction.** We should not be surprised at this given how asymmetric the benefits and costs can be, and how they often they provide reward for luck or even simple market exposure, rather than skill. Never give up on a good thing!

Of course, it is a free market, asset managers can set their own charges and clients have the agency to decide if the terms are attractive. I would just encourage everyone to think carefully about how well-aligned their incentives really are.  

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* This would also be true for someone who had no investment skill.

** There are better and worse ways to structure performance fees. Too many fall into the latter group.

—-

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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Until recently I was seemingly one of the few people who hadn’t seen the TV show ‘The Traitors’.  It became popular so quickly that my stubborn, contrarian streak prevented me from indulging. After some persistent persuasion from my children, however, I succumbed and have been watching the latest UK ‘celebrity’ version. Not only do I have to reluctantly admit to enjoying it, but I have found the contestants’ – often baffling – approach to the game starkly reminiscent of some of the most destructive investor behaviours.

For the uninitiated, the game is very simple. A group of (20 or so) people are put together and a small subset (usually 3) of them are secretly selected to be ‘traitors’. Each day the traitors covertly select one of the ‘faithfuls’ to ‘murder’ (remove from the game). Also, each day, the entire group have to discuss and vote to banish a member of the group who they suspect of being a traitor. For the faithfuls the aim is to rid the group of traitors, while for the traitors it is to remain undetected until the end and claim a prize for themselves. (Party game fans may recognise this structure from Mafia / Werewolf).

A distinctive feature of the game is the almost complete absence of useful evidence the players can use to guess who might be a traitor in the group. The traitors are selected by the producers prior to the show, and players must make judgements based on their interactions with each other during the game. 

The way players decide on who to banish for being a suspected traitor follows a consistent blueprint:

– There is virtually no meaningful evidence about who is a traitor.

– All players significantly overstate their skill in ‘reading’ people and hugely overweight meaningless information. 

– Players construct persuasive, compelling and entirely spurious reasons about why another participant is a traitor.

– The players who put together the most elaborate arguments are considered smart even though they are consistently wrong.

– The player identified as a traitor is banished and it transpires that they were a faithful.

– Players lament their approach and consider whether a different strategy might be worth considering next time.

– In the following round they do precisely the same thing, seemingly forgetting it didn’t work before.

These are all very human behaviours and almost identical to those that we see from investors attempting to predict the short-term movements of financial markets.

The hallmarks of which are:

– An environment defined by noise and very few signals.

– Massive levels of individual overconfidence in the skill to make predictions about asset class performance.

– A wonderful ability to create impressive and coherent stories about market conditions.

– Credibility and airtime given to investors who sound smart.  

– Those investors frequently being wrong.

– Everyone carrying on doing the same thing anyway without acknowledging it didn’t work before.

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Whether we are trying to guess who the traitor is in a party game or predict the performance of US equities over the next 6 months, the patterns will be familiar. We will inevitably see evidence where there is none, be wildly overoptimistic about our own capabilities, and create stories to alleviate the discomfort of randomness and uncertainty.

Human behaviour doesn’t change much, just the context. 

—

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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Although it could have easily escaped your attention, as it has received such little fanfare, the price of gold has been rising sharply – recently surpassing $4,000 per ounce. Significant moves in the gold price are fascinating from a behavioural perspective because gold is probably the perfect belief asset – that is an asset which is impossible to value in any reasonable way so it’s worth is entirely dependent on what we think other people believe it to be. This has significant implications for how gold might behave, and how people both talk about it and trade it. 

We are currently in the stage of the cycle where many people conjure up reasons for why gold is so attractive because they cannot admit that they mainly like it because its price has gone up a lot. That is not to say that there are not valid reasons why an investor might hold the asset but, as usual, near term performance must bear much of the responsibility.

How should investors think about gold?

Gold is not a better form of money: One of the most common and vociferous arguments from investors who are bullish on the prospects for gold is that it is far superior to standard fiat currencies because it holds its value, whereas the like of the US dollar or sterling lose their purchasing power through time. This view makes very little sense. In a well-functioning and growing economy, a positive level of inflation is desired – it encourages spending and investment – this means currencies should lose value through time. It is a feature not a bug. Yes, a dollar today may buy you less than it did 30 years ago, but I am pretty sure that salaries have changed over that time also, and I am confident people do things with their money – like spend it and invest it.

The merits of owning gold change depend on what question you ask. Is holding gold over the long-term better than putting cash under the mattress? Quite possibly. Is holding gold over the long-term a better option than owning productive, real economic assets (such as company shares)? I am not so sure.

Gold has excellent Lindy properties: Although the ‘debasement’ argument often made about gold is an exceptionally dubious one, gold does benefit from the Lindy effect. This is the idea that the expected life of something that is non-perishable is proportional to its current age. In simple terms this means that the longer something has existed, the longer we assume it will last. (The expected future life of Great Expectations is significantly longer than anything published last week). The concept is named after Lindy’s deli in New York City where it was speculated that a show running for a month on Broadway could be expected to last for another month.

Gold has been used as a store of value for thousands of years. People have believed in it for an extremely long time, which should give us some confidence that people will keep believing in it. This feels somewhat amorphous – but when you don’t have much else to go on it matters.

Belief assets can be extremely volatile: The more assets are based on belief than anything tangible the riskier they are likely to be. Why is this? If an asset is driven by strong fundamental features – let’s say a high-quality bond with a contractual return and fixed maturity – the range of potential outcomes is very narrow. The more speculative the asset, the more it is based on indefinable beliefs, the wider the range of outcomes and the greater the uncertainty.*

Assets that have long-term, fundamental value drivers experience a (sometimes light) gravitational pull towards some form of fair value. As belief assets have no fair value the price can vary widely – this can be both incredibly lucrative and, at times, painful. (Belief assets are perfect for bubble formation – there is nothing to hold them back).

Prices for belief assets change because perceptions change. If the gold price were to drop to $2,000 is it more or less attractive than it is now? Nothing will have changed about the yellow metal, just what people believe other people believe about it.  

Price moves in gold create stories about gold: As we are being bombarded with stories around the reasons for the rise in gold price – debasement, fiscal largesse, central bank purchases, political uncertainty – it pays to remember the causality here. Price moves come first and then the narratives to justify it second. It is not that the stories have no validity, it is just that they become more persuasive the higher the price rises, creating a self-reinforcing loop – for a time at least.   

Do you like the asset or its trend?  Momentum investing has a long and storied history of delivering positive returns – but only if carried out in a deliberate and measured fashion. One of the problems with strongly trending belief assets is that rather than acknowledge that they want to participate in the price momentum, investors need to offer a compelling fundamental rationale. Although this might make them sound smarter, all it means is that they are a closet momentum investor without the discipline required to do it well.

Know why you own it: Perhaps the key for any investor owning gold is to be very clear about why you hold it, otherwise you risk being whipsawed around as price trends (and beliefs) fluctuate. If you purchase it tactically be specific about the precise factors that are informing your view (even if it is just trend following). If it is a structural portfolio holding you should be willing to bear periods of significant losses with equanimity and understand the exact role it is playing.  

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There is nothing inherently wrong with holding gold, but it is important to accept the type of asset it is and the investment behaviour it may encourage. If Ben Graham had been asked about gold, he may have said something like:

In the short-run, the market (for gold) is a voting machine, and in the long-run it is also a voting machine.

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* Whether an asset is a belief asset or a fundamental asset can also depend on time horizon. An equity investor trading on a three-month view is turning stocks into a belief asset because they are worried only about sentiment (belief) changes – the fundamentals are largely irrelevant.

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Investing can often feel like one giant prediction game. Most financial market commentary involves forecasts about the future that are hastily discarded and wilfully forgotten, and many investment approaches are founded on taking bets about the complex interactions of economies and asset prices. The problem with all this activity is that the world is a highly uncertain place and we are wildly overconfident in our ability to foresee what will happen next. A fact confirmed (again) in a recent study by Jeffrey A. Friedman, an associate Professor of Government at Dartmouth College.

Friedman ran a large-scale study of over 63,000 judgements made by nearly 2,000 national security officials from NATO allies and partners. The expert participants were given a set of 30 to 40 statements and had to estimate the chances that they were true.

Such as:

“In your opinion, what are the chances that NATO’s members spend more money on defense than the rest of the world combined?”

Or apply probabilities to future events: 

“In your opinion, what are the chances that Russia and Ukraine will officially declare a ceasefire by the end of 2022?”

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How did these experts fare when posed these questions?

It is fair to say that their calibration was a little off or, to put it another way, they exhibited pronounced levels of overconfidence.

When the officials believed that a statement was likely to be 90% true, this was the case on only 57% of occasions.  On the flip side, when a statement was assigned a 10% likelihood of truthfulness, it was correct 32% of the time. Notably, participants were more likely to say something was true when it was not, than the reverse (false positives were more common).

There was also a problem in dealing with certainty. When a participant had absolute confidence that a statement was false, they were incorrect 25% of the time. (They were obviously ignorant of Cromwell’s rule).

Here is a visual depiction of the calibration gap, or level of overconfidence:  

Friedman’s paper goes in to more detail on the study, and he has also written an excellent book on decision making under uncertainty, which I would strongly recommend, but I wanted to turn to the implications of this study for investors:

– Be very careful with geopolitical risks: Investors get very excited about geopolitical risk and love the opportunity to become foreign policy experts for the week, but making decisions based on geopolitics should be avoided. In Friedman’s study, experts in the field consistently made off the mark, poorly calibrated judgements – what chance do generalist investors have?

– Financial markets are harder to predict than most things:  Although the foreign policy questions in Friedman’s study were difficult, they are not as challenging as those many investors try to tackle. When investors make market predictions they are attempting to forecast something as complex and chaotic as the global economy and how that will impact financial markets. It is incredible to me that anyone thinks this is possible.

– Reduce your confidence levels: The participants in the study were overconfident, investors are overconfident, humans are overconfident. A very useful rule of thumb is to reduce our conviction every single time we express a view, this will almost certainly make our guesses more realistic.

– Don’t make an investment approach reliant on predictions: I appreciate that it feels like we should be constantly making predictions about financial markets – it is interesting, lucrative and everyone else is doing it – but it is a really bad idea. 

– Make easier predictions:  Of course, all investing involves making predictions about the future in some form but let’s make easy ones. I predict that over the next decade economies will grow, and stock markets will generate real returns. It is a forecast, and it is not certain to be true, but I have a reasonable level of confidence in it being so. Simple predictions, humbly made are always the way to go. 

– Reduce overconfidence by diversifying: Diversification is an exercise in humility. The future is uncertain, and we are terrible at making predictions, so our portfolios should reflect this.

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If you are reading this and thinking that financial market forecasts are not really as difficult as I am making out then feel free to replicate Friedman’s test. Make a set of statements about the future and apply a probability to them being true. Things like these:

The ten-year US treasury yield will be above 5% by the end of 2026.

 or

The US equity market will not lose more than 25% in value at any point over the next 12 months.

Let me know how you get on.

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It is an oddity that investors are often reluctant to systematically measure themselves in this way given how much time we spend making predictions. It suggests that even though we behave in an overconfident way underneath it all we know the truth, we would just rather not remind ourselves of 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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

Most investors would be better off doing less. Whether it is the folly of market timing or the irresistible lure of performance chasing in mutual funds, more activity is likely to be bad for us. In most aspects of life doing less is the easiest thing, but in investing it is incredibly difficult – and getting harder. 

The challenge of doing less is in part a psychological one – not reacting to the incessant stream of financial market stories and acute emotional stimulus they provoke can feel almost impossible. As humans we are wired to respond – fighting that instinct takes huge effort.

Alongside this there is also a profound incentive problem, which Warren Buffett captures well:

“Wall Street makes its money on activity, you make your money on inactivity”.

Most, if not all, professional investors are incentivised to be active. Imagine the difficulty of progressing your career when at the end of the year you have barely touched the portfolio you manage. It makes it incredibly hard to make the case for that promotion. 

There will be similar expectations from clients, who may well ask:  “What are we paying you fees for? You haven’t done anything.”

Activity can be good for the professional investor, even if it is bad for their investment results. 

The key reason why more activity is a rational decision for professional investors is the inevitability of underperformance.

Nobody likes to underperform but any concerns your clients or employers may have might be placated by activity – signs that you have ‘done something about it’.

What is totally unacceptable is to underperform and do nothing.

The randomness of financial markets mean that even great investment strategies will struggle for prolonged periods of time. As underperformance is inescapable, activity is an essential survival strategy. 

There is some merit to the argument that investment activity that has very little supporting evidence of adding any value – such as making short-term tactical trades – can have a useful placebo effect. While it is likely to be (at best) pointless, it might make investors feel better to know something is being done (and therefore more likely to stay invested).

Although this may be true in some instances, being more active than you need to be while not destroying value is a tough ask.

I am not advocating never doing anything. There will be times when action makes sense. For most investors, however, this should be a rare occurrence, and you must be very clear in what types of situations you are likely to act.

If you are not extremely disciplined about defining when you might need to make changes, you will almost certainly be captured by the next incredibly consequential story that comes off the conveyor belt of financial market news. 

To embrace the benefits of less activity over more, we need to stop asking – ‘why haven’t you done anything’? And start asking – “why are you doing something?”

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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).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.