What Do Investors Believe They Can Do But Can’t?

It is often said that a useful measure of happiness is the gap between reality and expectations. A similar approach can be adopted for identifying poor investment decisions. They tend to occur when our expectations of what we are capable of exceed the reality. This miscalibration leads us into activities and behaviours that we really should avoid.

Here are some of the most significant examples of what we think we can do, but probably can’t:

  1. Time markets: Perhaps the most grievous example of investors overestimating skill is a belief in market timing. This is not just predicting what will happen, but when it will occur. The second part of this equation is even more difficult than the first. Forecasting with any precision the behaviour of a complex, adaptive and chaotic system is just not feasible.

  2. Truly understand complex funds: Complex funds are alluring because they come with outlandish promises of high returns and low, differentiated risks. They also breach a cardinal rule of investing – don’t invest in things we don’t understand.

  3. Predict inflation (or other macro variable): Our inability to accurately forecast macro economic variables seems to have no impact on our willingness to keep doing it.

  4. Pick funds that consistently outperform: The greatest myth in fund investing is that any manager or strategy can consistently beat the market. Even a skilful fund manager will underperform for prolonged periods. When we fail to realise this we get trapped in a painful cycle of selling losing funds and buying yesterday’s winners.

  5. Withstand poor performance: Spells of weak performance are inevitable for any strategy, fund or asset class. These are easy to deal with in theory, but the lived experience is an entirely different proposition. The stress, anxiety and doubts that occur during difficult periods will lead us to make poor decisions at just the wrong time.

  6. Ignore a compelling story: Every bad investment comes with a beguiling story. We think that it is other people that will be taken in, but, one day, it will be us.

  7. Be a long-term investor: The great rewards available for long-term investing only exist because it is so difficult to do. Doing very little feels like the easiest task in the world, but the temptation to act is so often overwhelming. Every day brings a new story, a new doubt, a new opportunity. A new reason to be a short-term investor.

  8. Avoid dangerous extremes: Most of what we witness in financial markets is just noise, but extremes matter. When performance, sentiment and valuations are at extremes (either positive or negative) the opportunity is for investors to take the other side; unfortunately, the pressure to join the crowd will likely prove irresistible.

  9. Overcome terrible odds: Investors frequently make decisions where the odds of success are incredibly poor. We think that we will be the person to actually make money from a thematic fund or invest in a star fund manager who keeps producing astronomical returns. We just cannot help ignoring the base rates.

  10. Find the ‘one’ investment: Although investors are aware of the benefits of diversification, it is a little boring and an admission of our own limitations. We would prefer to find the ‘one’ investment that will transform our financial fortunes, whether it be a stock, theme, fund or ‘currency’. Such ambition does not tend to end well. 

Throughout my career I have heard people say that ego and a level of arrogance are a pre-requisite for a successful investor because there is a requirement to ‘stand out from the crowd’. This is nonsense. These are dangerous traits, not beneficial ones. Far more valuable is being humble about the challenges of financial markets and aware of our circle of competence. We need to avoid being our own worst enemy.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Ignoring My Own Behavioural Advice

Since starting work in the investment industry in 2004, I have managed to accumulate a selection of pensions by virtue of having several different employers. Maintaining these was becoming increasingly cumbersome and inefficient, so I decided to consolidate them into a single account. As I probably have more than 20 years until retirement my pensions are close to 100% invested in equities; however, the process of moving them into a single scheme will mean that everything is sold. My pension will become 100% cash. I know the rational decision is to immediately reinvest the money back into equities, returning my pension to its former state, but I don’t want to do that – why?

Having studied and written about behaviour for many years, I feel reasonably well-versed in the dangers and pitfalls that lead to poor and costly decisions. The problem is that this doesn’t make me immune to them.

My reticence to immediately reinvest my pension into equities stems from my concern about the current environment; I can foresee a scenario where central banks hike rates into a recession with negative ramifications for equity markets. There could be a much better time for me to put the cash back to work.

There are, however, some very important caveats to this view:

  1. I have no skill whatsoever in predicting short-term economic and market developments, in fact I do not believe that anyone does. The value of my views or feelings about the near-term prospects for markets is close to zero.

  2. Everyone is bearish. Many indicators of investor pessimism are at maximum readings. Whenever all investors agree about the future we can guarantee one thing – something else is going to happen.

  3. There are always reasons to be worried. There are very few occasions where it doesn’t feel like an uncomfortable time to invest; indeed, we should be more worried when we feel sanguine.

  4. The only reason I am holding cash is because of an administration decision I have made; it has nothing to do with investment. If I had not attempted to streamline my pensions, I would not even be in this situation.

The behavioural predicament I find myself in is one of regret aversion. What if I invest the cash and equities fall another 30%? I will feel awful. I ‘knew’ this was going to happen and I didn’t do anything about it! Regret or the prospect of it is a very powerful influence on decision making.

So, what are the options?

I could hold cash until I identify a more opportune time to invest. This is an unequivocally terrible idea, which will likely have dire consequences and provoke the opposite type of regret.

The alternative is to gradually invest the cash into its desired end state – pound or dollar cost averaging. This will smooth out my entry price and ensure I mitigate the risk of investing at a single, untimely moment. It is also a sub-optimal approach.*

If I have a long-time horizon and a lump sum, investing it immediately into equity markets is the rational choice. Equity markets rise more often than they fall, and, therefore, making phased purchases is likely to reduce returns.

The advantage of pound / dollar cost averaging is that it is a regret minimisation strategy. If markets rise during the period of investment at least I have started to invest the cash and, if they fall, I can be glad that I didn’t go all in. Despite its limitations it is also a significantly better option than trying to guess the right time to invest, which is a fool’s errand.

I know that I cannot predict or time financial markets, and I am aware of what the rational, optimal course of action is. Yet it feels like the wrong thing to do. If I were to take the averaging in option, I would be paying a financial cost simply to limit the feeling of regret. Wilfully opting to pay a behavioural tax.

Humans are just not designed to make sensible investment decisions.   

* The pound / dollar cost averaging described here is very different to the eminently sensible process of making regular investments into our pensions or savings account from our salary. These are actually small, incremental lump sum investments based on the cash we have available each period.  

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

How To Identify Behavioural Investment Opportunities and Risks

It is easy to think about investment behaviour as a problem for the individual, a risk that we need to manage to avoid poor choices and costly mistakes. But it is much more than that. The challenges that we encounter as solo investors – our tendency to extrapolate, our susceptibility to stories, our obsession with random short-run outcomes (I could go on) – also operate in aggregate. They impact everyone. Major market anomalies arise because of group behaviour. If we want to exploit behavioural opportunities and avoid the risks, we need a framework for recognising them.

Identifying behavioural opportunities and risks is about comparing two critical facets of investment – evidence and expectations. Behavioural irregularities become apparent when there is a disconnect between what the weight of evidence tells us about a likely investment outcome and what market expectations are. What is in the evidence versus what is in the price. The greater the divergence, the greater the prospect or danger.

I will discuss in more detail how we should think about evidence and expectations later in the piece, but first I want to present a simple matrix that we can use for categorising where our investments sit from a behavioural opportunities and risks perspective:

Behavioural Opportunities and Risks Matrix:

The matrix is easy to use. For any investment we start by proposing a hypothesis, such as:

This asset class / fund / strategy will deliver above average returns over the next ten years.

We can then assess how strong the evidence is that this proposition is true, and whether market expectations for the investment are positive or negative. 

Let’s take each quadrant in turn:

Quadrant 1: Strong Evidence / Negative Expectations: This is the most attractive area from a behavioural opportunity perspective, it is where robust evidence is seemingly in conflict with market expectations. 

An example of this would be the value factor in equities in recent years. The evidence that there is a long-term premium attached to this factor is strong, but market expectations were dire – this could be seen in pricing, performance and general sentiment.

Such situations give investors two chances to benefit – the evidence that there is an additional return available in a steady state, plus the potential reversion of extreme market / behavioural positioning.

There is a problem, however. Although this quadrant presents the greatest opportunities, they are also the most behaviourally challenging.  Market expectations conflict with the evidence – so if we follow the evidence most people will think we are wrong. The more extreme the market positioning, the greater the potential return, but the more intense the pressure will be to fold.

We can think of the returns in this area as – at least in part – a reward for the behavioural fortitude required for this type of informed contrarianism.

Quadrant 2: Strong Evidence / Positive Expectations: Here market opinion aligns with the evidence. There are solid reasons to believe an asset, fund or security should deliver favourable outcomes and market sentiment is consistent with that. Positive evidence allied to positive sentiment.

The major pitfall for investors with assets in this quadrant is where positive expectations become so fervent and valuations so stretched that this significantly dampens the prospective return – despite robust evidence of an investment’s efficacy. For example, our hypothesis might be that on a long-term (10 year+) view a market cap based global equity allocation approach is optimal, yet in situations such as the Japanese equity bubble when a market trading at near 100x cycle adjusted earnings made up close to 50% of global indices, that assumed advantage diminishes. Expectations can run so far that they can compromise an investment even when supported by reliable evidence.

Quadrant 3: Weak Evidence / Positive Expectations: This is the worst quadrant for (most) investors to be involved with. These are situations where the evidence supporting good outcomes is weak but the market is behaving as if the opportunity is incredibly attractive. In this type of scenario there is typically severe friction between evidence and stories. There is likely to be talk of ‘new paradigms’ for investments in this quadrant.

A prime example of this would be a star fund manager at an extreme positive in their performance cycle. The evidence would strongly suggest that funds that have generated extraordinary returns and hold stocks at astronomical valuations will go on to (severely) disappoint. Yet market expectations are telling us something different – inflows will be increasing, the manager will become prominent across all media outlets and narratives will be weaved about their otherworldly abilities. This scenario is a major behavioural risk for investors where the potential for catastrophic losses is very high.

Unlike quadrant 1, however, this type of investment will be behaviourally comfortable, perhaps even exciting. The broad evidence about funds with stellar performance will be roundly ignored, in favour of the far more exciting stories that will be told about this specific manager. And, of course, it will be persuasive because the track record is so strong!

Quadrant 3 should only be a hunting ground for momentum investors, who are interested in the price trend of an investment rather than the fundamental evidence. The behavioural fervour should present an investment opportunity, and they should have the rules and disciplines to exploit it dispassionately. Everyone else should avoid.

Quadrant 4: Weak Evidence / Negative Expectations: This quadrant is where investment stories go to die, and is a short seller’s paradise. Not only is there weak evidence supporting an investment delivering good outcomes, but market expectations have soured and now support that view.

A recent example of an investment residing in this quadrant is ultra-high growth companies over the past eighteen months, which have moved from quadrant 3 to quadrant 4. There is scant evidence that expensive, growth companies deliver good long-run outcomes and market sentiment has turned dramatically against them. This is a toxic combination.

Quadrant 4 is where a behavioural risk has been realised.

There are potentially opportunities here for short sellers, and also for naive contrarians who will invest on the basis that expectations have become simply too negative.

Moving Between Quadrants

As is hopefully apparent, profits and losses from behavioural opportunities and risks are generated primarily when an investment moves across quadrants because of changing expectations. Profits will be realised from a movement between quadrants 1 and 2, whereas losses will be incurred in the shift between 3 and 4. The gap between expectations and evidence closes, either positively or negatively.

What is Evidence?

While the matrix is designed to be simple, the decisions about where an investment should sit will often not be (although at times it might seem obvious). The first challenge is judging the strength of evidence. This is not about deciding on its validity alone, but which evidence to use.

The best way to think about this problem is to delineate between two types of evidence – an outside view and an inside view. The outside view will be the general evidence from history about similar situations. In the star fund manager example I used to explain quadrant 3, this would be looking at all previous instances where funds have delivered comparable levels of excess returns or had similar valuations. This would form our base rate – on average what does future performance look like for funds with these characteristics?

We can complement this with an inside view. These are the details specific to this particular investment. The features of the fund manager, environment and portfolio that might provide relevant insights.

Our tendency is to heavily overweight the inside view because it is more salient, recent and compelling, but this is entirely the wrong approach. The assessment of the strength of evidence should be heavily biased towards the outside view, with a modest adjustment from the inside view. We should not make an investment without taking an outside view and understanding the base rates involved.  

What are Expectations?

Although the idea of market expectations seems quite nebulous and difficult to define, in some ways these are easier to judge than the evidence. I would simply look at three factors to quantity expectations: performance, valuation and momentum. If medium-term returns have been abnormally robust, valuations are rich relative to history and shorter-term momentum (under 12 months) strong then it is easy to tell where expectations are, with the reverse also being true. The more extreme these measures, the more likely there are to be behavioural opportunities and risks present.

Extremes Matter

Extremes are incredibly important. Most of what we see in markets is noise – normal, random variation around some long-term trend or average. It is impossible to make judgements about such fluctuations and they should be largely ignored. It is when expectations and opinion reach extreme levels that behavioural risks and opportunities will become acute. This is because taking contrary positions against unjustifiable extremes is so difficult – running counter to the crowd is against our instinct and most likely our incentives. Going against the evidence and following outlandish expectations will feel comfortable but come with a heavy behavioural tax.

It is impossible to define what an extreme is (although we will probably know it when we see it).  We might want to define specific levels or merely just monitor valuation, performance and momentum relative to an investment’s history – there is no perfect way to approach it. Whatever strategy we adopt for identifying extreme expectations, we will never accurately call the peak or trough. 

Not a Timing Tool

Though it is possible to observe extreme dislocations between expectations and what the evidence tells us, we will not be able to successfully judge when such a gap will close (unless we are incredibly lucky). Extremes can persist for longer than we think and become more extreme than we ever felt reasonably possible. This presents a particular problem because sensible, evidence-based decisions can look quite the opposite for prolonged periods of time.

There are two important consequences that stem from our inability to time markets, even when the evidence strongly supports out view: i) We must be aware of our behavioural tolerance for investment views to continue to move against us, even when things appear detached from reality. ii) As investors we should not be trying to make heroic calls on markets, but merely make sensible decisions that will work on average through time, while avoiding disasters. We are trying to get the odds on our side, rather than bet everything on 15 black.  

What Does it Miss?

The main limitation of this approach to identifying behavioural opportunities and risks is the potential to misjudge the evidence. We might use the wrong evidence – such as an incorrect, biased sample – or overweight specific parts, such as the inside view. The evidence we use should be as impartial as possible, but of course the way we search for it and decipher it will be influenced by our own priors and preferences.

The other issue is where there is a gap between evidence and expectations, but it closes in the opposite manner to what we expect – the evidence comes to meet with expectations. This will be a ‘paradigm’ or ‘regime’ shift situation, where historic evidence is no longer (or at least less) relevant. Of course, whenever market expectations are stretched and diverge materially from the evidence it always feels like a paradigm shift, until it doesn’t. We can be successful investors without ever predicting such unlikely events.

Who Can Use It?

This approach to identifying behavioural opportunities and risks might seem quite niche, but it is relevant to all investors. Understanding evidence and market expectations is central to any decision that we might make. Even investors who want to reside firmly in quadrant 2 and have no appetite for the potential pain and anxiety that comes with the opportunities in quadrant 1 should still think in these terms – why? Because even the most strongly evidenced investment will at some point in time be out of favour and found in quadrant 1, or be enjoying such positive expectations its future returns are materially compromised.  Also, at some juncture, we will inevitably be lured towards the spectacular stories being told about the investments that sit in quadrant 3. Thinking about where our investments are in the matrix can help us manage the challenges of such situations.  

Understanding Behavioural Opportunities and Risks

While understanding and controlling our own behaviour is paramount to good, long-term investment outcomes; we cannot ignore the behaviour of our fellow investors. Indeed, our own actions are typically a response to the aggregate behaviour of other market participants – the choices made, and the stories told. Not only do we tend to focus overwhelmingly on the expectations and behaviours of others at the expense of the evidence, but we make the wrong inferences about those expectations – assuming that extreme positive returns in the past are a prelude to similar results in the future, being the prime example.

If we want to make the most of the opportunities that arise from investor behaviour and avoid the risks, we need to assess the evidence supporting our investment decisions and judge how they compare with investor expectations.

Watch for the gaps.   

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Should Fund Investors Pay Lower Fees for Making Long-Term Commitments?

Investing in funds for the long-term has never been more difficult. Not only do we have to face an incessant cacophony of market noise, but we can trade on a daily basis. An environment heavy on stimulus and light on friction is of detriment to both investors, who are constantly tempted by the next shiny object, and asset managers who operate as if the money they are responsible for might be withdrawn tomorrow. This destructive myopia is endemic across the industry. There must be a better way.

One path is to think about the power of incentives. Can behaviours be changed by reducing fees for investors willing to commit to investing for the long-term?

It is not that the benefits to investors of greater choice, access and control are non-existent or immaterial, it is simply that the behavioural costs are both hidden and profound. The more that technological advancements make the lives of investors easier, the harder it becomes to reap the benefits of long-term investing. We spend far too little time considering this damaging dichotomy.

We should also not ignore how increasing short-termism creates entirely the wrong incentive structure for asset managers. If they know that money in daily dealing funds can be removed in a moment, what types of behaviours does this encourage?

– Obsessing over short-run results.

– Launching flavour of the month funds.

– Firing managers for poor short-term performance.

– Rewarding short-term decision making.

Asset managers and the fund managers that work for them won’t make long-term decisions if they don’t believe they will be here for the long-term. Short-term survival becomes the primary goal.

This creates a vicious circle where investors exist in against a backdrop that fosters short-term decision making and asset managers react to that perceived need by operating in a fashion that exacerbates such behaviour. And so, the cycle continues.

This situation is not in the interests of investors or well-intentioned asset managers.  

Is this an inescapable reality, or can changes be made to improve the situation?

Given the power of incentives to drive behaviour there must be a means of rewarding investors for making long-term choices. Although long-term investing has substantial benefits, these accrue slowly and we only become aware of them when it is too late – we need something more prominent.

One option would be for asset managers to offer discounted management fees on special share classes which investors can only redeem after a set period. The same daily dealing, public market fund we would normally invest in but with certain ‘commitment’ share classes available for long-term holders. Think of it as a means of accruing the real illiquidity premium of private equity – behavioural temperance – but without the costs, opacity and other drawbacks.

So, how might it work?

Let’s say I want to invest into an global equity index fund in my personal pension (20 years+ horizon). The standard management fee is 20bps, but there are three other ‘commitment’ share classes available. Exactly the same fund but differing liquidity terms and management fees, such as:

3 Year Vest: 15bps management fee.

5 Year Vest: 10bps management fee.

7 Year Vest: 5bps management fee.

(The fees could also be set relative to the cost of the primary daily dealing share class to account for declining charges over time).

These are hypothetical numbers, but I hope the point is clear. Funds could have share classes that are tagged with a certain vesting date, which cannot be sold until this point is reached. Upon vesting the share class can default to again become daily dealing (as per the standard type) or provide the option for a renewed long-term commitment. Fund groups could launch share classes with new vesting date tags over set periods – I may have found a use for the blockchain!

What are the benefits for investors? The fee reduction would be attractive but more importantly it incentivises and compels long-term investing behaviour. Once the decision is made, we must buy and hold.

What are the benefits for asset managers? They have a level of certainty over funds under management across time horizons greater than a day and can make business decisions on that basis. Their fund managers can also be confident that they have more assets committed for the long-term. 

Alongside these benefits there are inevitably a range of limitations. While investors will be prevented from making lots of poor decisions through time, they might simply make one and be locked in for five years or more. Long-term investing is only a good idea if we make a sensible decision at the start, it is a disaster if we make a poor choice and are stuck with it – being trapped in a thematic fund at its performance peak for the next seven years doesn’t feel like the right type of commitment to be making. Of course, there could be protections against this, such as only making it available for funds with a substantial track record. 

There are also drawbacks related to investor flexibility. A change of individual circumstance might mean that cash needs to be raised, but this cannot be achieved in a share class with a five-year commitment. This means such an approach only works where the investment must be long-term (such as a pension, where we cannot drawdown before a certain age) or in asset classes where we should never invest unless we have an appropriate time horizon (equities being the obvious example).

There is also a wider question of whether it could work for actively managed funds. The principles and advantages remain similar as with the passive example above, indeed the benefits of long-term capital might be greater for active managers. Yet there are nuances that make it more problematic. For example, what if we buy a seven-year vesting share class with an active fund manager and they leave, or the company is taken over, or they begin to behave in a manner that was inconsistent with expectations? For this approach to work for actively managed funds, there would need to be a range of covenants which, if broken, would see the fund revert to its daily dealing structure.

The other problem is liquidity. If a fund manager was aware that they had a high proportion of investors committed for five years they might be tempted to take on positions with poor liquidity. This would not be the desired outcome. The model would only work if funds were managed as if they were 100% daily dealing.

A diluted version of this concept is simply to create share classes where the management fee ratchets down as the ownership period increases but with no lock-in. To my earlier example, the management fee is 20bps for the first three years, then declines to 15bps, then 10bps and then 5bps after holding for seven years.

This does incentivise long-term behaviour, but the risk is that the reduction in fees would be easily overwhelmed by the powerful drivers of short-term decision making. It would also not change the situation for asset managers in any material fashion. It would, however, be far easier to implement.

A derivation of this technique would be to award bonus units in a fund (or even cash) once certain holding period thresholds are reached – like a fee reduction, but perhaps more salient.

I am uncertain about these ideas and am not oblivious to the drawbacks and technical challenges. Yet, I am certain that the industry needs to do far more to promote and reward the right type of behaviours. A good place to start would be by incentivising long-term investing with lower fees.   

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Bear Markets Are a Test of Investor Emotions

In a bear market it can be impossible to escape the pervasive negativity. Not only will our portfolios be falling in value, but there is likely to be an incessant flow of news highlighting the harsh realities of the prevailing backdrop. Dealing with this is not just an uncomfortable experience, it changes how and why we make investment decisions.

Our ability to make consistent and considered choices can quickly be overwhelmed by the negative emotions we experience; be it fear, panic or anxiety. It does not matter how many charts of past market declines we have seen; it won’t appropriately prepare us for the challenges of a severe bear market. It is critical that we don’t ignore the emotional demands of investing through such exacting market conditions. 

There are three pivotal means by which the emotions evoked during a bear market can lead us astray:

Emotions can diverge from rational assessment

In 2001, George Lowenstein and colleagues proposed the ‘risk as feelings’ hypothesis; it’s contention was that “emotional reactions to risky situations often diverge from cognitive assessments of those risks”.[i] Not only do emotions impact decisions, they can dominate them; leading us to make choices contrary to what we would rationally believe to be the best course of action.

There are three critical elements of the hypothesis that are relevant for investors and the emotional strains of bear markets:

1) The strength of our feelings is closely linked with vividness – the more powerful and salient the images and stories are, the greater our emotional response will be.

2) Our fear will increase markedly as we approach “the moment of truth”. There will be no comparison between how we feel about knowing there will be a bear market in the next ten years and being in one right now.  We are likely to hugely understate how much emotion will impact us prior to actually experiencing such a negative scenario. Bear markets are easy to navigate on paper.

3) The feeling of fear and a heightened sense of risk will be amplified by the behaviour of other people. Anxiety and panic in others will create a damaging, self-reinforcing feedback loop.

Bear markets are a breeding ground for emotions-based investing. We won’t anticipate how we will feel during them, we will be besieged by intensely negative stories (and realities) and be surrounded by investors reacting in a similar fashion.

It is no surprise that they can transform our decision making.

Emotions can provoke rapid, short-term decisions

Psychologist Paul Slovic and colleagues suggested that individuals use a mental shortcut called the affect heuristic, which can lead to rapid, emotion-led decisions. [ii] Here, how a situation makes us feel generates an automatic, rapid response that serves to “lubricate reason”.

The severe negative emotions that we may experience during a bear market, such as fear or dread, leave us vulnerable to overstating the risks of a given situation (because we gauge it based on the severity of feeling). It is also likely to drastically contract our time horizons – the heuristic pushes us towards dealing with the emotion that we are feeling in that moment.

As with most heuristic or instinctive decisions, it is easy to see its underlying usefulness. Acting rapidly to respond to strong emotional cues (particularly related to danger) is clearly an effective adaption in many instances, yet one that inevitably undermines our ability to withstand periods of market tumult or invest for the long-term.

Emotions can cause us to ignore probabilities

Although investors are not renowned for their consistent use of probabilities, strong emotions can make this problem significantly worse.  In 2002, Cass Sunstein wrote a paper on probability neglect, in which he argued that when powerful feelings are stirred our tendency is to disregard probabilities.[iii]  In particular, salient examples of disastrous, worst-case scenarios tend to overshadow the consideration of how likely they are to occur.

Sunstein offers the example of a study where participants were asked about their willingness to pay to eliminate cancer risk.  Across the subjects both the probability of cancer (one in 1,000,000 or one in 100,000) and its description (clinical or emotional) was varied.  When cancer was described in in a vivid and “gruesome” manner, the impact of a tenfold change in its likelihood on the willingness to pay to remove the risk was markedly less than when the disease was described in non-emotive terms. Simply altering the wording to provoke emotion – in a hypothetical setting – rendered individuals far less sensitive to changes in probability.

In a bear market our fears will be amplified by the inevitably lurid stories of how much worse things will get. Our ability to reasonably assess the likelihood of future developments will be severely compromised. Strength of feeling will outweigh strength of evidence.    

How can we dampen the influence of emotions?

There is no easy or failsafe solution to diminish the impact of emotions during difficult market conditions, but there are some steps that all investors should take.

Although we cannot replicate the lived experience of a severe market decline, we can better prepare ourselves for their unavoidable occurrences. It is very common for investors to be informed of a reasonable expectation for losses over a cycle; for example: ‘with this global equity portfolio you should expect periods of drawdown of at least 40% over the holding period’.  Yet this type of framing does not go far enough.

The presentation of an anodyne historic number is no guide whatsoever to what this sort of loss actually means and how it might feel. While we will never anticipate the precise cause of a bear market, we do know that it will often arrive amidst ceaselessly negative news, bleak forecasts about the future, some cataclysmic predictions and perhaps a recession with all that entails. Investors need to prepare as best they can for the emotional realities of losses and be forewarned of what a period of severe decline might mean about the broad backdrop.  

As we are currently experiencing a challenging market environment, now is not the ideal time to plan for how we might cope with one in the future. So, what can we do now to ward off the dangers of emotion-laden decision making?

There are two key behavioural actions. First, is to remove ourselves from emotional stimulus – turn off financial market news and check our portfolios less frequently. Long-term investors should stop doing anything that provokes a short-term emotional response. Second, we should never make in-the-moment investment decisions, as these are likely to be driven by how we feel at that specific point in time. We should always step away and hold off from making a decision, and reflect on it outside of the hot state we might find ourselves in.

These actions are no panacea; we cannot disconnect ourselves from the impact of emotions on our investment decisions. We know, however, that the negative feelings of stress, anxiety and fear that we experience during a bear market are likely to encourage some of our worst behaviours and we must do our best to quell them.   

[i] Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin127(2), 267.

[ii] Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2007). The affect heuristic. European journal of operational research177(3), 1333-1352.

[iii] Sunstein, C. R. (2002). Probability neglect: Emotions, worst cases, and law. Yale Lj112, 61.

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

What Can Sherlock Holmes Teach Investors?

In the first full length Sherlock Holmes novel ‘A Study in Scarlet’ the brilliant detective’s sidekick, Watson, is staggered to discover that Holmes is apparently not aware that the earth revolves around the sun.[i] Watson cannot comprehend how an astonishingly intelligent individual can be ignorant of such basic facts. Holmes, however, explains that he actively disregards and forgets information that is not relevant to his detective work:

“A fool takes in all the lumber of every sort that he comes across, so that the knowledge which might be useful to him gets crowded out”.

Holmes’ approach provides a useful framework for investors. It is essential that we find a means of cancelling out incessant market noise if we are to behave in a manner that will allow us to meet our long-term goals.

For Holmes, skill is about our ability to focus singularly on the elements that are relevant to our task:

“Now the skilful workman is very careful indeed as to what he takes into his brain attic. He will have nothing but the tools which may help him in doing his work”.

Here Holmes is distinguishing between signal and noise. Noise, as defined by Daniel Kahneman, is where our judgements are “strongly influenced by irrelevant factors”.[ii] There is probably no field where noise or erroneous considerations impact our choices more than investment. The overwhelming majority of what we hear and see about financial markets is entirely inconsequential to achieving our objectives. It is just exceedingly difficult to accept this.

There are two forms of noise that matter to investors, which we can think of as conscious and unconscious noise:

Conscious noise is where we react or respond to information that we think is meaningful but is entirely redundant. Worse than that, the fact that we interpret it as some form of signal transforms it from being innocuous to damaging because it leads to poor behaviours. Take, for example, a long-term investor consistently checking the latest stock market movements or worrying about how some macro-economic event will impact their portfolio. There is no signal in this, nothing that can be used to better fulfil their aspirations, quite the contrary.

Unconscious noise arises in situations where our decisions are influenced by extraneous factors, but we have no awareness or acceptance that they have affected our judgement. The best examples of this are related to emotions; how we feel – pressurised, stressed, excited or fearful – can lead to wildly inconsistent choices through time.

The concern Holmes expresses on noise is around it’s propensity to obscure or overwhelm the insightful knowledge he holds or the mental models he wishes to use. Likewise, an investor might be applying a simple and effective set of models to meet their long-term needs – diversification, rebalancing, regular saving, and compound interest – yet this sensible framework can be torn asunder by the magnitude and force of market noise:

“Depend upon it there comes a time when for every addition of knowledge you forget something that you knew before.”

It is in treacherous market conditions – like those we are facing at present – where the potential for noise to wreck our investment intentions is most pronounced. Emotive and salient negativity will be inescapable, and it will seem negligent to ignore it. This not only risks us forgetting our best laid plans but questioning whether they are even still relevant.

As investors we not only need to ensure that we are able to focus on what matters and why, but we must be constantly on guard against the often-irresistible spectre of noise.

“It is of the highest importance, therefore, not to have useless facts elbowing out the useful ones”.

[i] Doyle, A. C. (1904). A Study in Scarlet. Harper & Brothers.

[ii] https://hbr.org/2016/10/noise

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Short-Term Performance is Everything

Two years ago value investing was dead, now it is the obvious approach to adopt in the current environment. What has changed? Short-term performance. There are more captivating rationales but underlying it all is shifting performance patterns. These random and unpredictable movements in financial markets drive our behaviour and are the lifeblood of the asset management industry; but they are also a poison for investors, destroying long-term returns.

Narratives + extrapolation

The damage wrought by our fascination with short-term performance is a toxic combination of two behavioural impulses– narrative fallacy and extrapolation. Narrative fallacy is our propensity to create stories and seemingly coherent explanations for random events; a means of forging order from noise. Extrapolation is our tendency to believe that recent trends will persist.

Short-term performance in financial markets is chaotic and meaningless (insofar as we can profitably trade based on it); but we don’t see this; instead, we construct stories of cause and effect.  Not only this, but the tales we weave are so persuasive we convince ourselves that they will continue.  

This is why when performance is strong absolutely anything goes. Stratospheric valuations, unsustainably high returns, made up currencies and JPEGs of monkeys cannot be questioned – haven’t you seen the performance, surely that’s telling you something?

Of course, it is telling us very little of use. It is just that we struggle to accept or acknowledge it. There must always be a justification.  

Performance is not process

In the years before the stark rotation in markets, I noticed a fund manager frequently posting on social media about the stellar returns that they had generated. Their approach was in the sweet spot of the time – companies with strong growth and quality characteristics, often with a technology element – but this was never cited as a cause of the success. Instead, the focus was on how their process and sheer hard work had directly resulted in consistent outperformance over short time periods. They were simply doing it better than other people.

This was palpable nonsense. Financial markets do not provide short-term rewards for endeavour. Nor can any investment approach consistently outperform the market except by chance (unless someone can predict the near future, which if they could, they wouldn’t be running money for us).

Many investors, however, seemed to accept this. Why did they laud such a bizarre notion? Because performance was strong. If performance is good a fund manager can say almost anything and it will be accepted as credible (that must be right, haven’t you seen their performance?) If performance is bad then everything said will be disregarded (don’t listen to them, haven’t you seen their performance?)

The problem with extolling short-term performance as evidence of skill (rather than fortunate exposure to a prevailing trend) is what happens when conditions change. If we say that our process leads to consistently good short-term outcomes, what do we say when short-term outcomes are consistently bad?

When performance is strong it is because of ‘process’, when it’s weak it is because of ‘markets’.

Sustaining the industry

Although the fascination with short-term market noise is a major impediment for investors, it serves to sustain the scale of the asset management industry. There is an incessant stream of stories to tell, fund managers to eulogise or dismiss, and themes to exploit. If financial markets were boring and predictable the industry would be a very different place.

Not only do the vacillations of markets give us something to talk about, but they also give us something to sell. The sheer number of funds and indices available to investors is a direct result of the randomness of short-term performance. There will always be a new story or trend to exploit tomorrow.

The impact of the reams of ever-changing narratives is compounded by our inclination to mistake positive short-run performance for skill. If investors struggle to disentangle luck and skill it means unskilled fund managers are rarely ‘competed out’ of the industry. It also incentivises new entrants – I have no skill in picking stocks, but if I selected a random portfolio there would be a decent chance of me outperforming over one year or three years, maybe even longer. It is a pretty lucrative business, so I might as well give it a go.

If we make judgements based on short-term performance everyone will look skilful some of the time.

ESG scrutiny

We have recently been witnessing an emerging backlash against ESG investing and, as the obverse of the resurgence of the value factor, this has undoubtedly been fuelled by weak short-term performance. Returns from ESG leaders, in-vogue companies and aligned industries have lagged and therefore the narrative has changed – outcomes are bad, maybe everything about it is bad.

The underlying problem is that any benefits of ESG investing were consistently obscured by unsubstantiated and unrealistic claims about its return potential. ESG investing was never (and should never have been) about the performance of any given fund or area of the market over arbitrary time horizons. As soon as we base the credibility of something on its potential to deliver short-run performance we are simply waiting for the reversal.

The desire to link every aspect of investing to the vagaries of short-term performance does nothing but scupper long-term thinking.

Misaligned incentives

The obsession with short-term performance is a vicious circle. Everyone must care about it because everyone cares about it. We can be the odd one out, but also out of a job. 

This creates a pernicious misalignment problem where professional investors aren’t incentivised to make prudent long-term decisions; they are incentivised to survive a succession of short-time periods. Irrespective of whether this leads to good long-term results.

The best way to preserve a career is to think short-term.

The more we are gripped by short-term performance, the worse our long-term returns will be.

Any investor with the ability to adopt a long-term approach has a profound and sustainable advantage, there are just very few of us able to exploit it.  

I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

My Book – The Intelligent Fund Investor

My first book, The Intelligent Fund Investor, will be published by Harriman House on the 29th November 2022. 

Fund investing is a fiendishly complex decision making problem. We are faced with a countless range of options and are constantly distracted by meaningless noise and turbulent markets. By asking fund investors to reconsider their beliefs and understand their behavioural biases, The Intelligent Fund Investor shows how we can make better investment decisions.

Each chapter explores a critical aspect of fund investing and provides specific steps on how to avoid the major pitfalls. Areas covered include:

– Why we should avoid star fund managers.
– The dangers of funds with smooth returns.
– How good stories make for terrible investments.
– Why past performance is the worst possible basis for investing in a fund.
– How the incentives of the asset management industry are often misaligned with its investors.

And much more…

You can pre-order a copy here.

You can find out more here.


“Researchers in behavioural finance have spent decades cataloguing all manner of cognitive biases. For investors, and fund managers, that is only a starting point. Recognizing how these biases influence your behaviour, and sidestepping them, is the key to better investment decision making. Wiggins does this and more in his blog and new book The Intelligent Fund Investor.”

Tadas Viskanta, Founder and Editor of Abnormal Returns and Director of Investor Education at Ritholtz Wealth Management

“Joe’s observations about both portfolio manager and underlying investor behaviour are astute, important, and thought-provoking.”

Clare Flynn Levy, Founder and Chief Executive Officer of Essentia Analytics

“Joe’s continuous insights on behavioural finance and investor psychology lays the groundwork on ways investors can control their emotions and position themselves for success in investing. There is no doubt that professional and retail investors can learn, grow and become better long-term investors by reading Joe’s work.”

Justin Carbonneau, Partner Validea Capital and co-host Excess Returns Podcast

“One of the oft overlooked keys to successful investment is the ability to control the behavioural biases and weaknesses in decision making to which we are all vulnerable. Joe does an excellent job of explaining the challenges faced by investors and draws on his own experience as a professional investor to suggest ways of addressing these challenges. His writing is always engaging, insightful and grounded in the real world of investing.”

Dan Kemp, Global Chief Investment Officer at Morningstar Investment Management

“Joe writes with great clarity about the biggest obstacle to investors achieving their financial goals — their own behavior. His advice is suitable for individual and institutional investors alike and is in stark contrast to the efforts of most financial writing, which tries to predict a future that is inherently unknowable. 

Simon Hallett, former Chief Investment Officer at Harding Loevner, Chairman of Plymouth Argyle football club

“If you are looking for common sense, look no further than Joe Wiggins. A student of behavioural economics and human heuristics, his thoughts and observations are frequently amongst the most insightful, and useful, I read in markets today. Well worth your time.”

Nick Kirrage, co-head of the Global Value Team at Schroders

“A natural contrarian, keen to challenge the established wisdom of the crowd, Joe is a breath of fresh air to the manager selection community.  Building on the foundations of his  extensive manager selection experience for market leading investment firms, his behavioural research and insights can help both amateur and professional fund investors avoid becoming their own worst enemies in achieving their goals.”

James Millard, Chief Investment Officer at Hiscox

“Joe Wiggins is a fount of knowledge on behavioural finance and fund investing, and explains the subject in a thoroughly engaging way.”

Robin Powell, author of Invest Your Way to Financial Freedom

What We Should Remember About Bear Markets

Bear markets are an inescapable feature of equity investing. They are also the greatest challenge that investors will face. This is not because of the (hopefully temporary) losses that will be suffered, but the poor choices we are liable to make during them. Bear markets change the decision-making dynamic entirely. In a bear market, smart long-term decisions often look foolish in the short-term; whereas in a bull market foolish long-term decisions often look smart in the short-term.

If we are to enjoy long-run investment success, we need to be able to navigate such exacting periods. There are certain features of bear markets that it pays to remember:

They are inevitable: Bear markets are an ingrained aspect of equity investing. We know that they will happen; we just cannot know when or why. That they occur should not be a surprise. The long-run return from owning equities would be significantly lower if it were not for bear markets.

It will feel predictable: As share prices fall, hindsight bias will run amok. It will seem obvious that this environment was coming – the warning signs were everywhere. We will blithely ignore all the other periods where red flags were abundant and no such market decline occurred.

We won’t call the bottom: Market timing is impossible, and this fact does not change during a bear market. The only difference is the attraction of attempting it when portfolio values are falling can become overwhelming, and the damage it inflicts will likely be greater than usual.

Economic and market news will be conflated: The temptation to interlace economic developments with the prospects for stock market returns can become irresistible during a bear market. Weak economic news will make us increasingly fearful about markets, despite this relationship being (at best) incredibly tenuous.  

Our time horizons will contract: Bear markets induce panic, which means our time horizons shorten dramatically. We stop worrying about the value of our portfolio in thirty years and start thinking about the next thirty minutes. Being a long-term investor gets even more difficult during a bear market.

We won’t consider what a bear market really means:
In the near-term, bear markets are about painful and worry-inducing portfolio losses, but what they really are is a repricing of the long-run cash flows generated by a business / the market. The underlying value of those businesses doesn’t change anywhere near as much as short-term market pricing does.

Lower prices are good for long-term savers: For younger investors saving for the long-term, lower market prices are attractive and beneficial to long-run outcomes (it just won’t feel like it).

Some losses won’t be temporary:
For sensibly diversified, long-term investors the losses from most bear markets should be temporary (there is a long-run premium attached to equity investing after all), but we should not naively assume that everything will recover. Injudicious or ill-conceived investment decisions will be exposed in bear markets. Inappropriate leverage, unnecessary concentration and eye-watering valuations tend to bring about permanent losses of capital that time will not heal.

Emotions will dominate:
Our ability to make good, long-term decisions during a bear market is severely compromised. Rational thought will be overcome by the emotional strains we are likely to feel – what happens if things keep getting worse and I didn’t do anything about it?  It is during such times that systematic decision making – such as rebalancing and regular saving – come to the fore.

Our risk tolerance will be examined:
Bear markets are the worst possible time to find out about our tolerance for risk. Everyone becomes risk averse when they are losing money. The problem for investors is that living through a 37% loss is a far different proposition to seeing it presented as a hypothetical scenario. If possible, we should avoid reassessing our appetite for risk during tough periods.

We will extrapolate:
During a bear market, it is hard to see anything ahead but unremitting negativity. Our tendency will be to believe that things will keep getting worse – prices will be lower again tomorrow.

Each bear market will be different:
We should ignore all charts comparing current declines with other bear markets in history, they are entirely unhelpful. There is no reason to believe that such a deeply complex, unpredictable system should mimic patterns of the past. Each bear market is unhappy in its own way.

Bear markets are the ultimate behavioural test:
The outcomes of bear markets are more about us than they are about the market. Investors entering a bear market with identical portfolios will have wildly different results based on the decisions that they make during it.

Equity bear markets make all the usual challenges of being a long-term investor that much more difficult. The noise of daily market fluctuations will become deafening, we will check our portfolios even more frequently and may find the urge to make short-term trades irresistible.

Everyone has an investment plan until they experience a bear market.

What Are the Odds of Making a Good Investment?

Last week I stumbled upon an old Grantland article by David Hill titled: “Can’t Knock the Hustle”. [i] It is a fascinating examination of the two faces of competitive pool in the US. On one side was the traditional approach of conventional tournaments with prize money awarded to the winners (think the PGA Tour), on the other was ‘action rooms’ where the purpose of the pool matches was gambling – spectators and players would bet on the outcomes of all manner of games with a variety of handicaps applied. Although it is the same game being played, the objectives are entirely different – in one it is to find the best player, in the other to find the best odds. This distinction is important for investors. We spend much of our time trying to find the best investor, company, fund or story, and not enough time thinking about the odds.

The focus of the article was two characters. Earl ‘the Pearl’ Strickland – one of the most successful and controversial players in history (he has won over fifty major titles) – and ‘Scooter’ Goodman, a player focused on gambling and action rooms.

Although Goodman was a pool player, this wasn’t his primary skill:

“Goodman has a knack for figuring out complex odds and probabilities”.

His main enjoyment from pool was not the game itself, but in attempting to secure an advantage in agreeing the terms of the game. His edge was not in shooting pool but setting the odds in his favour.

“That’s my favourite part, the negotiating…This is where you win.”

Critically, Goodman understood that he did not need to be a great player like Strickland, he wasn’t interested in winning tournaments or climbing rankings. He just had to understand how good he was relative to the competition.

“I can play the best in the world up here if you give me enough weight”.

By “weight”, Goodman means advantages or impediments that impact the odds. This might be one player giving up all the breaks (a major impairment) or the weaker player having to pot fewer balls to win the rack. There is all manner of adjustments that can be made to transform the probabilities of the game.

While Goodman thought about little but the odds of success, as investors we are prone to neglect them. This leaves us incredibly vulnerable to making decisions where the chance of a good outcome is vanishingly small.    

Against the Odds

Why don’t investors like thinking in terms of odds? There are two reasons – because its less exciting than the alternative, which is largely storytelling, and because it is perceived as too difficult.  

Identifying a star fund manager, ten-bagger stock or the next great investment theme is far more captivating than trying to make a realistic assessment of the odds of success in that type of activity (particularly when the odds are usually terrible). When we have a compelling, narrative-led inside view, its salience means we grant it far more importance in our judgement than we should.

Calculating odds also feels like an inherently complex or even impossible task, but this is not the case. We don’t need to be spuriously accurate about the likelihood of a good outcome, just a general guide can be incredibly insightful.  

When making an investment decision, we should think about the odds of positive outcomes in two ways:

1) What are the base rates for this type of decision? This means forgetting the specifics of a situation but looking at the outcomes of a reference class of similar instances.

Let’s take an example. In 2021, Jeffrey Ptak at Morningstar wrote a timely piece looking at the subsequent performance of funds after they had returned more than 100% in a calendar year.[ii] The results were bleak – of the 123 funds that had achieved this feat since 1990, 80% went on to register losses in the three years that followed. 

This type of analysis is about creating a base rate to provide us with an outside view on a decision. When looking at a fund that has produced stratospheric returns it is very easy to be beguiled by the inevitably compelling stories that will be told about the theme and its manager. This can leave us entirely blind to the odds we are likely to be facing.  

There is no right answer on base rates, no single metric that will provide precise and accurate odds but taking this type of outside view should be integral to any investment decision.

2) How difficult is the game we are playing?  We should also spend time reflecting on the difficulty of the task we are undertaking. Imagine we are trying to forecast where ten-year treasury yields will be at the end of the year. We can carry out forensic analysis of inflation dynamics and Fed policy, but before beginning this process we should be asking – how likely is it that we are going to get the answer to such a complex question right? 

Overconfidence leads us to involve ourselves in investment activities where the sheer difficulty of the activity means that a successful result is very unlikely.

Thinking about odds and probabilities is not intuitive and often uncomfortable, but it should be essential for all investors. It is far better to be an average investor with the odds on our side, than a good investor with the odds stacked against us.  

[i] » Can’t Knock the Hustle (grantland.com)

[ii] What to Expect From Funds After They Gain 100% or More in a Year? Trouble, Mostly | Morningstar