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tempted by the next shiny object, and asset managers who operate as if the money they are responsible for might be withdrawn tomorrow.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.

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 bulletin, 127(2), 267.

[ii] Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2007). The affect heuristic. European journal of operational research, 177(3), 1333-1352.

[iii] Sunstein, C. R. (2002). Probability neglect: Emotions, worst cases, and law. Yale Lj, 112, 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.

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.

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 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.

Endorsements

“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

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.

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

Although I am clearly partial to a blog post and enjoy a good tweet or thread, few things can beat reading a great book. The beauty of a book is not just the depth in which a topic can be explored but the focus it necessitates – the physical act of buying and reading one can act as a commitment device, encouraging us to learn something new or think about something differently. Books do not make us immune to the enticement of other attractions competing for our attention, but they can add a healthy element of friction between us and the next shiny object.

I often get asked which books an investor keen to learn more about behaviour should read, and almost certainly give wildly inconsistent answers. To rectify that, here is a list of some of the books that have most influenced my thinking and are also brilliant reads. The majority of those listed are not explicitly related to behavioural finance, but they are all about how and why we make the decisions we do:

Annie Duke – ‘Thinking in Bets’: A fantastic book which not only extols the virtues of probabilistic thinking but manages to do so in an engaging and captivating fashion.

Jeffrey A. Friedman – ‘War and Chance’: Something of a hidden gem, ‘War and Chance’ is a fascinating study of decision making under conditions of uncertainty through the lens of international politics. Particularly insightful around why people are reluctant to talk in probabilistic terms.  

Tren Griffin – ‘Charlie Munger – The Complete Investor’: Nobody speaks more lucidly on investor behaviour than Charlie Munger, and Griffin does an excellent job of distilling his wisdom. Those short on time should read Munger’s speech: “The Psychology of Human Misjudgement”, which is probably the single best piece of work on investor behaviour. 

James Montier – ‘Behavioural Investing’: If my unreliable memory serves me correctly it was James Montier’s forthright and humorous writing on the vagaries and inconsistencies of investor behaviour that really got me engaged in the subject. This book is hard to get and expensive, but Montier has a ‘Little Book’ version, which incorporates some of the insight and ideas of its larger sibling.    

Daniel Crosby – ‘The Behavioral Investor’: Not only does Crosby’s book provide a great overview of how behavioural concepts interact with our investment decisions, but he also offers practical ideas about dealing with our most damaging foibles.

Daniel Kahneman – ‘Thinking Fast and Slow’: Just in case this hasn’t been read by everyone, it is worth highlighting the book that became the foundation stone for the burgeoning interest in behavioural science. No, not every study cited replicates; but yes, it is a great introduction to human behaviour and the choices we make.

Gerd Gigerenzer – ‘Risk Savvy: How to Make Good Decisions’: Gigerenzer’s work is incredibly underrated. His focus on the effectiveness of simple heuristics and decision rules to navigate complex systems is essential for investors who are constantly faced with a volatile and unpredictable environment.

Peter Bernstein – ‘Against the Gods – The Remarkable Story of Risk’: Achieves the extraordinary feat of explaining the history of risk – from Greek mythology to portfolio insurance – in an entirely fluent and engaging manner.   

Nassim Nicholas Taleb – ‘Black Swan – The Impact of the Highly Improbable’: Although the term ‘black swan’ is now widely misused, Taleb – in his own inimitable style – covers the folly of predictions, the dangers of models and the often-neglected impact of extreme events. Essential lessons for any investor.

Michael Mauboussin – “The Success Equation: Untangling Skill and Luck in Business, Sports and Investing”: No investment writer has a higher signal to noise ratio than Michael Mauboussin, his hit rate for producing distinctive and rigorous work is unsurpassed. “The Success Equation” is particularly important for investors because one of our primary failings is our inability to distinguish between luck and skill – a consistent and costly mistake.

Will Storr – ‘The Science of Storytelling’: Not obviously about investing or behaviour, Storr’s book looks at humanity’s fascination with stories and how and why they have such a profound impact on us. It is hard to think of any investment behaviour that doesn’t have a story at its heart, which makes understanding narratives essential to understanding our decisions.

Rory Sutherland – ‘Alchemy’: Aside from being very funny, Sutherland’s book challenges conventional wisdom about our behaviour and encourages counter-intuitive thinking.

Robert Cialdini – ‘Influence’: A timeless psychology book. As investors we are always being influenced or trying to influence others. Cialdini breaks this process down into six critical principles.  

Morgan Housel – ‘The Psychology of Money’: The beauty of Housel’s wildly successful book is its coupling of vivid storytelling with broad appeal. It is a book about our relationship with money but it’s not for investors, it’s for everyone. 

—

I have inevitably missed some personal favourites that weren’t in my mind at the time of writing and there are also those which, tantalizingly, I have not yet discovered!

It has been a torrid start to 2022 for bonds. Spiralling inflation has transformed the long-moribund interest rate environment and yields have risen substantially in most major markets. Not only are most bond investors nursing losses, but these losses have been registered at a time of equity market weakness. Bonds have seemingly lost their diversifying properties, produced poor returns and face into a prevailing market narrative that paints an unremittingly bleak outlook for their prospects. Given this, is it fair to question why anyone would hold bonds in this environment? No, it is not.

The unremitting negativity around bond investing reflects several major behavioural failings we face as investors – we greatly overweight the recent past, are overconfident in our ability to predict the future and struggle to accept the behavioural realities of diversification.

Rather than obsess over short-term performance and negative sentiment, it is far more important to think about the features of bond investing, the role they play in a portfolio and what recent market activity means:

– Rising yields should mean higher future returns:

The best predictor of bond returns is their starting yield. The significant rise in yields mean that future performance prospects are now brighter than they were. I would much prefer a 3% yield from a ten-year treasury (nearly) than the close to 0.5% it reached in 2020. It is incredibly common for investors’ return expectations to perversely increase as valuations become more expensive (it happens in equity markets consistently) but it is more puzzling in bonds where the interest and principal payments are contractual.*

– The chances of losing money in bonds in any given year have reduced:

Aside from those with negative yields, at the start of each year our expected return from a bond investment is positive – we will receive our coupon and roll down the yield curve (for the sake of simplicity let’s assume the curve is not inverted and there is no credit risk). The higher the yield and steeper the curve, the more yields need to rise for bonds to lose money. The considerable increase in yields means that our chances of losing money in bonds over the course of a year have reduced significantly. Higher yields give us greater protection from the threat of rising interest rates. This was detailed in this typically excellent Verdad post.

– The market has the same information as us:

The concerns about the prospects for bonds – central bank rate hikes, rising inflation etc… – are generally expressed as if the market is blithely unaware of these risks. It isn’t. The behaviour of bond markets in 2022 reflect the attempt of market participants to accurately price them. What is it we know about inflation and rates that the market does not?  

– Bonds represent a diverse range of security types:

Although I am guilty of discussing bonds in incredibly generic terms here, we should not forget the diverse range of securities that are encompassed by this broad definition. The features and sensitivities of floating rate notes are distinct from a treasury bond (real or nominal) as they are distinct from a CCC high yield credit.  It is important to understand both the similarities and distinct features of the various areas of the market and the specific role they might play in a portfolio.

– High quality bonds are excellent diversifiers

High quality bonds are an excellent portfolio diversifier when held alongside risky assets. Despite recent returns they are likely to remain one of the most effective protections against equity market risk. No asset class works against all backdrops and in a stagflationary environment where inflation is rising and equities are weak, nominal bonds may fare poorly – but that is just a single specific scenario. In a more typical equity sell-off or economic slowdown, it is reasonable to expect higher quality bonds (particularly sovereigns) to be an effective component in a portfolio. **

– Rebranding government bonds

Government bonds have something of an image problem – the common complaint is that yields are so low that there is no point in holding them compared to other asset classes (this is less true than it was a year ago). But rather than thinking about low returns, it pays to reframe their role.

High quality government bonds are typically (though not always) lowly correlated with equities, and they often make profits when equity markets suffer severe declines. This sounds like a reasonably effective portfolio diversifier and unlike a tail risk hedge there is no burn cost, in fact we get paid somewhere close to 3% (US ten year) for owning it.

From a portfolio perspective, it is critical not to focus solely on an asset’s expected return but how it behaves relative to other positions in a portfolio. The value of something that can protect value or even make money when equities are losing heavily is not simply about lower drawdowns and volatility. It is about the ability to rebalance and reallocate from your defensive asset into much more attractively valued risky assets. The compound impact of this through time can be profound.  

Of course, it is worth restating that nominal government bonds are not always a good diversifier against equities, but they often are and being paid to own those characteristics can be a compelling option from a portfolio perspective.  

– The future is unpredictable and we are overconfident

Given the inflationary backdrop and recent losses, it is not surprising that sentiment around bonds seems uniformly negative. In the current environment it is incredibly easy to take strident views about the direction of yields from here (higher) and claim that owning bonds is nothing more than a wilful destruction of value. We should ignore such perspectives.

A call to give up on bonds is nothing more than an aggressive market / macro-economic forecast and we all know how successful investors are at making those. Prudent diversification is about owning assets and securities that will deliver in different market environments because the future is unknowable.

At any given moment it always feels like we are on a single inexorable path based on recent information, but that is never the case. There is always a range of potential outcomes.

Let’s map out a future scenario – inflationary pressures remain and central banks hike rates aggressively to subdue it. The rising cost of money leads to significant pressure on consumer demand and results in a recession. This is a highly stylised and simplified example but does not have a zero probability and it is an environment where exposure to high quality bonds might be valuable.

There is another scenario where inflation runs further away from central banks and bond yields must rise substantially to reflect a new reality even as equities decline. The point is we cannot know with any confidence how the economic picture will play out, nor how asset class relationships may alter.

We should make investment decisions based as much on what we don’t know, as what we think we do.

–

Current concerns about bonds are simply a reflection of our behavioural struggles with diversification. Diversification means that at any given point in time elements of our portfolio won’t be working, which is dissonant with our inescapable desire for everything to be performing in unison.***

If all holdings in our portfolio are successful at the same time, we should prepare ourselves for the time when they all struggle at the same time.  

Highly concentrated positioning or the abandonment of certain asset classes is little more than a reflection of dramatic overconfidence.  Either we believe in maintaining diversification, or we believe that we can predict the future.  

—

* It is important to remember the distinction between owning an individual bond – with set characteristics and, typically, a fixed maturity – and a bond fund which usually has an evolving set of fixed income exposures.  

** Bonds are by no means a requirement for all types of investors, but for an investor whose risk appetite would usually involve holding fixed income securities abandoning them would be nonsensical.

*** Diversification applies across asset classes and strategies, not bonds alone.

There are few things the active fund management industry likes more than a tale of a manager consistently outperforming the market, year after year. It seems that there is no better sign of investment acumen than to overcome the odds and produce excess returns with unerring regularity.  The problem is that this notion is entirely spurious. Patterns of consistent outperformance are exactly what we would expect to see if results were entirely random. It is a measure that alone tells us nothing, but a belief in its significance is likely to lead us toward an array of investing mistakes.

Throughout my career there has been a fascination with hot streaks of outperformance from active fund managers. The careers of most star fund managers have been forged on seemingly rare runs of good form. Performance consistency is also often used as a tool for rating and filtering active fund managers – with skill linked to how regularly they beat their benchmarks over each year, or even each quarter or month.

Although it instinctively feels that consistent outperformance should be a marker of skill, it pays to think through the underlying assumptions that must hold for this to be true.

To think that the delivery of regular benchmark beating returns is indicative of skill we need to believe one of two things:

1) A fund manager or team can consistently predict future market conditions.

For a fund manager to outperform on a consistent basis and for us to consider it evidence of skill, then we must suppose that some individuals or teams can accurately predict the forthcoming market environment. If they cannot, then how they possibly position their portfolio to outperform through a constantly evolving backdrop?

2) Financial markets will consistently reward a certain investment style.

If we do not accept that a fund manager can predict the prevailing market backdrop each quarter or year (which we shouldn’t, because they can’t) then we must believe that a fund manager has an unimpeachable approach that always outperforms – no matter what the market conditions. It is a strategy that is impervious to cycles and styles.

It is difficult to discern which of these claims is more incredible, but if we are using performance consistency to inform our investment decisions then we are implicitly making (at least) one of them.

Stories over randomness

The overarching problem is one of narrative fallacy. We refuse to accept a randomly distributed set of performance numbers, instead we must build a compelling story to explain and justify them.

If we had a universe of 500 fund managers and each selected their portfolios based on the names of companies that they picked out of a hat we would still witness spells of consistent outperformance. We could easily create a captivating backstory about why a certain fund manager was able to beat the market with such regularity even if the results were based entirely on chance.

If there was no persistent skill or edge in active fund management (which is not an heroic assumption to make) and all results were entirely random, performance consistency would still make it appear as if skill existed.

The existence of consistent outperformers is almost certainly the result of fortune rather than skill.  

In any activity where there is a significant amount of randomness and luck in the results, outcomes alone tell us next to nothing about the presence of skill. The only way of even attempting to locate skill is by drawing a link between process and outcomes.

If we are claiming that performance consistency is evidence of skill then we must also show which part of the process leads to the delivery of such unwavering returns.  

Consistently poor behaviour

Unfortunately, the obsession with performance consistency is not just a harmless distraction, it is an issue that leads to poor outcomes for investors. There are three main problems:

1) It leaves investors holding entirely unrealistic expectations about what active funds can achieve. Consistent outperformance is unlikely to occur in the fund we own and, if it has occurred in the past, we should not expect it to persist into the future. A better rule of thumb would be if a fund has outperformed the market for five years straight then at some point it will underperform for five years straight.

2) If we buy funds following an unusually strong run of performance, we are increasing the odds of walking into expensive valuations and painful mean reversion. Rather than consistency being an indicator of skill, it is more likely to be a sign of more difficult times ahead.

3) The narratives that are weaved around consistent outperformance foster a culture of undue adulation for star fund managers. Adulation which always ends well…

Fund investors should stop focusing on and thinking about consistent excess returns – it tells us nothing meaningful – and instead concentrate on consistency of philosophy and process. In a complex, unpredictable system that is all that can be controlled.

A belief that consistent outperformance from an active fund manager is an indication of skill that is likely to persist is not only wrong, but also dangerous. Flawed expectations about the realities of active fund management inevitably lead to poor behaviours and disappointing outcomes.