Whether it is a simple extension being built on a house or the bold development of a brand-new railway line, we know two things: both projects will take longer to complete than estimated and will cost more (often a lot more) than budgeted. In How Big Things Get Done, Bent Flyvbjerg – one of the world’s leading experts on megaprojects – and Dan Gardner explore the somewhat puzzling phenomenon of repeated cost and time overruns, and explain how projects can be improved. Although the complex construction of a bridge may seem poles apart from the (relative) simplicity of making an investment decision; they both share a stark vulnerability to the foibles of human decision making. They can both fail in similar ways. What can investors learn from how projects go awry?

It is obvious to see when a project goes wrong – we start with a set of expectations about the finished product, how much it will cost and how long it will take, and those are either met or not. For investment decisions things are a little trickier – good choices can have bad outcomes (and vice-versa). The randomness and noise in financial markets means that we cannot call every decision that fails to outperform or meet it target a failure.

Let’s take an example. Imagine I invest my entire portfolio in a niche thematic fund that has already produced startling returns and holds assets with stratospheric valuations. Over the next three years its ascent continues and it trounces the broader market. Does that mean it was a good decision? No, it was a terrible one, just extraordinarily lucky.

So, if a failed investment decision is not necessarily one where performance disappoints, what is it? One where the odds of success at the point we make the choice are poor. Bad investment decisions can often be seen from the very start. The same can often be said for large projects.

Psychology and Power

Flyvbjerg and Gardner identify two “universal drivers” that separate a successful project from a flop – psychology and power. Investors should be well-versed in the challenges of making good choices whilst battling our behavioural biases. Any decision-making process – whether it be for an investment or project – that does not explicitly attempt to address these is destined for trouble.

While the influence of power seems obvious for major projects – politicians attempting to impact outcomes to suit their personal agenda – it can seem an irrelevance for investors, but it matters. This is particularly true of institutions that can make investment decisions that are tainted by ambitions, hierarchies and misaligned incentives.

The problem of psychology and power is not just that they can dramatically impact the decisions that we make; it is that they are unspoken. Few people would admit that an investment was driven more by our psychology than our analysis, and nobody would ever say that politics played a part. If we don’t acknowledge it, we cannot do anything about it.

Think Slow, Act Fast

One of the foundations of successful projects, according to Flyvbjerg and Gardner, is the ability to “think slow, act fast”. The basic premise is that we should take our time in diligent planning, as getting the planning right dramatically improves the accuracy and speed of the subsequent work. Far better to find problems in the planning stage, than deal with them halfway through a project.

The difficulty is that planning has a stigma attached to it. People want to see action not spreadsheets and PowerPoints, so there is an allure to getting started. Action trumps thinking. Not only this, but individuals with a vested interest in a particular project are also keen to see shovels in the ground – they know that once costs become sunk and commitment is entrenched the ability to turn back is severely compromised.

Acting in haste and repenting at leisure is undoubtedly also a behavioural issue for investors. The nature of financial markets – the stories, the trends, the performance obsession – almost compels us to act immediately. Either we have no particular plan in place, or emotions ride roughshod over the plan we thought we were going to follow. So we act in the moment.

Most investors really don’t need to be acting fast, but if we do it should only be when following a prudent plan of action which is aligned with our goals.     

Why – at the start, middle and end

A common pitfall identified by Flyvbjerg and Gardner in major project work is losing sight of reason it was undertaken in the first place. A project should start with an understanding of why it is being carried out, and that should remain at the forefront of all decision making throughout. It is incredibly easy to imagine how large and time-consuming projects become so complex that everybody involved forgets what they were actually trying to achieve at the start.

Investors can easily forget what the purpose of their investment decisions are. We might begin with a plan to save regularly over 30 years to fund our retirement. Yet three years down the line we are revamping our portfolio because it underperformed the market over the past six months, or because of an article we saw in the weekend newspapers. Living our portfolios day to day, week to week can easily lead to us forgetting the reason that we began investing.

What’s the reference class?

An area where major projects and investment decisions share identical failings is a lack of willingness to understand appropriate reference classes. We tend to think that the situation we face is distinct – nobody has ever built a bridge like this before / this fund manager is uniquely talented. This is the ‘inside view’, where we obsess over the specifics of our circumstance and ignore the lessons that we might learn from the ‘outside view’ – a wide reference class of similar scenarios.  

This is the reason why very few people adjust expectations for the work being undertaken on their house despite being aware of the cost and time overruns suffered by everyone else. It is the same reason people flock to star fund managers despite the poor record of these types of investments (high level of assets / expensive valuations / unsustainable performance). We seemingly cannot help but think that the precise information that pertains to our case is far more valuable than general comparators.

Reference class / outside view thinking is quite dull, we lose the attractions of the compelling narrative and replace them with some dry probabilities. Yet for investing and major project management, dull is likely to win out.  

A failure to learn

Perhaps the real unifying feature of troubled major projects and poor investment decisions is that despite seeing them all around us we don’t learn the lessons. In both cases this is driven by an unwillingness to accept and address the realities of our behaviour, so we keep repeating the same mistakes.

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https://www.amazon.co.uk/How-Big-Things-Get-Done/dp/1035018934

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

The main challenge in capturing the benefits of long-term investing is that the long-term is comprised of very many days. Being able to cope with the events, cycles, shocks and stories that form a lengthy time horizon is a formidable task. Potential long-term investments should not be considered solely on their prospective return and risk, but also our ability to endure and survive the inevitable fluctuations in performance. The gap that exists between short-term pressures and long-term objectives is so significant that I have often heard people comment that they would make different choices if they could ignore their investments for 10 or 20 years. But what if that were true? What if we could put our investments in a time capsule and not touch them for many years.* What would you do differently?

Let’s assume we have to make a number of investments or investment views now, and, once decided, we cannot do anything with them for ten years (I would have preferred longer, but in this investing world even this seems extreme). They must remain untouched until a decade from today.

Below are six investment views I would place in the said ten-year time capsule. Clearly these are all probabilistic judgements in which I have varying levels of confidence, but such nuance is no fun in a time capsule so I will present them as binary opinions. Here goes:

– Equities over bonds (MSCI ACWI over Bloomberg Global Aggregate Bond USD Hedged): This seems like an easy call, and I have certainly been conditioned to believe through my career that this is close to a slam dunk, but global equity valuations are not cheap and bond yields are much more attractive than they have been for some time. Despite this I would still favour equities.

– Small cap over large cap equities (MSCI World Small Cap over MSCI World): Moving into more controversial territory, it has been an unusually weak period for small caps versus large cap indices driven primarily by the ascendancy of a group of staggeringly successful mega caps. Perhaps this is a new paradigm (it is certainly not impossible), but I would rather lean on the side of history.

– Non-US developed over US Equities (MSCI EAFE over S&P 500): There are many reasons why the dominance of the US market may continue for another decade and they are hard to disregard in the midst of a prolonged spell of outperformance, but I still tend to believe that (extreme) valuations matter.  

– EM over developed equities (MSCI EM over MSCI World): Taking a ‘close your eyes’ view on emerging markets can seem pretty risky – what if something happens in China? – but these risks always feel more acute when an asset class is already underperforming.

– Value over Growth (MSCI ACWI Value over MSCI ACWI Growth): After a brief period of respite, growth stocks have resumed their crushing dominance over their much-maligned cheaper counterparts. I am inclined to think that this will not continue for another ten years. (These indices are not the perfect way of capturing value and growth, but will suffice for the purposes of this post).

– 60/40 over hedge funds (MSCI ACWI / Global Aggregate Bonds over HFRI 500 FWC): Despite equities looking historically rich (in aggregate), I would still favour a combination of them and bonds to outstrip a collection of expensive hedge funds attempting to do incredibly difficult things.

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Now these views are in the time capsule, I will not return to them for ten years. If most of them prove correct I will write a piece about the power of long-term investment thinking, if most are wrong then I will assume nobody will remember I ever wrote this.

There are a couple of serious points stemming from this post. First, is that these types of views are generally only ever meaningful at extremes of valuation and performance. For the most part such marginal investment calls are nothing more than superfluous, unpredictable noise; we are usually far better off doing nothing. Second, if there is a chasm between your actual investment position and your time capsule views, it is important to understand what is causing it and at what cost.

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* Recreating the magic of private equity.

# This post does absolutely not constitute investment advice!

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

In 2015 three academics, in conjunction with a smart beta ETF provider, published a set of research papers that showed that between January 1969 and December 2014 adopting alternative approaches to index construction produced better returns than a conventional market cap weighting methodology.¹ A market cap based scheme was so inferior that even sizing stocks based on the Scrabble score of their stock market ticker generated dramatically superior returns. Delivering outperformance seemed easy, so what happened next was almost inevitable. In the years that followed, market cap indices (in most regions) set about trouncing all other index types. Equity investors moved from “anything but market cap”, to “what’s the point in anything but market cap?” Was the research flawed or was something else going on?

Looking back at the studies, with glorious hindsight from 2023, the central argument seems entirely anomalous given what we have experienced over the past decade. The research showed not only that alternative approaches to equity index construction (such as equally-weighted, fundamentally-weighted or maximum diversification) are significantly better than the traditional market cap structure, but randomly selected ‘monkeys and dartboards’ indices also beat market cap (outperforming 99.9% of the time across 10 million simulations). Results that seem to run entirely counter to the evidence of the efficacy of market cap investing which has now become accepted wisdom.

What is the explanation for the apparent disconnect?

The obvious answer is fees. There are approaches where the evidence suggests that alternative weighting methodologies (or what we might also call active management) have an advantage over a market cap (traditional passive) process, but that evaporates once charges are taken into consideration. While this is true to an extent, it does not tell the entire story. Between 2015 and 2023, the S&P 500 generated total returns over 30% greater than its equal weighted counterpart without any help from a fee advantage. Something else is at play.

There is another simple explanation to the apparent quandary, which has some profound behavioural implications. In the period covered in the study (1969 – 2014) smaller and cheaper companies delivered higher returns. In the subsequent period, however, the reverse was true; stock market performance was dominated by a select group of mega / large cap companies making it extraordinarily difficult for non-market cap strategies to outperform.

Size (and Value) Matters

The research does indirectly touch upon this issue. It runs a factor attribution for the main alternative index construction strategies versus market cap, in virtually all cases (including Scrabble) the resultant indices have significant sensitivity to both size and value factors. They prefer companies that are smaller and cheaper. They also tend to be underweight momentum – this is to be expected given the inherent momentum tilt of a market cap index.

In recent years (with brief bouts of divergence) equity market performance has been led by mega cap, tech related names, and the US has been in ascendancy over other developed and emerging markets. This has meant that the odds of success from doing anything other than market cap investing have been very poor. Whether it be low-cost smart beta tilts or concentrated, high conviction active investing.

There have been certain exceptions to this most notably the UK, but this has been a market where smaller companies have outperformed the largest making it far easier to improve on the index.

There was nothing wrong with the research published in 2015. In the period they observed, alternative methodologies (which almost always have a bias towards smaller and cheaper companies) did produce better returns than a market cap approach. This is broadly consistent with the established factor investing literature. What has occurred subsequently doesn’t invalidate that, but nor does this research mean that market cap investing is a bad idea.

Inescapable Cycles

This post is not about the relative merits of market cap investing compared to other approaches, it is about the fluctuations of markets and how they lead us to make poor choices. Decisions that come with a far greater cost than the precise construction methodology we might prefer.

Markets move in cycles. These can be prolonged and pronounced. These are always accompanied by narratives that allow us to explain and extrapolate. At the peak of a particular cycle, we will feel as if there isn’t even a cycle.  The future path and the right decision to make will seem obvious. Performance creates story, story creates performance, performance creates story and so on.

When an equally weighted index goes through a period (or era) of outperforming a market cap approach then the narrative will be about the higher growth of smaller companies against leaden and expensive large cap names, of course equal weighting is superior. When a market cap index has its turn in the sun then large, dominant companies will continue to use their scale and influence to trounce and overwhelm smaller businesses.

These cycles can go on for so long that the strength of the story combined with the power of incentives makes them almost irresistible. We become unflinching converts to every new paradigm at its peak.

The major problem with these inescapable patterns is that they lead us to make terrible, costly decisions. Take the market cap approach to equity investing – right now it is the easiest decision in the world and a perfectly sensible approach to adopt. Yet it is close to inevitable that at some point it will go through another period similar to that observed between 1969 and 2014, maybe next year or maybe in ten years’ time.  Will that mean that market cap investing will become an awful concept? No, it will just feel like it (imagine the headlines). In a similar fashion to how holding a tilt towards cheaper and smaller companies has felt like the epitome of insanity for most of the last decade.

The Behavioural Challenge of Market Cycles

It is the incessant cycles of financial markets that makes them such a chronic behavioural challenge. Even if we make sensible long-term decisions, we will have to endure inordinately lengthy periods where they look foolish.

We can deal with these cycles in four ways:

1) Make prudent decisions and stick with them: This is simple in practice but fiendishly difficult in reality. Financial market cycles always tend to last one day longer than our behavioural tolerance is to bear them.

2) Timing cycles: Market timing is a wonderfully alluring notion and will always sell. It is just not clear that anyone can do it consistently well. Complex adaptive systems are notoriously fickle things.

3) Waiting for extremes: Although there is certainly some value in leaning against the prevailing wind when cycles become extreme (as suggested by Howard Marks), this is perhaps the most exacting behavioural challenge in investing. We can only attempt this if we have the right time horizons (long ones) and are in an environment that supports it.  

4) Buy and sell at the worst possible time: The most likely course we will chart is to make bad decisions at the point of maximum pain. This may sound disparaging, but it is not. The pressure to make pro-cyclical choices at the peak of a cycle is intense and, often, in our best (career) interests. It is incredibly difficult to avert this behaviour.

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Is a market cap index easy or hard to beat? It depends. Although financial markets are close to impossible to forecast, one thing we can be certain of is that they move in cycles. Sometimes a market cap approach will be a laggard, at others it will be unimpeachable. Our investment success with not be defined by our ability to predict such periods, but to withstand them.   

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1. https://www.bayes.city.ac.uk/__data/assets/pdf_file/0004/353866/what-lies-beneath-cass-business-school-invesco-powershares-part-2-nov-2015.pdf ↩︎

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

The enduring appeal of thematic funds can seem somewhat puzzling given their track record of delivering disappointing returns to investors (and sometimes worse).[i][ii] Yet from a behavioural angle, there is no puzzle to solve. Their composition exploits some of our most damaging psychological traits. No matter how many flavour of the month funds fail, there will always be a new story to sell.   

Although we like to frame our investment decisions with rigorous analysis and metrics, more often than not it is the stories that really matter. Our desire to believe a compelling narrative that draws a comforting line between cause and effect is an inescapably human trait. Financial markets are noisy, capricious and uncomfortable, persuasive stories help to remove that nagging pain of uncertainty.

Thematic funds prey on our desire for clarity by making everything easy. Something significant is happening in the world (usually some seismic and profound change) and we can profit by investing in it.

The vital sleight of hand played by the purveyors of thematic funds is that a story being true means that we are going to make money from it. These are always framed as being one and the same question – if you believe, then you should invest – but in fact they are two entirely distinct issues. There have been countless cases of narratives, themes and stories being valid – the internet was transformative / emerging markets did grab a far larger share of global GDP – and investors still losing plenty of money.

Key to avoiding the allure of thematic funds is finding some way of living with this cognitive dissonance – if the story is true how, how can it not be a good idea to invest?

Thematic funds are built on three core components that form a (for a time) virtuous circle: strong performance, a convincing story and social proof. Each element feeds the next inflating a form of micro-bubble. High returns need an explanation, so a narrative is forged, more investors are drawn in boosting performance, which further bolsters the credibility of the story. And so on…

At some point this circle of virtue (or profit) will turn vicious when each element will damage rather than support the next as the hype fades or shatters. In most circumstances we can be confident that this will happen, we just don’t know when.

All investors are either valuation or momentum driven. We invest because we believe that an asset is undervalued or because we think the price will (continue to) go up. Thematic fund investors are almost always momentum investors – they just might not know it. Why can’t thematic investors be focused on valuation? Because it is tough to believe that an area of the market can be underappreciated / materially undervalued and have a specialist fund launched to exploit it.

Momentum investing is a perfectly robust and proven approach, so why can’t thematic fund investing work on this basis? Because too many thematic investors don’t realise they are chasing momentum, instead they rely on the fundamentals of the story. Momentum investing works because of the deliberate and dispassionate application of rules – it is following a system not chasing a story. Engaging in it without acknowledging it is a recipe for disaster.

While it may be difficult for investors to make money from thematic funds, it is easy for asset managers. Stories sell and thematic funds come with in-built marketing. The investment thesis and sales pitch are the same thing. Not only is the sales message readymade, but financial markets are narrative generating machines. There is always the next story to place on the shelf.

Given the evidence around the disappointing outcomes from thematic funds, what accounts for their ongoing popularity? It is a classic inside / outside view problem, where we focus on a specific issue and ignore the general lessons. When we are considering the latest area of thematic fervour (AI anyone?) our attention is trained on the strength of that particular story, so we ignore the litany of failures of other themes that have momentarily captured and overwhelmed investor attention. It is the base rate of success in thematic funds through history that matters. Although the stories are different, the behavioural drivers and lessons are the same.

Most thematic fund investing is founded upon ideas that are simply not credible:

– Buying expensive, in-vogue assets tends to end well.

– Unsustainably strong performance will in-fact be sustained.

– We can make accurate forecasts about fiendishly complex economic / technological developments.

– Being correct about economic / technological developments mean that we will outperform.

– Abandoning diversification for thematic concentration can be a smart idea.

These make for a toxic set of implicit and erroneous beliefs. Maybe we can strike lucky and succeed with thematic investing, but the odds are horrible.

The sad truth is that the type of thematic fund most likely to make money would be one that very few people would want to buy.

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[i] Ben-David, I., Franzoni, F., Kim, B., & Moussawi, R. (2023). Competition for Attention in the ETF Space. The Review of Financial Studies, 36(3), 987-1042.

[ii] https://www.morningstar.co.uk/uk/news/236136/comment-thematic-investing-appeals-to-our-worst-instincts.aspx

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

You are a goalkeeper about to face a penalty kick. You have three options to make the save. You can dive left, dive right or stay in the middle. Having looked at the stats you know the probabilities are most in your favour if you stand still.* So what do you do? You dive to the left or the right. Why? Because if you don’t and the penalty taker scores it will look like you didn’t even try. Not only will you feel worse, but the fans won’t be happy – the least you could have done is put some effort in. This bias towards action is not just an issue for goalkeepers, it is a major problem for most investors. We just cannot stop doing too much.

The penalty kick example was taken from a 2007 paper exploring the concept of action bias.[i] This idea is something of an oddity as it runs counter to a more common behavioural foible – omission bias, which is our tendency to view the harm from doing something as greater than the harm from not doing something. Whether we have a bias towards action over inaction will depend on the prevailing norms. If there is a strong expectation for action in a given situation (whether justified or not) then not doing anything will likely be viewed harshly.   

For investors it is undeniable that there is a powerful and inescapable assumption that we should be constantly active. Why is the idea so pervasive?

– Markets are changing, so must our portfolios: The relentless variability and noise of financial markets means that there is always a new theme, new story, new paradigm, which we must react to. We cannot stand still whilst everything seems to be shifting around us.

– Our behavioural biases lead us towards action: A range of behavioural traits provoke action and activity. We trade because we feel emotional (fear or greed), we trade because we overweight the importance of what is happening right now, we trade because someone is making more money than we are. The fluctuations of financial markets stimulate some of our worst behaviours.

– Underperformance is inevitable: All investors, no matter how seasoned or intelligent, will experience painful periods of underperformance whatever their approach. Even if we are adopting the right strategy, for prolonged spells it is likely to be perceived as naïve, anachronistic or just plain stupid. Our tolerance for such periods is much shorter than we think, and so we trade.

– Justifying our careers / fees / jobs:  It is really difficult to build a career by doing less than other people. How do we keep our clients if we are doing nothing when performance is poor and the returns of people doing everything are better than ours?  If we are the person in the room suggesting doing nothing, our promotion prospects are probably not looking too good. Action is a rational career choice and an institutional imperative, it’s just often not in the best interest of clients.   

– We need to tell stories: Everyone wants to hear stories. What did you do last quarter? How are you reacting to the emergence of AI? If we don’t do anything it is hard to spin a convincing narrative. We make changes so we can tell a story. (One of the strongest reasons for the pervasiveness of TAA / market timing is that it provides us with regular stories to tell).  

While there are factors that compel us towards action, there are several reasons why we should avoid it:

– Predictions are difficult: The more changes we make to our portfolios, the more we are likely to be engaging in short-term market predictions. It is reasonable to assume that the average (and above average) individual is not great at forecasting economic events nor the market’s reaction to them. We need to be right twice and most of us fall at the first hurdle.

– Whipsaw risk: It is not just that making forecasts about a complex adaptive system is a pretty difficult ask, it’s that we find ourselves reacting to each captivating narrative that the financial system spits out. Trading and tinkering incessantly. The notion that we will get this more right than wrong seems entirely fanciful.

– There is a reason for diversification: One of the primary reasons for diversification is that we do not know the future (if we did, we would only own one security). A sensible level of diversification creates a portfolio that survives different environments and where there is always something working and something lagging (this is a feature, not a bug). An appropriate level of diversity should allow us to do less.

– Negative compounding: Too much investment activity results in the incredibly powerful force of negative compounding, where the costs of our trading (a combination of fees and being wrong) act as a material long-term drag on our returns.

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The typical response to the idea of investors doing less is: “well, you can’t just do nothing”. Yet the point is not that there is never a reason to make changes – of course there are – but the default must be flipped from “what have you been doing?” to “why have you done anything?” The threshold for change must be higher.**

It seems ridiculous to suggest that thinking of ways to reduce our activity could be a route to better investment outcomes. Yet, as always, the things that seem unfeasibly simple in investing come with significant behavioural challenges. These are not impossible to overcome, we just need to find a way to do less in a system that incentivises and encourages us to do more.

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* There is a bit of a quirk here in that the best penalty taker may only strike the ball into the centre of the goal because they have already seen the goalkeeper dive. So, if the goalkeeper does stand still, the player may not kick the ball towards the centre of the goal. But let’s not let that spoil a good analogy.

** The underlying assumption here is that we have made sensible choices to start with. If we have made some terrible initial decisions, change is good!

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[i] Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action bias among elite soccer goalkeepers: The case of penalty kicks. Journal of economic psychology, 28(5), 606-621.

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

It is incredibly easy to be cynical when businesses talk about culture. It is more likely than not to mean another anodyne PowerPoint full of empty buzzwords quickly forgotten. Ask most businesses what they actually mean by culture and they would probably struggle to come up with a convincing answer.

The problem is we cannot just treat culture as another element of corporate BS to readily ignore. It really matters.

So what is culture? In simple terms, I see culture as the expected, encouraged and incentivised behaviours within an organisation. Individual decision making doesn’t occur in a vacuum, it is inescapably framed by the environment in which we operate.

Understanding what culture is and how to create the right culture is absolutely critical for any organisation or team. If you want to promote good behaviour and decision making, thinking about culture is essential. It’s just not that easy.

In this episode of Decision Nerds, Paul Richards and I tackle culture and decision-making with WCM Investment Management. They have some fascinating insights as the assessment of culture forms a key part of their company analysis. They have also thought exhaustively about how to structure their own culture to make better choices.

In this session, we cover a range of fascinating topics, including:

The need for alignment between culture and strategy

Is scale the enemy of culture?

Should culture evolve through different business/operating environments?

Where and how can culture go sour?

What does management often get wrong when talking about culture?

Companies – how often do stated cultural ambitions align with compensation structures?

What’s the most practical way to take the cultural temperature of a company?

You can listen on your favourite apps, or here.

As Glastonbury has just drawn to a close Paul Richards and I have recorded a bitesize, festival-themed episode of Decision Nerds, where we uncover some behavioural lessons from the stars of rock and pop.

We discuss:

– Lana Del Rey – the need to understand who’s got the power (literally in this case).

– Van Halen reconsidered – does a rider request about brown M&M’s make them divas or behavioural gurus?

– Elton John – the peak-end rule and what set lists can teach us about being remembered.

Click below to listen, or get in all your favourite pod places.

https://www.buzzsprout.com/2164153/episodes/13119587

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why is this widespread assumption likely to be flawed?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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