My daughter is soon due to change schools and I recently spent an hour being shown around a potential destination for the next seven years of her education. As we were being told about how many lunch options there will be available each day, my mind started drifting off into the topic of decision making under uncertainty (a very tedious character trait). Choosing the ‘right’ school for your child can be an incredibly tough decision and, much like investing, the difficulty stems from the challenge of disentangling signal from overwhelming noise.

In England, most children attend different schools between 5-11 (junior school) and 11-18 (secondary school). The jump between the two is significant and in most areas involves a process of assessing a range of secondary schools (relatively) local to you and then applying for your preferred choice. In the area where I live many secondary schools are also selective, meaning that a child must pass an exam if they are to have a chance of obtaining a place.  

For parents, a critical part of choosing the preferred school for your child is a visit. These are near identical irrespective of the school – you will walk around some unusually quiet, well-behaved corridors and classrooms (often with a guide), then you will listen to a generic talk from the headteacher (principal) and hear the experiences of a precocious student and witness a performance by a piano virtuoso.

There is nothing wrong with these events, except they provide you with precious little information about whether the school is likely to be a good fit for your child. Outcome bias is also rife – parents know about the ‘performance’ of these schools in the form of exam grades, so no doubt take these tours with pre-conceived ideas about whether it is a ‘good’ school.

Similar to fund investing, one of the reasons that academic performance carries such a weight in the decisions that parents ultimately make is because it is difficult to know what the most meaningful criteria are. Also similar to fund investing, an obsession with headline performance inevitably leads to some poor decisions.

Not only does strong academic performance seem like a vital indicator amongst a sea of ambiguous information, there are also some other behavioural foibles at play. As parents we like to signal to our contemporaries that our children are smart by sending them to the school with the highest historic grades. We also believe that our child deserves a spot because they are obviously above average – overconfidence by proxy.

There is a jarring disconnect between the idea that the school where your child will be happy will be the school with the highest grades, but this is not the only problem – grades are often a poor guide to the quality of a school because of a major selection bias issue. Selective secondary schools that achieve the best grades will pick the children achieving the highest grades at junior school. There are a range of factors that will impact which children achieve such results aside from ‘general intelligence’, including whether they attended fee paying junior schools, or the socio-economic background of their parents.

Whatever the reason, that many of the most highly rated secondary schools select from the children with the highest academic achievement prior to joining means that their subsequent strong results are the least we might expect. Not necessarily a signal that they are superior institutions.

There are measures of success for a secondary school that are more nuanced than exam grades, such as a ‘value add’ score that seeks to measure how much a student improves; yet these feel less influential than knowing how many people a school sent to Oxford or Cambridge.

Another common decision-making trait when uncertainty is high is the use of gut feel. Parents will often prefer a school because of some form of instinct – usually driven by an experience when visiting – your guide was especially kind, or your child enjoyed the science demonstration. These signals are not without value, but we are likely to hugely overweight their importance.  

Stories and anecdotes are also incredibly powerful. Parents may discount schools as options because someone they know had a bad experience. Again, such scenarios may not be without merit but n=1 decision making is rarely a good idea.

What does my rambling about selecting a school have to do with investment decision making? They are both choices taken under huge uncertainty, where we aren’t always clear what the critical variables are, and where past performance can be misleading.

Amidst pronounced uncertainty we are also prone to strive for more and more information. Past a particular point, however, (earlier than we think) more information leads to greater confidence, but not greater accuracy. Furthermore, obtaining superfluous evidence may well lead us to neglect the things that really matter.

What is the answer? It is not possible to make a high uncertainty decision easy – whether it is an investment view or a new school for your child. The outcomes will be far more heavily influenced by randomness than we would ever like to think. We can, however, attempt to simplify complex decisions by narrowing our focus to the most important things. For most investors, aspects such as valuation, time horizon and cost will likely dominate other factors. Selecting schools can be an even harder choice but being clear and honest about what we care about and why is always a good starting point for a sound decision.

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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 1999, Richards J. Heuer, Jr – who worked for the CIA for almost 45 years – produced a volume of writing called: ‘Psychology of Intelligence Analysis‘. It collated internal articles written for the CIA Directorate of Intelligence. Its aim was to provide analysts with the tools to reach judgements in situations which “involve ambiguous information, multiple players and fluid circumstances”. The insights drawn together by Heuer, Jr are designed to assist in the profound challenge of using our limited human mind to tackle deeply complex problems. Investors face this exact test but spend far too much time focusing on getting more, better or new information, and far too little time on how we process it. Good analysts and investors need to think about thinking. This book is an excellent place to start.

The full text is available to download, but here are some of my own highlights:

“the mind cannot cope with the complexity of the world. Rather we construct a simplified mental model of reality and then work with this model.”

We use mental models (consciously and unconsciously) to help us interpret a fiendishly complex world. We cannot escape all the limitations of this necessarily parsimonious approach, but we can be more aware of the models we use, why we use them, and the implications they have for the choices we make.

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“perception is demonstrably an active rather than passive process; it constructs rather than records reality.”

As investors we do not impartially receive information, but instead interpret it based on our own experiences, identity, biases and incentives.

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“When faced with a paradigm shift, analysts who know the most about a subject have the most to unlearn.”

I am always become nervous when investors talk about ‘paradigm shifts’, as it is usually a prelude to losing money. The point Heuer, Jr raises is a good one, however, in that experienced analysts can often be vulnerable in situations where the environment changes dramatically. Moving from an environment of no inflation to high inflation might be a good example of this in recent times.

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“Events consistent with these expectations are perceived and processed easily, while events that contradict prevailing expectations tend to be ignored or distorted in perception.”

If feels great when things transpire as anticipated, but quite troubling when they don’t. It risks our thesis being wrong or our credibility being questioned. Therefore, when we receive information that seems contrary to our view we are prone to reinterpret it to fit our narrative, or downplay it.

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“despite ambiguous stimuli, people form some sort of tentative hypothesis about what they see. The longer they are exposed to this blurred image, the greater confidence they develop in this initial and perhaps erroneous impression.”

We tend to make initial, snap judgements based on sketchy information. Although this might be an effective adaption (is that a lion approaching?) it can also be a problem. We can easily become wedded to that first impression even if the evidence is weak.”

—

“The amount of information necessary to invalidate a hypothesis is considerably greater than the amount of information required to make an initial impression.”

We live in an investment world where people not only want an opinion on everything, but they want it instantly. This is incredibly dangerous. Initial judgements are not throwaway, they can have a sustained impact on our future decisions, even if they are deeply flawed.

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“dealing with highly ambiguous situations on the basis that information that is processed incrementally under pressure for early judgement….is a recipe for inaccurate perception.”

Speed and pressure are a terrible combination for good investment decisions.

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“There is, however, a crucial difference between the chess master and the master intelligence analyst. Although the chess master faces a different opponent each match, the environment in which each contest takes place is stable and unchanging.”

Financial markets are a complex, adaptive system. This makes them both endlessly fascinating and incredibly difficult to predict. Investors need to understand the nature of the game they are playing.

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“A historical precedent may be so vivid and powerful that it imposes itself upon a person’s thinking from the outset”.

Salience of past events has a dramatic impact on how an investor thinks. Understanding the events that we have experienced is likely to provide a good read on how we might interpret a new situation.

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“inferences based on comparisons with a single analogous situation are probably more prone to error than most other forms of inference.”

The worst type of chart crime in investing – a current bear market overlaid with an historic bear market – is a vivid example of the dangers of using one striking historic precedent as a basis for judgement. That is not how complex adaptive systems work.

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“Analysts actually use much less of the available information than they think they do.”

More information often does not lead to better decisions, just greater confidence in those decisions. How much of the information in that 134-page research report really influenced our judgement?  

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“Information that is consistent with an existing mindset is perceived and processed easily and reinforces existing beliefs.”

Confirmation bias is one of the most powerful forces in investing. We see the information we want to see.

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“analysts typically form a picture first and then select the pieces to fit.”

Most investors start with a conclusion and then select the appropriate analysis to justify it.

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“Critical judgement should be suspended until after the idea generation stage of the analysis has been completed.”

Generating new ideas and hypotheses is very difficult. It is particularly challenging if they are immediately criticised and killed (it is easy to dismiss something new). The best way to avoid this friction is to separate the development of fresh thinking from its criticism. (Idea first, critique later).

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“Analysts start with the full range of alternative possibilities, rather than with a most likely alternative for which the analyst seeks confirmation.”

As much as we may dislike it, there is always a range of potential future paths ahead of us and we need to be clear about what they may be. Point forecasts or singular views are a recipe for poor judgements (although they will occasionally make us look very smart).

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“The most probable hypothesis is usually the one with the least evidence against it, not the one with the most evidence for it.”

Investors should spend as much time looking for ‘broken legs’ – reasons why their view is flawed – as they do seeking to prove they are right.

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“certain kinds of very valuable evidence will have little influence simply because they are abstract.”

Investors love the inside view – this fund manager has delivered stellar returns and has an incredible backstory – and ignore the outside view – only 5% of fund managers in this area deliver alpha.

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“Coherence implies order, so people naturally arrange observations into regular patterns and relationships.”

Financial markets are chaotic and full of randomness, which we abhor. Thus, we spend our time attempting to find spurious links and causality.

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“two cues that people use consciously in judging the probability of an event are the ease at which they can imagine relevant instances of the event and the number or frequency of such events’.

The availability heuristic can easily overwhelm our probability judgements. Recent and high-profile occurrences become high(er) probability.

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“an intelligence report may have no impact on the reader if it is couched in such ambiguous language that the reader can easily interpret it as consistent with his or her own preconceptions.”

It is okay to be specific about probabilities. Not only does it immediately acknowledge uncertainty it makes it far easier to change our mind than a single point forecast.

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Nothing is more important for investors than spending time considering our own behaviour and thought processes. What we believe to be cool headed, impartial judgements are no doubt choices shaped by a sea of incentives, biases and foibles many of which we will be oblivious to. It is hard to admit it, but we don’t’ really know why we make the choices we do. Heuer, Jr’s book can help.

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Heuer, R. J. (1999). Psychology of intelligence analysis. Center for the Study of Intelligence.

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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).

There is a pervasive idea in the active fund industry that a fund manager investing heavily in their own strategy is a uniformly positive signal. The more they invest the better. Not only does it mean they are invested alongside us, but they have genuine conviction in their approach. This feels right, but is it true? Probably not.

Why is this widespread assumption likely to be flawed?

Unclear Causality: Although there is some research suggesting that a link exists between the level of fund manager ownership and performance.[i] It is not entirely clear which way the causality runs. Is a fund manager investing in their own strategy a prelude to improved returns, or does a fund manager invest more after they have performed well?

Many confounding variables: It is difficult to isolate a fund manager owning a significant stake in their own strategy from other related factors such as experience (long-serving managers are more likely to have the wealth to invest) or firm size (managers working at smaller firms might have greater ability or necessity to invest in their own funds).

Chasing past performance: The type of fund managers with the ability to invest large amounts in their own funds are most likely to be those that have performed well in the past and are now responsible for a significant amount of money. Strong past performance and substantial assets under management is generally not a fantastic recipe for positive future returns. Does that mean that too much investment from a fund manager is a bad sign?

Not a sign of skill:  It is not entirely clear why fund manager ownership should be an important performance indicator. Active fund investors are looking to identify skill, do we think fund managers know whether they do or do not have skill? This seems incredibly unlikely. Many more will believe they do when they don’t than knowingly possess some form of edge.

Following overconfident fund managers:  If we make the safe assumption that there is a selection bias into fund management roles for overconfident individuals; surely it is dangerous and imprudent to believe that heavy investments into their own funds is some form of relevant validation. We are a more impartial judge than they are. 

Fund manager investment doesn’t really measure ‘skin in the game’: One compelling argument behind the benefits of skin in the game through fund ownership is that the fund manager bears the same risks as their investors, but this is usually a spurious notion. I recall working on a team earlier in my career where there was a high conviction in an experienced fund manager launching a new and niche strategy primarily because they had made a substantial personal investment into it. But their situation was entirely incomparable to ours. They were incredibly wealthy and could afford to bear the stark risks of the approach far better than we could.

Skin in the game is only effective where the responsible individuals face similar (or worse) consequences for bad outcomes. An inexperienced fund manager at a small, fledgling firm has far more skin in the game than an experienced, established manager, even if the latter is able to invest far more in their own strategy. As a standalone measure, a fund manager’s investment in their own fund is not a great indicator of skin in the game.

Prudent investors diversify: A fund manager’s salary, bonus and career should be dependent on the success of their fund. Not only does this lead to some (imperfect) alignment, it makes it imprudent for them to invest substantially in their own funds. A well-calibrated individual that understands the randomness of financial markets and the low probability of success in active fund management would probably invest away from their own strategy.

—

There seems to be three possible reasons why fund investors believe that fund manager ownership is a positive sign.

1) The fund manager knows something about themselves (that they possess skill) or have some distinctive insights into a particular area of the market.

2) The fund manager bears the same risks as their investors.

3) The fund manager will focus their attention on the portfolios where their own money is invested.

Of the three, only the last seems credible and is, at best, marginal. Even if it is true, additional focus doesn’t transform an unskilled investor into a skilled one. There are also far better measures of focus (such as the number of strategies they manage, or the additional responsibilities that they hold).  

Understanding how a fund manager personally invests is interesting information and may, at times, be telling. The idea, however, that it provides a powerful predictor of future returns or measures skin in the game effectively is difficult to substantiate.

Maybe the fund managers who invest less in their own funds understand probability and diversification better than those that invest more.

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[i] Khorana, A., Servaes, H., & Wedge, L. (2007). Portfolio manager ownership and fund performance. Journal of financial economics, 85(1), 179-204.

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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 the Decision Nerds podcast, Paul Richards and I explore one of the most important subjects in the asset management industry – diversity and inclusion – with Tom Gosling. Tom is a committed and thoughtful supporter of D&I. A practitioner turned academic who helps build bridges between researchers, policymakers and those at the coal face.

He has a thoughtful take on some important strategic and practical D&I issues. In the episode, we discuss:

– Why overstating the business case for diversity (improved profitability or alpha) may be more harmful than beneficial.

– Why the moral, social and economic arguments for diversity may be stronger but are not talked about enough.

– How to make genuine and substantive change around diversity and avoid a culture of box ticking.

– What more diverse teams mean for performance.

– How we can create decision making environments that make the most of the advantages of diverse teams.

This is a fascinating and important subject from both a macro (social justice / fairness) and micro (how do diverse groups function) perspective. The issue is far more complex than we could hope to do justice to in a single podcast episode, but we hope that it is a useful starting point for further debate and discussion.

You can listen here: Decision Nerds

Easy and instant access to information is often framed as a major advantage to present day investors compared to their predecessors, but if anything we suffer from a profound information disadvantage. The benefit of improved knowledge is easily overwhelmed by the behavioural challenge of dealing with an incessant torrent of noise. Much of what investors consume is little more than investment junk food, tempting us into decisions that feel good in the moment but come with a material long-term cost.

Whether it be an update on why the stock market closed lower today, a vivid description of a new and profound economic theme, or a compelling account of why we are headed for a recession, such communication bears a striking resemblance to the attractions and dangers of junk food. It provides us with a quick fix, is more interesting than the stuff that does us good and can create long-term damage.

Not only is it appealing, it is everywhere. Investment junk food is prolific. It is like being in a supermarket with row upon row of cakes and ice cream, with the fruit and vegetables hidden on a shelf in the back corner. Making smart decisions in such an environment is incredibly difficult.

The driving force of this problem is incentives. Investment junk food is created for usually one of two reasons – raising assets or attracting eyeballs. The primary motivation is not typically to improve our long-term financial health, but to profit from us in some fashion.

While the occasional chocolate bar is unlikely to be of detriment to our long-term well-being; investment junk food can be more pernicious. Seemingly small, in the moment, mistakes can compound into dramatic long-run costs. This torrent of unhelpful communication matters and is far from benign.

Financial markets are a natural and compelling storybook. A constant stream of heroes, villains, opportunities, threats, failures and successes. This makes them captivating and intriguing – the perfect setting for creating investment junk food.  There is always a new story to tell and sell.

One of the major behavioural problems investors encounter is mistaking the ceaseless action in markets as a call to action in our portfolios. If something is happening in markets, then something should be happening in our portfolios. Investment junk food preys on this misconception. It tells us that things are changing and asks us why we are not doing anything about it.

For most investors financial markets should be chaotic and fascinating, but our portfolios should be stable and dull.

The most common defence of the industrial production of investment junk food is that clients demand it, so it must be produced. If we didn’t tell them how the stock market performed last month, they would demand to know why. There may be some truth to this, but it is also a vicious circle. Clients want it because they are continually fed it. Perhaps we could try reframing those expectations and talking more about good investment behaviour.

The problem with these fruits and vegetables of the investment communication world, is that they can seem repetitive and dull, much like good, long-term investing. There are two solutions to this – communicating the same messages in different ways (which certain people do exceptionally well). Or by telling people about all the enthralling and emotive things that are happening in financial markets, and then why they should not be doing anything about it.

We can look at the junk food, but just not eat 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).

One of the main challenges faced by professional investors is that good behaviours are often in direct conflict with our own interests. This is either because our incentives are misaligned – what’s beneficial for the business or my career is not necessarily good for my client – or we feel compelled to meet the erroneous expectations of what good investing behaviour is. This profound dissonance means that there are plenty of things that professional investors should be saying, but really can’t.

Such as:

“Sorry, I am not sure how the market did yesterday, I didn’t check.”

“Yes, this is the second quarter in a row where we haven’t made any changes to your portfolio. I hope we don’t make any all year.”

“You could listen to me talk about inflation, but I am just as bad at forecasting it as everyone else.”

“We are managing too much money, its probably not in your best interests to invest with us.”

“Our recent strong performance is totally unsustainable.”

“I have to admit, we have been incredibly lucky”.

“Our new CEO is really focused on improving short-term performance.”

“The performance fee structure means that I can become very rich, even if I underperform.”

“There really is little value in complexity, you are better off keeping it simple.”

“Yes, I have kept a record of my macro forecasts and trades, would you like to see it?”

“If you want to take a genuinely long-term, active approach, you will have to put up with years of underperformance. Even if we are good.”

“Although I say I have a long-term investing horizon, most of my decision are about keeping my job for another year.”

“To tell you the truth, this merger has been an absolute nightmare.”

“The recent team restructure has changed everything, we have lost some of our best people”

“I have no idea how markets will perform over the next year, and neither does anyone else.”

Although these issues can seem minor and akin to the classic sales activity of any industry – highlighting the perceived virtues of a product or service – there is something more damaging going on here. Incentives drive behaviour and too often the incentives of professional investors are pointed in the opposite direction of their clients.

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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 often talk about making a decision based on a feeling in their gut. Explaining how some form of unconscious intuition led them to the correct choice.  Although this is an appealing notion – particularly as people only seem to mention it following success – it can also be a dangerous one. Should investors really be trusting their gut and, if so, when?

In 2009, psychologists Gary Klein and Daniel Kahneman published a paper called: “Conditions for Intuitive Expertise: A Failure to Disagree”. This work was particularly notable as the two authors had seemingly ideologically opposed views on the subject of intuitive judgements. Klein had focused much of his career on how experts often make high quality, snap judgements; whereas Kahneman had famously highlighted the flaws and biases inherent in such short-term views (often referred to as system one thinking).

Despite these seemingly polar opposite opinions on intuition, Klein and Kahneman found that they concurred much more than they disagreed. Their common ground can tell us a lot about whether and when we should rely on our intuition.

Klein’s view on intuition is defined as the study of ‘naturalistic decision making’, the genesis of which came from the observation of chess grandmasters and their ability to make robust, instinctive decisions. This work expanded into other fields where similar expert intuition was found to be in evidence – such as a fire chief anticipating the collapse of a building, or a nurse rapidly identifying a child with a dangerous infection.

This type of expert intuition is a form of pattern recognition, where we draw on historic experience to the extent that it becomes an ingrained, unconscious feature of how we reach a judgement.

Contrastingly, Kahneman’s perspective was trained on heuristics and biases – how our instantaneous judgements are often partial, noisy and flawed. Such mistakes in thinking were made by esteemed and experienced experts such as clinicians, political forecasters and – unbelievably – investors.

In one instance we have individuals able to make strong intuitive judgements, even in stressful and uncertain environments; in another we have our intuitions leading us horribly astray. How can we align these seemingly diametrically opposed stances?

The answer is that whether or not we trust our gut is dependent on the context of the decision.

Klein and Kahneman agreed that there were two critical conditions, which needed to be in-place for expert intuition to be effective:

– It must be a ‘high validity’ environment: ‘High validity’ seems a somewhat impenetrable term but is relatively simple. To quote directly from the paper: “Skilled intuitions will only develop in an environment of sufficient regularity, which provides valid cues to the situation”. Good intuition relies on some form of stable relationship between cause and effect; these don’t have to be perfect but need to be reasonably predictable. Despite a chaotic environment, there are a set of signals that might indicate to a firefighter that a building is about to collapse.

– There must be an opportunity to learn: Intuition is about recognizing patterns, so we must have enough opportunities to learn those patterns and receive feedback. It is very dangerous to develop intuition based on small but highly salient examples.

It is easy to see how investors can fall foul of gut feel choices. We are constantly making decisions in low validity environments – where conditions are unstable, noisy and prone to change through time. The patterns we observe in one period may not repeat in another.

Does that mean that investors should never be led by their gut? Not quite. It depends on what the intuition relates to. If we have a feeling that we are about to enter another bear market for stocks, this is likely to be entirely erroneous – such views meet both criteria of where intuition fails us.

If, however, we have a gut feel that investing in an asset class that has risen stratospherically over the past year is likely to be a bad idea, this is more likely to be a smart intuitive judgment. Why? Because there is far more validity in this situation – regular historic patterns of assets with spectacular performance subsequently disappointing.

As Klein and Kahneman point out, high validity does not mean that every intuitive decision will be right, but they will put the odds on our side over time.

The challenge for investors is to know when to trust our gut and when to ignore it. We almost inevitably make more intuitive judgements than we care to admit. Often making up our mind immediately, before carrying out some more detailed (after the fact) work to disguise the real driver of our choice.

The other major issue faced by investors is the conflation of intuition and emotion. They are both decision-making factors that can lead us to act quickly, but they are very different. Making a choice based on fear, greed, anxiety or excitement can feel something like intuition but has little to do with pattern recognition and all to do with biology. We should always avoid emotion-laden investment decisions.

The relief for investors is that – unlike the firefighter or the nurse – most of us don’t have to make snap judgements, we have time on our side even if we often don’t act like it. This doesn’t mean we should entirely ignore our gut but use the time we have to think about what it is telling us and whether it is the right type of situation to trust it.

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Kahneman, D., & Klein, G. (2009). Conditions for Intuitive Expertise: A Failure to Disagree. American Psychologist, 64(6), 515.

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My first book has just 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).

We all make mistakes, some big and some small.

Understanding how errors happen and how they can be managed is a critical element of good decision making. Whether in investing or everyday life.

In this bite-size episode of Decision Nerds, Paul Richards and I tackle this by examining the curious case of the ultra-marathon runner who got in a car. Getting in a car wasn’t the problem – the fact that it was in a race and that she took a podium position was. Several days later, she had to apologise and explain what had happened with all the grief, Twitter pile-ons and general angst that you might expect.

Was this a case of a cynical cheat getting caught, or an example of when environmental factors can lead to a poor decision that spirals out of control? Our take is that it’s probably the latter and we’d all do well to learn what we can from this unfortunate situation so that we can manage our own errors more effectively.
 
We discuss:

The crucial role of the decision environment – the impact of factors such as tiredness, anxiety, emotions etc.

Short-term, ‘in the moment’, thinking – how we often act to satisfy short-term needs and neglect the long-term costs of our choices.

The compounding effect – how small errors can become big problems.

Sharing the burden – how getting others involved quickly can make things easier, but why we might need strong incentives to do this.

Available through all your favourite pod places, or stream it here: 

The football (soccer) team you support has just lost another game. You watch an interview with the manager (coach) and they lament their bad fortune. They dominated the match, had countless chances to score, but were just unlucky. Is this true or are they just trying to mask another bad performance? To answer that question, there is a metric that can help. Expected Goals (xG) has become widely used in football and hockey in recent years. xG tells us the number of goals a team should have scored based on the quality of opportunities created. As with all metrics it is imperfect, but it does provide invaluable help in disentangling skill from luck. Fund management is another area where we have severe difficulties in seeing beyond randomness and chance. Could a metric like xG help, and how might it work?

xG models are complex, but what they are trying to achieve is simple. For every chance created in a game a likelihood of scoring will be ascribed to it, creating an ‘expected goal’ between 0-1.  These probabilities are derived from analysis of historic scenarios. For example, the long-run conversion success rate of a penalty kick is 80%, so, if your team is awarded a penalty, that will result in an xG of 0.8 (whether or not they go on to score).

Why is this information useful? There are three main benefits:

– It provides an insight as to whether a team is underachieving or overachieving (or are perhaps experiencing good or bad luck).

– It may highlight if a team is unusually strong or weak in the most important aspect of the game – do they persistently overshoot their xG, scoring more goals than the model suggests they should?

– It can highlight where a team is going right or wrong. Maybe it is not that they cannot shoot, they don’t even create any good chances to score. 

There is still a great deal of judgement required here – is my team unlucky or terrible at shooting? But just because a metric doesn’t give us a finite answer, doesn’t mean it is not useful.

Investors in active funds are wrestling with many of the issues that the xG metric seeks to address in sport. Are results more a consequence of luck or skill? What are reasonable expectations for performance?

The problem of using a similar idea in investing is that it is a far noisier activity than football. A complex adaptive system, compared to a discrete game with fixed rules and a vast evidence base of similar situations. This distinction, however, does not mean that employing such a concept for active fund investing is without merit. The underlying problem statement is very similar:

xG in football:  Given the opportunity, what was a reasonable expectation for a goal to have been scored?

‘Expected alpha’ in investing: Given the opportunity set, what was a reasonable expectation for a fund manager’s performance?

How do we go about estimating how much alpha a manager should have delivered over a period? There are two possible methods:

Top-down / factor based: In this approach, we can use historic returns to describe a fund manager’s results as sensitivities to various factors (value, quality, momentum, size etc…). We can then compare the performance of their fund to a simplified version of their strategy based on the returns to those factor exposures.

The advantage of this technique is that it is reasonably simple to build a model that is consistent with the historic factor sensitivities of a fund. The downside is that a performance track record of some length is required, and, for some managers, it may be difficult to capture their results through factor exposures. This might be because they carry lots of idiosyncratic risk, or their style shifts through time. Such situations will, however, be in the minority.  

Bottom-up / fundamental:  A more robust approach is to create a systematic replica of the manager’s approach (all fund managers should do this anyway). To do this we would need to understand the investment process in detail – characteristics of the securities purchased, positions sizing etc… In essence we are attempting to build a rules-based, systematic imitation against which we can compare the actual decisions made by the fund manager. This could be as granular or simple as we wished.

The benefit of this more nuanced system is that it is not reliant on historic returns, but the philosophy and process of the manager. It can also provide a clear contrast between what a manager is doing in their fund, and what is happening in our model. The downside is that it requires the bespoke development of a stock picking / portfolio construction model, and is very reliant on how we might interpret the process adopted by a given fund manager.

Both of these approaches are imperfect and noisy, and provide nowhere near the confidence that we might take from an xG metric in football. We are, however, in an industry where discussions of skill are sorely lacking, and there is a heavy reliance on simple past performance with little attempt to separate luck and skill.

Creating some form of ‘expected alpha’ model for funds would have two primary benefits.

First, it would help form sensible expectations for a fund manager’s performance and allow us to focus on the divergence between that and reality. If our expected alpha model is struggling it is reasonable to expect the manager to be performing poorly. This moves us away from constantly obsessing over underperformance and outperformance versus a standard benchmark

Second, highlighting disparities between a fund manager’s results and a simple approximation of their approach could help to identify some form of skill or edge. Is there something happening that is distinct from what can be easily, systematically replicated? Is it worth paying for?

There is no magic bullet in assessing fund manager skill or edge, but the idea behind xG in football points towards a more nuanced means of looking beyond the luck and noise that dominates investing. Assessing fund managers through the lens of ‘expected alpha’ could help investors not only set reasonable performance expectations but better understand if value is being added and, if so, where it is coming from.

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My first book has just 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).

When we make an active investment decision, we obsess over the particulars of a given opportunity, whether it be a security, fund or asset class. This, however, distracts us from a far more important issue, which is so often ignored – should we be participating in the activity at all? This must always be our starting point. To make it so, we need to ask ourselves these questions:

– What are the odds of the game?

The critical first step is establishing the odds of the game we are playing. We want to engage in an investment activity where the odds are in our favour, or at least more in our favour than in other games. The major mistake we tend to make is grossly overstating our chances of success due to overconfidence in our abilities. To paraphrase Charlie Munger, who cares that 90% fail when I am in the 10% that succeeds?

The best means of guarding against such biased thinking is to assume that we are average. Rather than ask how likely is it that I will be successful, ask how likely is it that any given person will be (you never know, we might even be average ourselves). This approach gives us a reasonable base rate or starting point.

– Do I have an edge?

Once we have established a satisfactory estimate of the odds of success in an activity, we need to gauge whether we have an advantage relative to the average participant. If we are going to engage in a game with terrible odds, we are either ignorant of them, playing for fun (like a trip to Las Vegas) or believe there is something about our approach that puts us in the 10%. 

For professional investors, there is one additional reason that we might play a game with a low probability of success – because the cost of participating is borne by somebody else. The chance of positive (lucrative) outcomes for a fund manager are often significantly greater than it is for their clients.

The worse the odds, the more conviction we must have that we have some form of advantage. 

– What is the edge?

It is not enough to believe we have an edge; we must be clear about what it is and why it might exist. For most active investors, an advantage can be categorised as informational (we have better information than others), analytical (we use that information in a superior way to others) or behavioural (we exploit the decision-making shortcomings of others).

It is often argued that financial markets are more informationally efficient than ever before. There is more data, greater transparency and less friction. Making a case for an information-based advantage (in most major asset classes) seems a somewhat heroic assumption. Analytical edges are possible but incredibly difficult to substantiate. Where an analytical advantage arises, it is probably not from the ability to synthesise information better but to use it for a different purpose. Are we trying to predict next quarter’s EPS for a business or its long-run value?

Most market inefficiencies stem from the vagaries of human behaviour. It is difficult to argue that investor behaviour is becoming more rational, and certainly possible that things are getting worse. There is a problem with a purported behavioural edge, however. Not only do we have to contend that other investors are irrational, but that we are not. We are somehow free from the psychological and institutional burdens that lead to poor decisions. This is far easier to say than do.

– Who am I playing against?

In zero-sum games, the ability of the other participants matters a great deal. My chances of winning at poker heavily depend on who else is sitting at the table. Investing is similar but different.

It is undoubtedly true to say that having sophisticated, well-resourced investors facing off against each other is not a great environment to find an edge. Yet there is a major difference between poker and investing. In poker, everyone is playing with the same objective; in investing, this is not the case. Even though it feels like it. If I have a twenty-year investment horizon (if only) and other participants take a one-year view, we are barely playing the same game. At best, we are playing the same game with very different rules. So, the question becomes not – who am I playing against? But – what is it they are playing, and why am I able to do something different?

A painful confluence of compelling stories and inescapable overconfidence means that we are prone to participate in investment activities where the chances of positive results are very poor. To guard against this, we need to better understand the odds and justify why we might be an exception.  

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My first book has just 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).