It is often stated that the key to strong long-term investment performance is the ability to compound good short-term results. Although avoiding near-term disasters (such as severe permanent losses or extreme volatility) is imperative for all investors; the idea that an acute focus on the immediate future when managing our investments will lead to positive outcomes over long-run horizons is deeply flawed. There is a paradox at the heart of our investment behaviour whereby the more we care about what happens in the short-term, the worse our long-term performance is likely to be.

Although the precise definition of long and short-term investing horizons is somewhat hazy, let’s assume that short-term is under three years and long-term is over ten years (we can ignore the piece in the middle for now).

For most investors the core tenet of successful long-term investing is about making sensible, evidence-based decisions that put the odds on our side and then letting it play out. Although this sounds easy, it is far from it.

Whichever investment strategy we adopt, whichever funds or assets we hold, they won’t work every quarter, every year or even every three years. They will all go through spells of poor performance where negative narratives abound and our concerns will be pronounced. The temptation to change course will often prove overwhelming.

This is not about active versus passive investing. All approaches will come under scrutiny. We need only look at the number of obituaries being written for the 60/40 portfolio following an unusually difficult 2022. Investors of all churches will have to withstand periods of scrutiny and doubt in order to meet their long-run objectives.

The underlying problem is one of continually unhelpful feedback. Long-term investors receive constant feedback on their choices in terms of short-term performance and the narratives that accompany it. We perceive this to be meaningful information but it is nothing more than distracting noise.

Smart long-term investment decisions will often spend plenty of time looking like stupid ones. If we cannot endure this reality, we are likely to be drawn toward the dangerous allure of short-term performance chasing.

Trying to manage short-term performance is both exciting and exhausting. Exciting because we feel good about latching onto the latest fad or trend; exhausting because markets are fickle and unpredictable.

Caring about how we compare to others over the next quarter or next year will inevitably lead to poor outcomes. As we constantly chase our tail, predict the unpredictable, pursue grossly overplayed themes, buy at the peak, and sell at the trough.  

If such myopia is a sure route to poor results, why is it so prevalent? There are three primary factors at play:

1) It relieves stress and anxiety: Doing nothing for lengthy periods as a long-term investor is tough, particularly when we are receiving negative near-term feedback (our performance is disappointing). Making changes based on what is working right now makes us feel so much better.

2) We mistake short-term market noise for information: We are overwhelmed by a constant stream of data releases, opinions and, of course, fluctuating returns. The functioning of financial markets makes us believe that things are changing and that our portfolios must change as a consequence.

3) Our incentives are aligned with taking a short-term view: For professional investors, in particular, our incentives are almost inevitably aligned with adopting a short-term perspective. It is the safest way to build a career, stay busy and not lose our job / assets. People are happy with the short-term decisions we make as they will be pro-cyclical (buy the winners / sell the laggards) and we will have a story to tell. We won’t see the long-term costs because by the time they come to fruition we will most likely be in another job.

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Aside from a select few who wish to dabble in short-term market timing (best of luck), the vast majority of investors would be better off in focusing on the long-term. Unfortunately, that is far easier said than done. Both our behavioural wiring and the febrile nature of financial markets makes short-termism our default setting. If we are going to be long-term investors, we need to have a plan for how we are going to do it.

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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).

If you are a staunch advocate of index funds then the answer to the question of whether meeting active fund managers before investing with them is a waste of time is unequivocally yes. So, to avoid another active versus passive debate, let’s assume we have to invest in an active fund – is meeting with the fund manager necessary and does it improve the odds of success? During my all too long career fund manager meetings have been something of a sacred cow – of course you must see the ‘whites of their eyes’ before handing a fund manager your money, it would be madness not to. But is this true?

The received wisdom around the value of meeting fund managers is so pervasive that I have rarely seen any alternatives proposed – aside from the occasional and dreadful performance (chasing) fund screen. Of course, different people have different approaches to such meetings – some are happy to simply be presented to, while others prefer to grill a junior analyst on their forecast for operating margins in the smallest stock in the portfolio – but most seem to miss a critical factor. Whenever we enter into an interaction with another individual the decision we make will often be overwhelmed by a range of unconscious behavioural factors. We ignore these at our peril.

What are the main behavioural problems we are likely to encounter when meeting with a fund manager?

Halo effect – Perhaps the most challenging behavioural issue of fund manager meetings is the halo effect. This is where we allow a positive view of one aspect of an individual to impact our assessment of an unrelated trait. A fund manager is a compelling, articulate presenter – surely, they must also be a good investor?

Outcome bias – Even though past performance is a poor guide to future returns and the presence of skill; we are likely to find the answers of an outperforming fund manager persuasive and an underperforming manager weak. In this sense, fund manager meetings can serve to perpetuate destructive performance chasing behaviour.

Selection bias – Successful fund managers who raise assets are likely to be good presenters and confident communicators. It will have helped them through every stage of their career. The bad presenters are probably more interesting propositions – they have had the odds stacked against them in getting to where they are.

Reading people – Part of the appeal of meeting fund managers is to gauge whether they are trustworthy and credible. Yet most of us hugely overstate our ability to ‘read people’, understand their motives and separate fact from fiction.

Perpetuating tropes – We inevitably hold a range of misguided archetypes and tropes about what characteristics individuals in certain roles should possess. One of the reasons why so many fund managers are men (aside from deeply-ingrained societal issues) is that we are beguiled by gendered traits such as overconfidence and charisma – despite them being unrelated to being a successful investor. These traits are often well in evidence in traditional fund manager meetings.

People we like – Although it is difficult to accept, we will hold more favourable views of investors that we like as people.

Reciprocity – Another issue that we struggle to believe would influence us is the power of reciprocity. If someone does something for us, we feel compelled to return the favour, often in ways that are entirely incommensurate. Small gestures can have a huge impact and is a spectre that looms over relationships fund investors may have with asset managers.  

Charisma – Charisma hides a huge number of ills and a fund manager meeting is the perfect forum to mask a lack of competence with personality. There is nothing more dangerous to an investor than a lucky fund manager with charisma.

Information / confidence – There is often a conflation between the depth of research undertaken on a fund manager (“we have had 15 meetings with them”) and the quality of the resulting decision. There are two problems here. First, we can easily lose sight of what variables matter because we are subsumed by irrelevant detail. Second, past a certain point, more knowledge simply leads us to hold more confidence in our view without it becoming any more accurate. In this situation, increased information reduces decision quality.  

Information asymmetry – Inherent in the interaction in a fund manager meeting is an information asymmetry. The fund manager should know more about the securities they invest in than we do. Yet I have attended countless meetings where a view on a fund manager is formed based on how well they ‘know their stocks’. Unfortunately, rote knowledge of securities is not a necessary or sufficient condition for being a successful investor.    

Storytelling – An effective fund manager meeting (from the perspective of a fund manager) is an exercise in storytelling. It is designed to make us focus on the inside view at the expense of the outside view – that is to concentrate on the specifics of the fund manager in question, not the general probabilities attached to successfully finding a skilful active fund manager. “Who cares if the odds are 1 in a 100, that was a great meeting”.

Sunk costs – In a fund manager due diligence process, we must always be aware of the impact of sunk costs. Turning back or changing our minds after so many hours spent in meetings is a difficult thing to justify to ourselves and others.

Front stage / back stage – One approach some fund selectors take when assessing a fund manager is to observe team meetings to see how interactions take place and decisions are made first hand. This is viewed with scepticism by many who argue that if a team are being watched then it is not a genuine interaction. Yet these same critics are often happy to sit in a standard fund manager meeting, which is surely more artificial. The simple fact is that – as sociologist Erving Goffman noted – we all have a front stage and a backstage self. The waiter in a restaurant behaves differently when they are serving us to when they are in the kitchen. All fund manager meetings are performative, and we will never know the true functioning of a team unless we work at the organisation.

Management of self – It is not just the fund manager that performs in a meeting, it is the fund selector also. They might be in awe of the fund manager, who will often have more money and power than they do. They might even be in the meeting alongside their own boss or client. The temptation is often strong to ask questions that might reflect well on them, rather than those that help make a good decision. ‘Intelligent’ but empty questions are easily favoured over ‘simple’ but searching ones.  

A problem for other people – There is one overarching factor that amplifies the damage caused by behavioural issues and that is our ingrained belief that they don’t affect us: “Other people? Maybe. But they have never influenced my decisions.” Until we accept that they do, it will continue to undermine the effectiveness of fund manager meetings.

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The regard in which fund manager meetings are held is such that I have never heard any reasonable alternatives proposed, indeed suggesting such things might be regarded as heresy. But let’s try.

How about instead of a face-to-face meeting with a fund manager, we reserve time with them and ask them to respond to a set of bespoke questions by hand. They have to do it themselves and on their own. If we were assessing a group of fund managers, we could even blind the responses.

I can hear the howls of protest about the loss inherent in such a method. There has, however, been such little progress in this area nor acknowledgement of the behavioural pitfalls of the current approach that fresh ideas are needed.

One less controversial method to help enhance the value of fund manager meetings is simply for fund investors to be clear about what it is they care about. It is so easy to become lost in a sea of noise. The most effective way to alight on this is to ask ourselves – if I could only know ten things about a fund manager before investing with them, what would they be?

It is not simple to define, but can lead to a much sharper focus. Having an agenda is not enough, we need to be trained on what matters and why.

Would I want to invest money without meeting a manager? Probably not, but perhaps it is just because I have been conditioned to believe it is essential. What is critical is that fund manager meetings are based on evidence pertaining to the factors that we believe are important. We should also always be underweighting what is said and overweighting what is done.

Are fund manager meetings a waste of time? No. Is it a waste of time or worse if we don’t acknowledge or deal with the behavioural biases that we carry with us into those meetings? Almost certainly.

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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).

I started my investment career in 2004. Although equity markets had begun their recovery from the damage wrought by the dot-com bubble, the scars were still evident. All too regularly I saw client portfolios with tiny, residual holdings in once-celebrated technology funds – stark reminders of costly past decisions.  With the wonderful clarity and confidence that only hindsight can bring, I remember thinking how I would never be swept up by such lunacy and, in any case, it was unlikely to happen again – investors will have learnt their lessons. One look at the all too recent obsession with ape JPEGs, made up currencies, (empty) shell companies and, once again, stratospherically valued technology businesses would tell you quite how naïve I was.

Why is it that we can have such vivid and painful investing experiences but go on to repeat the same mistakes?

The central problem for investors is about behaviour and stories. One of them changes and the other doesn’t.

Lessons Not Learnt

GMO’s Jeremy Grantham was once asked what lessons investors would learn from the 2008 Global Financial Crisis, he replied: “In the short-term a lot, in the medium-term a little, in the long-term, nothing at all. That would be the historical precedent.” 

Part of this phenomenon is down to the half-life of painful investment episodes. Memories fade and scars heal. There is also always a new set of younger investors, unburdened by the baggage carried by the previous generation – ready to learn the same lessons anew.   

Yet this is not sufficient to explain the unerring cycle of mistakes. Most investors live through multiple spells of mania, greed, panic and despair. And, even if they haven’t, there is plenty to read about it. Despite the evidence, our behaviour doesn’t change.

Something Really Is Different This Time

The reason that it is so easy to discard the lessons of history is that the story is always fresh. We can reject the behavioural failings of the past as an irrelevance – this is a new situation and the old rules do not apply. Our focus is always on the persuasiveness of the narrative of the moment – it is how we interpret the world – rather than our behaviour.

Sir John Templeton’s famous comment about the danger to investors of the four words “this time it’s different” is absolutely true as it pertains to the nature of investor behaviour – that doesn’t alter. Yet our willingness and ability to repeat those poor behaviours arises only because the story is different each time.

The story changing allows our behaviour to remain the same.

Incentives (Always) Matter

No discussion of investor behaviour can be complete without a consideration of incentives. New stories allow and compel us to ignore behavioural lessons, and incentives act to leverage this effect, exacerbating the disconnect.

Investment narratives are wrapped up in a virtuous / vicious circle alongside performance and social proof. A captivating story, strong (or weak) performance and the behaviour of other investors creates a self-reinforcing loop, where one element validates the next. High (or low) returns seem to further corroborate the story and persuade more investors. And so it continues.

At some point most people get captured by the gravitational pull of this interaction. Whether it is the pain of poor performance, our neighbour making more money than us or the threat of losing our job. We become incentivised to behave poorly.

We don’t need everyone to believe in a story for it to overwhelm sensible investment behaviour, just enough so it becomes in almost everybody’s interest to go along for the ride.   

Is Our Behaviour Getting Worse?

Although our behavioural characteristics don’t change, there is a risk that the impact is becoming more severe. Why? Because there is more stimulus and more opportunity.

Financial markets are narrative generating machines. Not only does modern technology mean that we have more stories being created than ever, but they are effortlessly disseminated and amplified. Add to this the ability trade in an instant and we truly have a toxic behavioural concoction.  

There are no easy solutions here. It is not simply that we do not learn from our investing mistakes, but that we are likely to make more of them.

It is undoubtedly harder than ever for investors to behave well.

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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.

Imagine we are attempting to design a stock picking model that will outperform the market over the next ten years. After a great deal of forensic research and testing we finalise our approach. Although we couldn’t know this in advance, the system we devise is optimal – there is no better way of tackling the problem we are trying to solve. Given this, what are we likely to do with the investment process we have developed over the coming years?

Change it and make it worse.

Even if we design a perfect investment approach the temptation to tinker and adjust is likely to prove irresistible. Why is it so difficult to persevere even when we have a sound method?

There is a mismatch between short-term feedback and long-term goals: If the objective of our investment process is long-term in nature; using short-term performance as a means of assessing its robustness is likely to be at best meaningless and at worst entirely counter-productive. All investment approaches will endure spells in the doldrums and reacting to these with constant process modifications is a certain path to poor results.  

The need to always be doing something: Keeping faith with an investment process for the long-term means a lot of time doing nothing. This sounds easy but is anything but. Financial markets are in a constant state of flux, perpetually generating new and persuasive narratives. Temporary fluctuations in markets often feel like a secular sea change when we are living through them. The urge to act is strong.

Doubting the process: When our approach suffers from poor short-term performance there will be intense pressure to change. This will be through internal doubt (what if my process is broken?) and, for professional investors, external pressures – ‘you are underperforming, do something about it’. Changing our process can make us feel better (less stressed, pressured, anxious) even if we don’t believe it is the right thing to do.

Feeling in control: The instability and uncertainty in financial markets can be deeply disconcerting; process adjustments can, erroneously, feel like we are wrestling back some form of control.

Overweighting recent information: Recency bias means that we will tend to overweight the importance of current events and heavily discount the past. Given the inherent variability of financial markets over short time periods this will mean we are continually tempted to adjust our process based on what is happening right now.

Overconfidence: Our ability to have a positive impact is hugely overstated. If we have a prudent investment approach to start with, improving it is not likely to be easy. We will inevitably grossly exaggerate our ability to implement changes that will improve our odds of success.

Optimising not satisficing: Our desire to adjust and attempt to enhance our investment process is driven by a belief that we should be optimising – finding the very best solution. While this is a noble aim in theory, the profound uncertainty of financial markets makes it dangerous in practice. An eternal and elusive search for the best investment process is likely to lead to at least as many bad decisions as good ones. Satisficing – adopting a strategy that is good enough – and maintaining it is likely to be the best route for most of us.

Intellect over behaviour: Our process changes will tend to be focused on the intellectual pursuit of finding new sources of information or applying them in different ways. Scant attention seems to be paid to the behavioural challenges of investing. The most robust investment approach will be torn asunder if we don’t have the fortitude to persevere with it.

It may seem as if I am suggesting that we should never attempt to improve our investment process. This is not the case. Striving to learn and develop is vital. It is critical to understand, however, that our tendency will inevitably be to do too much, often at the wrong time. We need to have an appropriately high threshold for change.

Never underestimate the advantage gained by an investor who has a sensible method and can stick with it.

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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.

Outperforming fund managers are dangerous for investors. Performance is cyclical and often mean reverting, and we tend to invest after periods of unsustainably strong returns. If these features aren’t damaging enough, there is another problem. If a fund manager has a strong track record we listen with rapt attention to everything they say about anything. If their returns are poor, we disregard their words. This may sound sensible but it is anything but.

We can see this phenomenon with certain growth / quality orientated active fund managers in recent times. As they generated stellar returns for a decade, we were hanging off their every word. Happy to treat them as sagacious on whatever subject they chose to opine on. Now performance has deteriorated our reaction to their utterances is more likely to be: “why would we listen to this idiot, haven’t you seen their returns over the past year?”

This mindset set is steeped in two behavioural issues: outcome bias and the halo effect.  Outcome bias means that once we see the result (in this case fund performance) we jump to a conclusion about the quality of the process that led to it. The halo effect is where an individual’s success in one field means that we (usually erroneously) hold a positive view of anything else they turn their hand to.

This is a toxic combination, which leads us to pay attention to people we shouldn’t and ignore those we should take heed of.

Why is it such an issue?  

There is a huge amount of luck involved in investment outcomes: From the unique life experience of a star fund manager to the early morning ice bath routine of a successful entrepreneur, we cannot help drawing a causal link between an individual’s success and their past actions. Yet so often the outcomes we see are nothing more than a mix of luck and survivorship bias, this is particularly true in the field of fund management.

Fund manager performance is cyclical: For even the most talented investor their fortunes will move in cycles. Periods in the sun will inevitably be followed by spells in the doldrums, even if the long-term trend is positive. Our use of performance as a marker for credibility means that we will frequently see the words of the prosperous chancer as more convincing than someone with genuine expertise.

Expertise is particular: Skill in investing, where it exists, is narrow and specific. Yet once a manager is outperforming, they have the freedom to confidently pronounce on any subject within the universe of financial markets (and sometimes far wider than that). Not only do they pontificate on these issues but we are willing listeners – their track record doesn’t lie! The pinnacle of this behaviour is where a fund manager – through some combination of hubris and necessity – shifts into an entirely different area to the one in which they forged their reputation and investors follow in their droves. This always ends well. 

We use past performance as a heuristic. In this context, as a quick and simple shorthand to give us an easy answer to the complex question: Should I pay attention to what this person is saying?

Amidst the squall of investment voices that surround us applying a (industrial strength) filter is essential, but if past performance is fickle and ineffective how do we go about it? There are three simple questions we should be considering:
 
1) Is it a relevant subject? The critical starting point is asking whether the subject is even worth our time. Is it something that matters to our investment outcomes and where expertise can exert an influence? If it is someone speculating on what will happen in markets over the next three months, we can happily disregard it.

 2) What are their motives?  We should always be sceptical in listening to a perspective from someone who is trying to sell us something, but this is not as straightforward as it may seem. If an investor genuinely believes in what they are doing, then they will inevitably be seen as “talking their book” but what else would they talk? It is not always easy to separate a knowledgeable advocate from a slick salesperson. The best differentiators are probably consistency, humility and depth.

3) What is their circle of competence? Judging an individual’s circle of competence is essential, and there are two aspects to consider. First, we need to understand the specific expertise they may possess. We should be as precise as possible here – “investing” does not count! Second, we must gauge why the individual has pedigree and credibility in their field, particularly relative to others.  

This approach may not quite be as effortless as checking whether a fund manager has produced stellar performance before deciding whether to pay attention, but it is likely to be more effective. The fact that there are far too many voices distracting investors is problem enough, we don’t need to compound the situation by listening to the wrong ones.

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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.

The long-term struggles of active funds versus index funds is primarily a problem of fees. There are other factors that influence the success rate of active strategies – most notably, in equities, the performance of small and medium sized companies relative to their larger counterparts – but it is the compound impact of highs costs over the long-term that causes most of the damage. Attempts to create charging structures that diverge from the simple % of assets under management model are typically focused on the use of performance-based fees, but in the vast majority of cases these (somewhat counter-intuitively) increase the negative asymmetry experienced by investors. Too often we pay lavish short-term rewards for underwhelming long-term results. To improve the odds of active fund success, the fee model needs a rethink.

One of the most egregious problems faced by fund investors is the problem of scale. As the size of a fund grows its profitability for an asset manager increases materially. Not just in terms of the revenues generated, but the profit margins. High operating leverage means that the marginal cost of an additional $100m invested into a $10bn fund is low. It is in the interests of asset managers to keep growing their largest funds.

There are two major difficulties that this model causes investors. First, is that the benefits of scale rarely have a material impact on the costs that they incur. As fund size grows and costs are spread across a greater revenue base this results in an improved margin for the asset manager but rarely a meaningful fee saving for the investor. Second, above a minimum threshold the growth in assets of a fund reduces the potential for future excess returns. Rising fund size means that the opportunity set is reduced, flexibility is compromised, and liquidity deteriorates.  

We are left with a situation where the investor faces a lower probability of outperformance whilst the profitability of a fund for an asset manager increases.

This is a major incentive problem for asset managers and creates a jarring misalignment with the objectives of their investors. Undoubtedly it is one of the primary reasons that funds are so rarely closed due to capacity constraints.

Is there a way of mitigating this problem and improving the situation for fund investors?

One option is to apply a $ revenue cap. How would this work?

A fund would launch with a standard fee level, let’s say 0.5%; but there would be a provision stating that all revenue earned over a certain amount ($Xm) would be reinvested into the fund. This would mean that above a given threshold of assets under management the benefits of scale would accrue to the underlying investors and provide compensation for the cost of asset growth in terms of declining performance potential. It would also greatly reduce the incentives of asset managers to ride roughshod over capacity concerns.

The advantages of such an approach are clear, but what are the potential drawbacks:

– Asset managers might increase fee levels to compensate for the cap. This is certainly possible but would only serve to further inhibit future performance.

– Asset managers may launch more products to mitigate the impact of capped costs, in particular launching similar / mirror versions of the constrained strategy. The last thing anybody needs is more funds.

– It might subdue innovation and development as large, ultra-profitable funds are no longer able to subsidise fledgling ventures or research. I am not sure I believe this is a genuine problem even as I write it.

– There may be technical difficulties (documentation etc…) if the size of a fund declines and investor fees increase. This doesn’t seem to be an insurmountable hurdle, but fee variability is not ideal.

A $ revenue fee cap is clearly going to be unattractive to the largest and most profitable asset managers, and this is not the only way that the current fee model can be improved. It is, however, an area that is ripe for disruption and where there is significant potential to improve both investor alignment and outcomes.

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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.

Although many people do it, making forecasts about how financial markets will fare in 2023 is an entirely pointless endeavour. What we can predict with some confidence, however, is how investors will behave – that doesn’t change much. So, what will we all be doing in 2023?

– We will spend a lot of time dealing with an event that hasn’t yet occurred and which will not matter to our long-term returns.

– We will make changes to our portfolios based on what happened in 2022. Not because it makes sense from an investment perspective, but so we can avoid having painful conversations about underperforming funds and assets.  

– We will speculate that an asset class or investment strategy is dead and no longer works.

– We will forget that we once said an asset class or strategy was dead after it makes a dramatic resurgence.

– We will become an ‘expert’ on an issue that we don’t currently know anything about.

– We will view what occurs in 2023 as inevitable, after it has happened.

– We will wonder what an underperforming fund manager is “doing about” their poor returns.

– We (alongside 7,534 other people) will spend a lot of time writing meaningless, short-term market commentary that few people will read, nobody will remember and pray that ChatGPT will soon come to our rescue.

– We will check markets and our portfolios far too much.

– We will have even less time to think than we anticipate.   

– We will tell somebody that the free time in our diary wasn’t an available slot for a meeting, but actually an opportunity to do some work.

– We will talk in certainties, not probabilities.

– We will speak confidently about short-term market performance as if it isn’t just random noise.

– We will extrapolate whatever happens in 2023 long into the future.

– We will not spend any time on how to improve our behaviour or think long-term, even though it always seems like such a good idea.

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We know that these behaviours are damaging, but it is difficult to stop them. It is in our interests to play the game. It is more lucrative and less personally risky to be part of the problem. We either feed the monster or get eaten by it.

What should investors be doing? Thinking, reading, walking, ignoring and trying to appreciate how much of the behaviour that is expected of us is of detriment to our long-term results.

If nothing else, we should all spend 2023 trying to give off a little less heat and a little more light.

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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 order a copy here.

A friend of mine was out on a run. He was on his usual route going down a narrow lane when he came across an ominously large puddle – it had been raining torrentially for the past few days. There was no way around it, he either had to turn back or go through it. Although the puddle was long, he assumed it would be shallow, so forged ahead. It was deeper than he expected, the icy water quickly covered his shoes. Thinking that would be the worst of it he carried on. But it kept getting deeper. The water went past his ankles and he wasn’t quite halfway through. As he was already cold and wet there was no point turning back, so he checked to see if anyone was watching and continued his increasingly slow paddle.  As he persevered and the water splashed up to his knees he wondered how long he would keep going if the puddle got deeper still. He had visions of just his head bobbing above the water. Fortunately, knee-height was as deep as the puddle got and he didn’t get to test quite how far his prior commitment would take him.

This must have been a bizarre sight for any onlooker.  Why would someone try to run through a puddle that deep? No rational human would consider that to be a sensible idea. Yet, of course, my friend would have agreed with this, right up until the point that he decided to put his foot in the puddle. As soon as he made that decision, everything changed.

It is easy to think of the choices we face as discrete, one-off decisions with a set of specific consequences (good and bad), but they are not. Each time we make a decision it impacts the choices we will be able to make in the future – it might commit us to a certain direction or close off other potential routes. There is a huge amount of path dependency in the decisions we make. This means that we should not consider only the immediate implications of any option we pursue but also its consequences for our subsequent behaviour.

Why did my friend continue running through a ridiculously deep puddle? Because he had already committed to the action. Not only had he incurred the cost of being wet, but he also didn’t want to feel or look stupid for choosing to do it in the first place. If he persevered it might look intentional.

He had set a new path.

There are three aspects to a decision that tend to influence how influential it might be over our future choices:

1) Does it impact our identity?

2) Does it change our incentives?

3) What costs will it incur?

Although these are inter-related, we can consider them separately:

Identity:

Whether a decision serves to shape our identity can be critical to our future choices. How we see ourselves or how we wish other people to see us will have profound implications for the choices we make or even the opinions we express. Once we make the implicit or explicit choice to create a particular identity, every subsequent judgement we make is framed by a desire to manage and bolster that it. We strive to make decisions that are consistent with our desired image.  

We see this behaviour clearly in politics – once we make a choice to align with a particular party or doctrine, everything we see is through that lens. Investors are also frequently guilty of allowing views and opinions to morph into an identity, through which all subsequent judgements are filtered. Often irrespective of evidence.

Incentives:

Incentives drive behaviour, so we must be particularly wary of any decision that materially shifts our incentive structure. We are likely to significantly understate how influential varying incentives will be on our future choices. The most painful and damaging scenarios are where there is a dissonance between what we believe and the direction that our incentives are pointed – “I believe that financial markets are highly uncertain over the short-term, but I make money if my clients trade more”. To resolve such friction, we will tell ourselves all sorts of stories to provide psychological comfort. In the end it is likely that our incentives will re-shape our beliefs.

Costs:

Sunk costs wreak havoc with future decisions. Whenever we expended significant time, effort or money on a choice, we find it incredibly difficult to change course. The idea of the sunk cost fallacy is now ubiquitous but it does not make it any easier to overcome.  Admitting we were wrong, moving backwards, or accepting ‘wasted money’ are too often deemed unpalatable. When we think about sunk costs we shouldn’t consider them as historic mistakes, instead they are very much recurring costs that are impairing the choices we are making right now.   

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When my friend was considering whether to run through the puddle, he was judging how likely it was to be deep, whether he minded soaking his feet and if it would ruin his running shoes.  What he should have been assessing is what he would do if he decided to go ahead and the water was too deep – how could he turn back? The consequences for his future decisions were just as important. 

If a choice has implications for our identity, the incentives we face or the costs we incur, we should be especially careful when making it. This is not just about the difficulty of quitting or the problem of commitment escalation, but how decisions made today can change everything about the decisions we will make tomorrow.

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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 order a copy here.

There are still too many people investing in active funds. Not because they are unnecessary, but because owning them comes with a unique set of behavioural challenges that we are often unprepared for. If we are to have any hope of benefitting from holding them, we must accept and embrace these. The worst – and all too common – scenario is investing in active funds whilst holding entirely unrealistic expectations about the realities of doing so. This dooms us to almost inevitable failure and disappointment. Before investing in active funds there are three questions we need to answer:

– Am I willing to own a fund for the long-term?

– Can I discount short-term performance?

– Can I withstand long periods of underperformance?

Let’s take these in turn:

Am I investing for the long-term?

As the investment industry has become increasingly myopic, I have had to moderate my view on what the long-term is because it seems too outlandish. I have heard people discuss the long-term as three years or more, but this is far too short  – it is much closer to 10 years. The longer our time horizon, the greater the odds of investment success.  Why is an extended time horizon so important? Because the shorter it is, the more our results are beholden to randomness and fickle swings in market sentiment. If we believe there is a strategy with an edge, we must give it time to play out, for fundamentals to exert themselves over noise. This does not mean that we must persist with an active fund whatever happens or that simply increasing our time horizon guarantees better results, but it at least gives us a fighting chance.

Can I discount short-term performance?

It is one thing to say that we are willing to own a fund for the long-term, doing it is another thing entirely. The biggest impediment to long-term investing is obsessing over short-term performance. Not only is it an entirely fruitless activity that sees us attempt to read patterns in the chaotic fluctuations of financial markets, but we persistently make poor decisions based on such fleeting observations. Each time we check performance, write a report or hold a meeting we are creating a decision point; another opportunity to make a near-sighted judgment. We need to be realistic about our situation – if the short-term matters (whether we want it to or not) active funds really should not be for us – it will simply mean constant anxiety and frequently poor choices.

Can I withstand long periods of underperformance?

Although incredibly damaging, the hardest part of active fund investing is not the senseless fascination with short-term performance, but the prolonged and painful periods of underperformance that are an inevitable feature of any active strategy. All skilful (and unskilful) active fund managers will go through years of underperformance – this is inescapable. Living though this on a day-by-day basis is exhausting and exacting. The doubts about the strategy – whether the manager has lost her edge, whether the process is broken or the market environment irrecoverably changed – will often be overwhelming. Yet if we want to successfully invest in active funds then we need to find a way to withstand them.  The alternative is believing that we can time our investment into active funds so that we capture the good times and avoid the bad (we can’t).

The problem with this required fortitude is that it is music to the ears of the unskilled active fund manager who will be delighted if we persist in investing with them despite their lack of ability, but this is the job of the active fund investor – to identify skill without relying on past performance.  If we cannot tolerate lengthy spells of poor relative returns, we should not be investing in active funds.

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If we answer these three questions in the affirmative, it does not mean that we should invest in active funds; these are simply the minimum entry requirements before we even consider attempting it. If we answer any of them negatively, we really should not be doing it at all.

None of these features are easy to deal with or manage, in fact the behavioural aspects of active fund investing are just as tough as finding a manager or strategy with an edge. Far too many investors neglect this and leave themselves in a position where the odds of success become vanishingly small. 

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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 order a copy here.

The moment has finally arrived. The Intelligent Fund Investor is published today!

Most of us invest in funds and the choices we make will have a profound impact on our financial futures. The problem is that fund investing is a decision-making nightmare. We are faced with a bewildering assortment of options and are constantly buffeted by market noise and narratives. Against this backdrop practising good investing behaviours is incredibly difficult. 

Despite these challenges there are surprisingly few books available to help us with the unique set of problems fund investing poses. The aim of The Intelligent Fund Investor is to fill this gap. I hope it can help all types of investors avoid costly mistakes and make better decisions.

You can buy a copy here right now.

If you enjoy the book, I would be incredibly grateful if you could leave a review. If you don’t like it, please don’t tell anyone!