Investors have never had it so good. We have unprecedented choice, improved transparency and easy access to valuable information. All this with ever-decreasing fees. Yet to believe that these are halcyon days ignores the behavioural reality. Many of the benefits that investors now enjoy come with significant behavioural costs that threaten to turn the best of times into the worst of times.

Let’s begin by looking at the main areas where investors now seem unequivocally better off:

Cost: The cost of investing in simple funds and strategies aligned to our long-term objectives continues to fall.

Control: Improved technology means that we can now select and change our investments at will. No longer are we condemned to persist with unsuitable holdings or thwarted by a quagmire of unfathomable paperwork.

Transparency: We can see exactly what is happening in our portfolios whenever and wherever we wish.

Choice: There is easy access to the full gamut of investment strategies, no matter what our requirements or preferences.

Information: Many high-quality investment insights are freely available.

So far, so good. Yet if we consider the same categories through a behavioural lens, a different picture emerges:

Cost: How can low costs be bad for investors? When they are used as a tool to lure us into activities that we should never engage in. Commission free or low cost trading in individual stocks, FX and even esoteric options comes at a punitively high cost for investors not simply because of the spreads, but the losses we will register with grim inevitability. There are scores of studies looking at the poor results of individual investors trading in such a fashion. Even the adverts for companies providing these services tell us just how bad we are in the small print.

Low costs here are not a benefit, just a hook to turn us into committed, unsuccessful gamblers.

Control: Closely aligned with transparency is the purported benefit of control. We don’t only see our investments each day, we can trade them too. Unfettered control means there is no protection against poor system one or hot state decisions. We make choices that make us feel better in the moment but come with a heavy long-term cost.

From a behavioural perspective, the combination of transparency and control can be toxic.

Transparency: It is difficult to argue that better transparency is a negative for investors, of course it is not. We must, however, be aware of the behavioural implications of improved visibility. The more frequently we observe our investments, the more likely we are to be captured by myopic loss aversion. Where our struggle to cope with short-term losses provokes poor decisions.

It is hard to think of a greater impediment to good long-term outcomes than being able to check our portfolios every day.

Choice: The vast array of choice available to investors is a curse rather than a blessing. Not only will we be confused by the complexity of options, but we will also never be satisfied. The paradox of choice means that we will be constantly frustrated by our failure to select the best option.

Too much choice can easily lead us to feeling confused and unhappy.

Information: We certainly have access to good quality information and guidance, but investors must also suffer a torrent of misinformation and noise.  From financial news channels counting down the seconds to each day’s market to open, to trading experts on Twitter (selectively) highlighting their otherworldly acumen; the weight of unhelpful information vastly outweighs that which is sensible. Brandolini’s law that “the amount of energy needed to refute bullshit is an order of magnitude bigger than is needed to produce it’, certainly applies to the investment information now easily available to us.

The problem of noise and misinformation is exacerbated by the fact that good investment guidance is boring, and the nonsense often far more interesting.  

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I often wonder who is better off. An unengaged investor who owns an underwhelming and unduly expensive active global equity fund in their pension but leaves it untouched over the years; or a fully engaged investor who assiduously checks their portfolio and trades actively. Whilst neither is ideal, the first investor will probably have superior outcomes because their ignorance insulates them from many of the sternest behavioural challenges we face.  

It is far too easy to ignore or understate the true consequences and costs of poor investment behaviour.

So, is now the best or worst time to be an investor?  Probably both. Like never before, investors have the opportunity to make simple and sensible decisions that deliver on their long-term goals. Yet this ignores the stark behavioural realities that we face. From a behavioural perspective it has never been more difficult to make good investment decisions, and unless we attempt to manage this it might really be the worst time to be an investor.

The Russian army’s intimidating presence on the border with Ukraine is the latest macro event that has investors concerned about equity markets. It is also the latest macro event that most investors would do well to ignore*.  We worry about specific, prominent issues because we want to protect against the losses that may occur if our worst fears are realised. The irony is the most sure-fire way for investors to make consistent and substantial losses is by lurching from one high profile risk to the next, making consistently poor decisions along the way. 

We have all seen the charts extolling the virtues of taking a long-term approach to equity investing.  They show how markets have produced strong returns in-spite of wars, recessions, and pandemics. They are a great illustration of the benefits of a long-term approach, but they don’t tell us everything.

What they fail to show is all those critical issues that worried investors but never came to pass. We are always confronting the next great risk to markets; the key to successful investing is finding ways of drowning out this noise.

There are two key reasons why this is incredibly hard to do:

First is how the media and industry serve to stoke rather than quell damaging behavioural impulses by obsessing over the latest macro risk. It’s far more interesting to speculate over the potentially dramatic implications of a given situation, than to repeat some boring lessons about sensible investor behaviour.

Second is that because some events have mattered in the past and some will matter in the future, we feel compelled to act on everything – just in case the current issue really does have an impact. Imagine if disaster strikes after we told everyone to disregard the risk.

Even though we can be certain that there are some events that will cause dramatic (short-term) losses for risky assets; discounting them is absolutely the best course of action for most long-term investors. This is for a host of reasons:

We cannot predict future events: Pre-emptively acting to deal with prominent risks that pose a threat to our portfolios requires us to make accurate forecasts about the future. Something that humans are notoriously terrible at.

We don’t know how markets will respond: We don’t only need to forecast a particular event; we also need to understand how markets will react to it. What is in the price? How will investors in aggregate react? Even if we get lucky on point one, there is no guarantee we will accurately anticipate the financial market consequences.  Take the coronavirus pandemic – if at the start of 2020 we had been able to see into the future and look at the economic data for the year ahead, we would have almost certainly made a host of terrible investment decisions. In investing, even foresight might not be enough to save us from ourselves.

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It is worth pausing to reflect on these first two reasons. Forecasting events and their impact on markets is an unfathomably complex problem to solve. We are incredibly unlikely to succeed in it.

2016 is useful example of this problem. For both the US election and Brexit (two macro risk obsessions at the time) investors were wrong footed by both elements – the forecast of the votes (even though they were binary) and the market reaction to them. Years and months were spent pontificating over positioning for those events, and many very intelligent people got everything wrong.   

When questions are posed such as: “What are you doing in your portfolio about Russia / Ukraine?” It is useful to unpack what is really being asked here, which is: “With limited information and a huge degree of uncertainty and complexity, have you made an accurate assessment of the likely outcome of the tense political / military stand-off between two countries, and then judged the market’s reaction?”

The answer should be no.

If the answer is yes, then we are displaying a huge degree of overconfidence.  

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We are poor at assessing high profile risks: We tend to judge risks not by how likely they are to come to pass, but how salient they are. This a real problem for macro events because the attention they receive makes them inescapable, so we greatly overweight their importance in our thinking and decision making. This is why the media and industry focus on them is so problematic – it makes us believe that risks are both more severe and more likely to come to fruition.  

We need to be consistently right: Even if we strike lucky and are correct in adjusting our portfolio for a particular event, that’s not enough – we need to keep being right. Making a bold and correct investment decision about a single event is one thing, but what about the next one that comes along? We need to make a judgement on that too, we can’t undo all our prior good work. Over the long-run being right about any individual prominent macro event is probably more dangerous than being wrong, because it will embolden us to do it again. 

Most events will not matter to our long-term returns: Daniel Kahneman’s comment that “nothing in life is as important as you think it is, when you are thinking about it” could be used in relation to short-term events and our long-term outcomes. In the moment that we are experiencing them macro events can feel overwhelming and all-encompassing, but on a long-term view they are likely to fade into insignificance.   

It is not that macro events are never significant for markets. There will be incidents in the future that will lead to savage losses in equities; we just won’t be able to predict what will cause them or when they will happen. Trying to anticipate when they will occur, rather than accepting them as an expected feature of long-term investing, will inevitably lead to worse outcomes. 

If we find ourselves consistently worried about the next major risk that threatens markets, there are four steps we should take:

1) Reset our expectations: Investing in risky assets means that we will experience periods of severe drawdown. These are not something we can avoid, they are an inevitability. They are the reason why the returns of higher risk assets should be superior over time. We cannot have the long-term rewards without bearing the short-term costs. We need to have realistic expectations from the start.

2) Check we are holding the right investments: The caveat to ignoring the risks of major macro events is that we are sensibly invested in a manner that is consistent with our long-term objectives. If we have 100% of our portfolio in Russian equities, it might make sense to be a little anxious about recent developments. The more vulnerable our investments are to a single event, the more likely it is we have made some imprudent decisions.    

3) Engage less with financial markets and news: There is no better way to insulate ourselves from short-term market noise and become a better long-term investor than to disengage from financial markets. Stop checking our portfolio so frequently and switch off the financial news. 

4) Educate ourselves about behaviour, not macro and markets: What really matters to investors is not the latest macro event or recent markets moves, but the quality of our behaviour and decision making. We need to shift our focus. The asset management industry can do a lot to help here because at present it does little but promote noise and unnecessary action, inflaming our worst behavioural tendencies.

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Provided we are appropriately diversified, the real investment risk stemming from major macro events is not the issue itself but our behavioural response to it – the injudicious decisions we are likely to make because of the fears we hold.

We need to find a way of worrying less about markets and more about ourselves.

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* As I hope is obvious, this observation is purely from an investment decision making perspective. Macro events will often have profound human consequences, which we should absolutely not disregard.  

I have a suspicion that over recent weeks and months you have become aware of a puzzle called Wordle. A simple, web-based word game that has become staggeringly successful since its October 2021 launch; so much so that the New York Times recently purchased it for a seven-figure sum. Both the structure of the game and its rise to popularity provides timely reminders of some crucial investment lessons:

1) Most activities are a combination of luck and skill: Like investing, Wordle is an activity that combines luck and skill. There are approaches that can be adopted to improve our odds of success (the word we choose to begin with, for example), but they don’t guarantee a good outcome. In any given game a statistically supported and robust approach can be outdone by someone starting with the word ‘toast’ because they were playing whilst eating breakfast. Over time, however, good decision making should win out.

2) How we start matters: Our fortunes in a game of Wordle will be heavily dependent on how we begin. A poor choice at the start, or some bad luck, will have a significant impact on our end results. Investing is about making sensible decisions at the beginning and sticking with them.

3) The usefulness of new information depends on the environment: Wordle is a small, stable game with a limited range of outcomes, where the new information we receive improves our chances. Investing is vast, chaotic and uncertain. We can never be sure what information is relevant, or how to apply it.  How helpful new information is depends on the environment we are in.

4) Going with our gut is probably a bad idea: Once we know some of the letters and their position, we will inevitably get an instinctive reaction as to what the correct word is (we might call this a system 1 response). Following how we feel rather than working to a plan will probably lead to poor choices and inferior outcomes. 

5) We don’t like missing out: We are social animals. We want to do what other people are doing and hate to miss out. This applies to the puzzle game that everyone is playing and the latest investment craze.

6) People enjoy showing off their successes: A key element of Wordle’s popularity is the ability to share our results on social media. Much like investors (selectively) lauding their investment performance on Twitter, we find it hard to resist highlighting our wins.

7) It is difficult to predict fads and fashions: Is Wordle significantly and obviously better than every other word puzzle game available that has not gripped our attention in the same manner? Probably not. Its resounding success is likely a result of a confluence of unpredictable factors such as timing, narrative and social connections. That is not to understate the attractions of the game, but in a parallel universe it may never have captured the public’s attention. We cannot hope to predict what games, stocks or themes will grab our imagination in the future, nor when the enthusiasm will abate.

8) Simplicity is powerful: The beauty of Wordle lies in its simplicity. It is easy to understand, has broad appeal and is quick to play. Achieving this type of simplicity is incredibly difficult. Its realisation was perhaps aided by the fact that its creator initially designed it as a game to play with his partner – it wasn’t intended to be a product to monetize. When we are designing something with the aim of selling it, we often have a bias towards complexity to prove our sophistication, evidence endeavour and ward off the threat of competition. This is certainly the case in investing where simplicity works, but complexity sells.

9) Costs matter: Wordle is (currently) free, it is almost certain that its enormous popularity would not have occurred had there been a charge to play. Costs are a critical factor in success.  

10) Games are meant to be fun; investing isn’t a game: Although there are ‘optimal’ approaches to solve Wordle that improve our probability of a quick win, it is fine to ignore them. Wordle is a game and supposed to be enjoyable. Taking a studious and deliberate approach will suck the joy out it for many players. We should be happy to just go with how we feel. Contrastingly, investing is not a game and if it gets fun or exciting, we should start to worry. Unlike Wordle, taking a boring, evidence-based approach that gets the odds on our side is always the right thing to do.

I am sure I have bored plenty of people in recent years by repeating the mantra ‘process over outcomes’. There is probably no more important frame or model to apply when considering how we make investment decisions. In an environment where skill is often overwhelmed by luck and randomness the more we focus on results alone, the worse our results are likely to be.

Drawing a strong and consistent link between process and outcomes is critical to making good judgements, but it is not everything. There is a third element that is often lost or obscured, but should be the starting point for any investor:

What do we believe about investing?

This seems to be an incredibly simple concept, but a clear sense of the investment beliefs that inform our actions is so often lacking. Without this it is almost impossible to assess the validity of an investment process, or gauge whether it is likely to lead to better outcomes.

The Three Parts of an Investment Decision

We can think about investment decisions as being based on three key parts:

Beliefs / Process / Outcomes:

Beliefs: These are the ideas that we hold to be true about investing. They can be broad, or specific to a problem that we are attempting to solve.  

A passive, index fund investor might believe that there is no reasonable means of consistently improving on the returns of the market. An active fund manager with a quality orientated equity strategy might believe that investors underappreciate the persistently high returns on capital from certain types of companies.

These types of beliefs must be the foundation of any investment decision.

Process: A process is the actions carried out or the steps designed to link beliefs to outcomes. We start by believing something about markets and then create a process that reflects our beliefs to deliver the desired results.

Outcomes: Outcomes have two distinct forms – at the start and end of an investment decision. At the beginning, outcomes relate to the goals or objectives we have – our investment intentions. At the close, they are the end results – a pure consequence of our beliefs and process.

The ultimate outcomes are the one element that we cannot control; although, ironically, it is the one we spend most of our time obsessing over.

Why do beliefs, process, and outcomes matter?

Without considering beliefs, process, and outcomes it is highly unlikely that we will make good investment decisions. 

It is incredibly common to see investment processes (at times quite complex in nature) that are not supported by any clear investment beliefs. This is odd. Presumably to create a process to make an investment decision, there must be an underpinning belief – or what is the point of the process?

There are two major errors investors make in this regard. First is to mistake an optically rigorous process (complex, lots of steps) for a good one. A process doesn’t exist in a vacuum, it can only be as robust as the beliefs that it is attempting to enact or exploit. Second is when investors focus solely on whether a process has delivered in the past, rather than why it should (or shouldn’t) work.

It is difficult to assess the credibility of a process without understanding the beliefs that support it. This is irrespective of how robust it may appear, or how comforted we might be by the historic results it has generated. A process (or decision) must be founded upon an explicit or implicit set of beliefs.

It is perfectly possible to have an investment process and not realise what the underpinning beliefs are, although I would not recommend it. 

The Problem with Beliefs

Having a set of beliefs supporting our investment decisions doesn’t guarantee success, but it at least gives us a fighting chance. There are, however, some obvious pitfalls:

Beliefs are wrong: Although holding investment beliefs is essential, it does not mean that they will be correct. In fact, we all have investment beliefs now that are likely to prove erroneous (I certainly do). Possessing a set of beliefs should not mean that they are immutable – rather things we believe to be true based on our assessment of the available evidence. We should always be willing to change and adapt; although if our beliefs are shifting too frequently, they probably don’t qualify as beliefs. 

Beliefs are too vague: Some investment beliefs are so vague they don’t really mean anything. We should be able to read or hear someone’s investment beliefs and have a clear idea about what that might mean for the design of a process or the decisions that they will make. Too often this is not the case, so the beliefs are rendered worthless. A vague investment belief is akin to someone being asked whether they are religious and they say “No, but I am spiritual”; it tells us something but nothing specific enough to enlighten.

Beliefs are inconsistent with process: There can often be a disconnect between our stated investment beliefs and the process we adopt. Let’s say there is an active fund manager who believes that a long time horizon is essential to delivering excess returns but has a process that is likely to lead to high short-term turnover in underperforming positions. They do so because they think they will be fired if they trail the market for a sustained period. Although this seems like an incentive misalignment issue, it is also a question of beliefs. In this situation the investment process is designed based on what the fund manager believes is required to keep their job. Investment beliefs are subordinate.

A high quality investment decision must always have a thread linking beliefs, process and outcomes.

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Investors can take huge strides towards better decision making by dialing down the incessant noise of headline performance, and instead focusing on the underlying processes that have led to certain results. But that is not enough. We also need to spend more time thinking about what we believe. Every decision we make says something about our investment beliefs, we should be clear about what they are and why we hold them.  

At its heart ESG investing is about the responsibility of companies to take accountability for far more than shareholder profit maximisation. Corporate behaviour can and will have profound implications for people and the planet, and this should be a critical element in the decisions businesses make. At times it feels as if this noble aim is lost in the fervour to sell ESG investing; an activity which often relies on unsubstantiated claims about the ability of an ESG approach to boost fund returns. Although lauding a performance advantage might attract investors in the short-term, it is almost certain to undermine the movement long-term. If ESG investing is going to be sustainable the asset management industry needs to change how it talks about it.

Does a Higher ESG Score Lead to Future Outperformance?

Much of the marketing around ESG falls foul of one of the cardinal sins of fund investing. Taking a short, noisy sample and then dubiously extrapolating. The most common approach is to extol the performance of ESG-oriented strategies over the last decade, and then suggest that this is likely to prove a permanent feature.

There are a host of problems with such statements:

– The typical 10/15 year history used is an absurdly short amount of time to draw firm conclusions about the viability of an investment approach. Any random investment strategy – such as picking stocks out of a hat – will enjoy comparable spells of success. Based on this technique, similar comments could have been made about technology in the late 1990s and emerging markets in 2010.

– The time period over which the virtues of companies or strategies with positive ESG credentials are acclaimed is one in which value investing as a style was trounced by quality and growth approaches. It is close to impossible to disentangle returns to ESG investing from what was a broad and sustained market phenomenon of value stocks (a grouping littered with ‘old economy’ names) trailing the wider market.

– Focusing on returns over a relatively brief period (in the context of market history) also falls foul of one of the most dangerous traps in fund investing – the cyclical nature of performance. Our base case should be that strong returns in the recent past are likely to be a prelude to weaker returns in the future. Generally because the market favourites become too expensive, or the environment changes.

– Definitional issues also create challenges for the performance-led arguments that are so often made. Given the understandable inconsistency about what good or bad ESG characteristics really are; it is difficult to make confident claims that there are a stable set of features that have and will deliver superior returns.

Is ESG Investing Lower Risk?

The performance narrative around ESG investing is not solely focused on the returns delivered in the recent past, it also stretches to assertions about it being intrinsically lower risk. The evidence used for this is commonly focused on how companies with positive ESG credentials have fared in periods of market drawdown. The credibility of this case is perhaps even weaker than those based on historic headline returns.

There are two main flaws:

– The sample size used is often ludicrously small. It is not unusual to see the suggestion that because the losses of ESG focused strategies during the March 2020 COVID induced sell-off were less severe than the market it follows that they have permanently lower risk. Leaving aside the dubious nature of conflating temporary drawdowns with risk; we should never make bold prognostications about the future based on one specific market period or event. We can take any style of investing and cherry pick a difficult market backdrop where it fared well. It will tell us nothing about the structural features of that approach.  

– The losses made by any investing style is dependent on myriad of unpredictable factors. The range from the operational features of the companies, the cause of broader market declines, the prevailing economic backdrop and valuations, amongst a host of other elements.  Making forecasts about future risk and losses from specific, narrow instances in the past is dangerous and impossible to robustly substantiate.

When the case is made for ESG investing based on the notion that historic outcomes have been strong and will continue, it not only creates false expectations, but it undermines the entire movement. It makes people invest for the wrong reasons. If the growth in ESG is meant to represent a genuine shift in our approach to investing and become an important lever in our ability to tackle issues such as climate change, then making it about fund performance is exactly the wrong tactic.

We know that investor tolerance for underperforming funds is staggeringly brief. What happens when stocks and funds with positive ESG characteristics start to underperform? Investors are likely to move on to the next outperforming trend, particularly as we told them to focus on the performance prospects.  

It is critical to remember that even if there is a long-term structural return advantage to holding positive ESG tilts in a fund, then it will still suffer prolonged periods of underperformance. Value has one and underperformed the market for the best part of 15 years.

I can entirely understand that strong advocates of ESG investing believe the best way to attract money and attention to the cause is to appeal to the primary driver of fund investor behaviour – past performance. Yet, in this case, taking the path of least resistance means stoking temporary enthusiasm that will be a prelude to a long-term whimper. The use of past performance as a sales tactic is a blight on the industry. It is designed to exploit the worst investor biases and is damaging to long-term outcomes. ESG should be about education not sales.

A major problem at the core of the performance angle for ESG investing is the assumption that believing that something is either good or true, means that you also must believe that it will outperform. If you are sceptical that ESG stocks or funds will outperform, it means that you disregard the entire concept.

This is not how investing works.

At the height of the dot-com craze I could have had a very high level of conviction that returns from internet-based companies would be terrible; this would not have meant that I didn’t believe in the internet.

They are not the same thing. Everything has a price.

How Might an ESG Approach Boost Returns?

Reading this piece so far, you might think that I believe all expectations about the future returns of ESG investing to be spurious. This is not the case. The issue is how the arguments are made. We should never make forward looking assertions about returns based solely on past performance. It is perfectly reasonable, however, to do so if we have a clear rationale as to why something is likely to fare well in the future.

If we have an investment view then we need to state our case.

So, why might ESG investing generate greater long-term gains from here? We can use a very simple model of equity returns to see how it could happen.

Our future equity returns will be driven by a combination of starting valuation + valuation change + growth. Any fundamental view about better performance from ESG investing should be based on one or more of these elements*.

We can take each in-turn:

Starting valuations: It is possible to argue that valuations of companies with positive ESG credentials are priced so that the yield / return we receive from here is more attractive than other areas of the market. This notion leads us directly to one of the main shortcomings in the discussion around the performance attractions of positive ESG stocks – the idea that companies with a lower cost of equity should outperform stocks with a higher cost of equity. This inverts a core principle of investing by stating that lower risk comes with a higher return. If a company manages ESG risks incredibly well, then its cost of financing from equity should be lower, as consequently should be the returns to investors.

Valuation / cost of equity change: Starting valuation is not the end of the story. Strong returns to ESG investing can come from the change in cost of equity / valuation. This can work in two main ways – companies that manage ESG better are rewarded with higher valuations / a lower cost of equity; or companies who manage ESG risks badly suffer from a spiralling cost of equity and major de-ratings. In the latter instance, investors require significantly higher returns to bear the risk of holding equity.

In these scenarios, an ESG investor can generate superior returns by either avoiding the companies with a rising cost of equity or owning those where it is moving in the right direction.

There is, however, a significant issue here with how the industry is reporting ESG. The pace and scale of the movement means that there is a drive for all types of investors to ‘prove’ their ESG mettle, which is typically done by displaying ESG scores or carbon metrics versus a benchmark. Everyone wants to look ‘more ESG’ than the index and peers.

What’s measured is what matters.

This makes no sense. A rational investor would want to be investing in companies with weaker ESG characteristics now but where they think there will be improvements in the future. Why? For two reasons. First, if we are right then we profit from the valuation / cost of equity change as the risk of the business falls. Second, they can use their ownership influence to push for the desired change.

Investing in this type of company means that we might look inferior from a headline ESG perspective. That to many is unpalatable.

The worst possible outcome for ESG investing is that optics matter more than materiality.

Growth: The final element is growth. Earnings growth could be far superior from companies with stronger ESG characteristics, and this is not reflected in current prices. This growth advantage is typically thought of being delivered by companies better positioned to access the opportunities presented in a shifting landscape (almost always related to climate); but it can also be about the reverse. Companies on the wrong side of environmental and societal developments could struggle to deliver earnings growth. An ESG performance edge may arise from avoiding such businesses.  

None of these potential arguments as to why a positive ESG tilt may lead to enhanced performance suggests that there is some ingrained feature that make it an empirically robust factor or risk premia such as value or quality (although ESG and quality are likely correlated). It is simply an expression of an investment view about why positive ESG traits may be currently undervalued and therefore likely outperform in the future. It could apply to the wider ESG complex, or individual companies.

The point here is not to suggest that these arguments are true, but that if anyone makes claims about the potential for improved future returns from ESG-oriented strategies they must explain how this will occur. Even if you disagree vehemently with them, it is surely far better than saying it will work in the future because it has worked for the past 10 years.

Any predictions about the performance potential from ESG investing is an investment view, which needs to be supported and owned like any other.

What is the Real Potential of ESG Investing?

Although I have spent some time attempting to explain the type of contention that must be made to credibly establish a view about the efficacy of ESG investing from a pure performance perspective; I actually think that specific claims about the returns of ESG funds and strategies are incredibly unhelpful. It is often little more than a sales and marketing strategy attempting to exploit the worst performance chasing, behavioural impulses of fund investors. It also blithely ignores the two main prospective ‘return’ benefits of ESG investing.

The two most credible positives of the ESG movement have nothing to do with fund level alpha; they are far broader:

– The shift towards stakeholder capitalism and away from short-term, shareholder return maximisation could have profound benefits for the environment and society. If it assists in slowing temperature rises, reduces biodiversity degradation, or helps limit modern slavery; these are powerful returns, just a different type.     

– Even if you are sceptical about the need or ability of the private sector to drive change in such areas and don’t think such externalities qualify as a type of ‘return’; there is a way that ESG investing may help boost long-term financial returns. If the broad embrace of ESG factors in investing contributes to limiting the rise in global temperature this could improve future asset class performance. Whilst by no means certain, it seems likely that equity returns would be higher in an environment without unchecked warming.

Although these are potentially the most powerful features of ESG investing, they don’t really get as much focus as the fund performance angle. Why is that? Because they don’t sell. If ESG as a movement helps the long-run returns and interests of everyone, that doesn’t help market my fund relative to the competition.

So, instead, we end up making dubious claims about the potential performance persistence of ‘high scoring’ ESG companies, fill our portfolios with businesses exhibiting the best current ESG metrics and dispose of the stragglers (to other investors who might have a different agenda to our own).

This might work in boosting asset flows in the near-term but undercuts the viability of ESG investing in the long-term. Fund investors will lose faith when the inevitable spells of difficult performance arrive, and the potential impact of a positive approach to ESG will be neutered by the desire of asset managers to manage optics and look better right now.   

If we really believe in it, it’s time to change the narrative.

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* We might not have a fundamental view at all and simply see it as a momentum trade. This is perfectly reasonable; we just need to make sure we have a plan for when to get out.

I try to avoid engaging in the folly of making predictions about financial markets, but here is one. Returns over the next decade from most asset classes will be significantly lower than they have been in the past decade. 

It doesn’t take a soothsayer to foresee this. Valuations in many areas are stretched and the expected return from a traditional 60/40 approach is close to historic lows. Of course, this forecast could be wrong; there are scenarios where returns run even hotter from here, but that should be considered a low probability path. 

What’s puzzling about the current backdrop is not that it is one defined by low expected returns – markets are cyclical and these environments will occur – but the investor response to it. We might anticipate a rational reaction to be an increased interest in out of favour areas with more appealing valuations, but that’s not what happens. Instead, we keep buying the most expensive assets. When confronted with lower expected returns we buy more of the asset classes and funds that are likely to have the lowest future returns. 

Rather than consider this activity to be incongruous however, it is exactly what we should expect to see. The structure of the industry, it’s incentives and our own behavioural foibles combine to make it close to inescapable.

What are the main drivers? 

Extrapolation: One of the most damaging investor traits of all and one which Charlie Munger labelled “massively stupid”, is our tendency to extrapolate the past. What has come before will continue. When we persist with buying expensive assets, we ignore the price being paid and simply extrapolate the strong performance into the future. In doing so we ignore every lesson and piece of evidence about capital cycles, valuations and mean reversion. It is why we happily pile our money into thematic ETFs at the peak of stratospheric performance. 

Charlie was right. 

Narratives: Compounding the problem of extrapolation is the power of narratives. Strong past performance is always accompanied by stories to explain and justify it. This creates a virtuous / vicious circle where stellar returns are given a compelling narrative and that narrative further boosts performance. Expensive assets always have great stories. There is nothing investors love more. 

Time Horizons: Most investors operate with time horizons that render valuations irrelevant. By time horizon I don’t mean our ultimate end objective, but the period we care about enough for it to influence our decisions. The latter is typically far shorter than the former. If our patience stretches only to one or two years, then we will rarely notice the importance of the price we pay. Until it is too late. 

Career Risk / Incentives: For professional investors, increasing purchases of expensive assets is about the management of career risk. As money flows into the most richly valued areas they become a dominant feature of benchmarks and the main driver of performance. Almost everyone comes to believe that owning more of these assets is obvious. As this phenomenon persists, we have the choice of either joining the party, or losing assets and our jobs. Our incentives are aligned with buying outperforming, expensive assets and funds even if the evidence suggests it is likely to be of detriment to future returns. 

Emotions: How we feel has an overwhelming impact on the investment decisions we make. Owning expensive assets is, for the most part, anxiety free. They are performing well, everyone else is buying them and the stories provide validation. For cheaper assets the reverse is true; the narratives are bleak, returns have been poor, and owning them means separating ourselves from the crowd.

Much of our investment activity involves doing things that make us feel good in the moment. We can then repent at leisure.

Overconfidence: We are happy to own assets with stretched valuations even if we acknowledge they are prohibitively expensive because we have an exaggerated belief in our ability to time our exit. We will stay invested whilst things are going well and then change course when things turn sour. Whilst this is an attractive idea, the history of market timing suggests the reality is unlikely to be so favourable. 

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Studying investor behaviour is typically about identifying the gaps between what we should do and what we actually do, but sometimes it is more profound than that. Our behaviour is often paradoxical.

Consider the following:

The more extreme the outperformance and rich the valuations of an asset class or fund, the greater the likelihood of disappointing returns in the future.     

And

The more extreme the outperformance and rich the valuations of an asset class or fund, the more attracted investors will be to it.*

Given that most investors are seeking to maximise future returns this inconsistency seems absurd, but it is not. Our instincts and environment make the behaviour both damaging and almost inevitable.**

We shouldn’t be asking why do investors chase performance and buy expensive assets but rather, why wouldn’t they?

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* Momentum investors get a free pass here because – in the simplest terms possible – chasing strong performance trends is their deliberate process.

** The behaviour won’t persist indefinitely – expensive assets don’t keep attracting assets and outperforming – market conditions will change and valuations will matter again. It is just impossible to predict when.

At the pinnacle of its bubble in 1989, a toxic combination of loose monetary policy, rampant loan growth and a spiralling cost of land led the Japanese equity market to trade at close to 100x cycle adjusted earnings. Inevitably this heralded decades of disastrous returns. Between 1990 and the end of 1999 the annualised return from Japanese equities was -4%; over the following decade it managed to fare even worse posting -5% returns per year.[i]

Although investing at such extreme prices seems foolhardy; passive global equity investors would have been increasingly exposed to Japan as the bubble inflated with their allocation hitting 45%. On an EAFE basis the concentration reached 65%:

Does this trait of growing exposure to astronomically priced assets mean a market cap based country allocation is a terrible idea?

No, it is perfectly rational. It just comes with costs and limitations. As with any investment strategy.   

In this binary world our default view is to stridently take one side and vehemently oppose the other. Committed passive investors will claim that an active country allocation is non-sensical given the underwhelming performance history. Active management advocates will argue that any approach that ingrains objectively bad decisions – like allocating half of our assets to staggeringly expensive markets – runs counter to all evidence about what drives long-term returns.

Financial markets are just too noisy and uncertain to take such forthright and singular views. Often two statements can entirely contradict each other whilst both being true.

Take the below examples:

A passive, market cap approach to global equity investing has and will prove to be an effective long-term option for many investors.

and

Investing near half of our equity assets in a market trading at 100x cycle adjusted earnings is an awful strategy.  

If we accept the evidence that buying very expensive assets is a recipe for poor future returns; how is it possible to claim that passive global equity investing can also be a sensible course of action?

There are several valid arguments a passive investor might make:

1) We do not believe there is another method that can consistently put the odds in our favour. It is not enough to say that a market cap, global equity allocation is deeply flawed; we need to have confidence in a robust alternative.

2) The long-run return of global equity markets incorporates incidents of bubbles and manias; they are a known and expected feature that must be withstood.

3) We have no way of telling where a bubble will occur, how far it will rise or when it will crash. Therefore, it is best simply to weather them.

4) It is easy to lament the cost of a bubble or the impact of buying expensive assets in hindsight; it is much more difficult to accept the years of painful underperformance which will come when we reduce our exposure early, yet the momentum continues. The behavioural challenges of an active approach are far too great to bear.

5) Country allocations based on market cap are a reasonable proxy for future earnings on average, despite being wildly inaccurate at times.

None of these arguments suggest that buying extremely expensive assets is prudent, rather they accept the drawbacks of a passive country allocation, whilst believing it to be the best (or least worst) option.

As guilty as active investors are of dismissing the evidence around the efficacy of index funds however, passive investors are equally culpable in rarely acknowledging the shortcomings they suffer. Even committed passive exponents should ask themselves whether there are any scenarios where index exposures become so extreme that they would be willing to go against everything they believe and take active positions away from the benchmark.

What would they do in a repeat of the Japan scenario?

Situations like the one we observed in late 80’s Japan will likely occur again; perhaps we are entering such a phase with the US.

It is easy to be complacent about the rise of US equities to close to 70% of the MSCI World Index. The strong performance that has led to it and the narratives used to rationalise it make extrapolation and justification easy. But we should not ignore that passive investors are becoming progressively more exposed to one of the most richly priced global equity markets.

So, is the US a Japan redux? No. The valuations are nowhere near as extreme (which is not really saying much) and the corporate fundamentals do justify a high US weighting. The FTSE RAFI Developed 1000 index, which weights companies based on factors such as dividends, cash flow and sales has a US equity allocation of c.59%. Not quite 70%, but even if we disregard stretched valuations, the US is still the world’s dominant equity market.

Not being Japan does not mean investors should blindly accept the situation. History would suggest that stretched valuations lead to disappointing returns. It is hard to argue that valuations in the US are not elevated (even relative to other regions).

I have heard passive advocates justify the increasing US weighting by making claims about US exceptionalism and the incredible profitability / market dominance of the tech and consumer names. Whilst this might be a credible case it is conflating an active investment view with the use of index funds.  The correct argument – as mentioned above – is that this type of situation is a known and expected feature of a market cap, global equity allocation; and they believe it to be the best method for capturing long-run global equity returns.  

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There are many awful ways to invest that we should avoid at all costs, but there is also no right way -just a range of reasonable techniques all of which come with advantages and serious drawbacks.  Most investors align themselves with a particular religion (active or passive) and summarily dismiss the other. This is unhelpful and belies the realities of hugely uncertain financial markets with often conflicting evidence.

In simple terms, passive country allocators need to accept that they will buy increasing amounts of punitively expensive assets; whereas active investors (at least those with a valuation discipline) will endure multiple years (maybe decades) of severe underperformance even if they are right in the end.

No approach is perfect, we must pick our poison.

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[i] The Age of Disorder – Deutsche Bank (db.com)

At the 2012 Jackson Hole Economic Policy Symposium, Andrew Haldane, who went on to become Chief Economist at the Bank of England, gave a speech to the gathered central bankers entitled: ‘The Dog and the Frisbee’. It was about simplicity and complexity. The speech began:

“Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to apply Newton’s Law of Gravity”. [i]

Dogs are good at catching frisbees, does that mean that they understand Newtonian Physics? No. A dog can make a successful grab for a frisbee by applying a simple rule of thumb: running at such a speed that the frisbee is maintained at an approximately constant angle.

The unusual but eloquent point being made by Haldane was that simple rules are often the best approach to solving or managing complex problems. Complex solutions are often too slow, ineffective, or designed to deal with yesterday’s challenges.

Financial markets are far more complicated than catching a frisbee, but we often seem resistant to adopting simple approaches.

—

Haldane’s speech drew heavily on the work of German psychologist Gerd Gigerenzer who is an advocate of using fast and frugal decisions rules, or what he calls simple heuristics, to make judgements and predictions in certain environments. There have been countless examples of studies testing Gigerenzer’s ideas. In one such study, researchers looked at the Wimbledon 2003 tennis tournament and found no difference in the quality of match predictions between laypeople simply choosing the name they recognised and the complex, computer generated rankings. [ii] This is known as the recognition heuristic.

A more pertinent example for investors regards portfolio optimisation; creating the mix of securities that can deliver the best or optimal returns for a given level of risk. A study showed that rather than utilising complex, computer-driven optimisation approaches incorporating returns, risk and correlations, the most effective rule was 1/n, which means to equally weight all available options.[iii]

This is the approach Harry Markowitz – the father of modern portfolio theory and winner of the 1990 Nobel Memorial Prize in Economic Sciences – is said to have adopted for his own investments.

Why would such a seemingly naïve approach work when dealing with such a complex problem?

Gigerenzer argues that simple heuristics are effective when the environment meets three key criteria: [iv]

 i) A high level of uncertainty.

ii) Many options.

iii) Short sample.

It is incredibly difficult to make optimal decisions in complicated, unpredictable environments where there is a broad assortment of choices and insufficient historical evidence. Optimizing for the past does not mean optimizing for the future.

Investing meets Gigerenzer’s three criteria. Yet rather than aiming for simplicity investors often layer complexity upon complexity. Not only is there the baffling variety of potential securities, funds and asset classes to assess; the markets in which we invest are adaptive and unpredictable.

Given this, why do investors often seem to prefer complexity over simplicity?   

There are four major drivers:

–  It can feel incongruous or even naïve to address a complex environment with a simple solution. To solve an intricate multi-faceted problem we must adopt an equally elaborate approach.  

– When we are presented with a complex situation with a huge range of variables and potential outcomes, the opportunity to over-engineer answers can prove irresistible. The torrent of noise makes us believe that there is always a better way.

– Complexity sells and sells for a higher price than simplicity. It is hard to differentiate ourselves, our product or our business by providing simple options.

– After the event, simplicity often won’t look like the best route to have taken as there will always be something more sophisticated that has delivered better results.

—

A simple approach is no panacea; an ill-judged decision rule or heuristic can lead to very bad outcomes. Simplicity does not equal efficacy. We should not, however, be in thrall to complexity. Investors should start with simplicity and make things no more complex than they need to be.

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[i] https://www.bankofengland.co.uk/paper/2012/the-dog-and-the-frisbee

[ii] Serwe, S., & Frings, C. (2006). Who will win Wimbledon? The recognition heuristic in predicting sports events. Journal of Behavioral Decision Making, 19(4), 321-332.

[iii] DeMiguel, V., Garlappi, L., & Uppal, R. (2009). Optimal versus naive diversification: How inefficient is the 1/N portfolio strategy?. The review of Financial studies, 22(5), 1915-1953.

[iv] G.Gigerenzer, Rationality for Mortals: How People Cope with Uncertainty (Oxford University Press, 2008)

In the second chapter of Mark Twain’s The Adventures of Tom Sawyer the protagonist is in a spot of bother. He has been involved in another scrap and as punishment is tasked by Aunt Polly to spend his precious Saturday whitewashing ‘thirty yards of board-fence nine feet high’. It seemed that a bleak day lay ahead for poor Tom, yet in a matter of hours boys from the town were queuing up to take a turn with the brush. Not only that, but they were paying Tom for the privilege.

How did he manage such a feat?

He applied some behavioural tricks to transform the situation, using the power of framing and scarcity.

Tom Sawyer has some lessons for investors.

As he was beginning his work on the fence, Tom was approached by Ben Rogers, a boy from the town.

Ben began to ridicule Tom’s predicament:

‘Say, I’m going in a-swimming, I am. Don’t you wish you could? But of course you’d druther work, wouldn’t you?’

Tom desperately wished he could stop painting and go swimming but he didn’t let on. Instead, he changed the frame:

‘What do you call work?’

‘Why, ain’t that work?’

‘Well, maybe it is, and maybe it ain’t. All I know is that it suits Tom Sawyer.’

Tom re-frames the situation. Painting isn’t a chore; it is what he wants to be doing. He would rather be whitewashing than swimming.

As Tom lovingly returns to his meticulous task, Ben’s perspective is changed entirely. He stops mocking Tom, instead he asks for a turn.

Tom reframes the situation by evoking a key driver of our behaviour – the notion of scarcity.

Painting the fence is not arduous graft, it is a rare privilege that is not available to everyone.   

‘Does a boy get a chance to whitewash a fence every day?’

‘I reckon there ain’t one boy in a thousand, maybe two thousand, that can do it in the way it’s got to be done’.

Tom was able to spend the day relaxing and ponder how he had managed to get three coats of whitewash on the fencing, whilst almost bankrupting all the boys in the town.

Why do the actions of Tom Sawyer matter? Because framing and scarcity are critical to how we make decisions and are vital concepts for investors to understand.

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We can consider framing to be the lens through which we interpret the world. The mental models that we apply to inform our view on a particular situation. The frames we apply can be intransigent and all-encompassing, such as a strident political view which influences how we understand almost everything. They can also be or more focused and potentially malleable – like Ben’s view on the joys of whitewashing a fence.

Some frames can be easily shifted, others cannot.

We spend a great deal of time trying to change the mind of people we disagree with by to them explaining how we see things – this is likely to be fruitless. We need to understand that they are viewing the evidence through an entirely different frame. Our starting point in the face of differing opinions should be to try and view the situation through the other person’s frame.

Many intractable investment debates are a faming problem. Take the inherent friction between a strong advocate of ESG-focused investing and a proponent of the idea that shareholder returns are paramount above all else. No amount of discussion and deliberation about the specific evidence is likely transform any side’s viewpoint, it is a framing problem. Understanding the model each side is applying is likely to be far more productive than exchanging different studies with contrary evidence.

Some of our most significant investment mistakes are also likely to be a problem of framing. It is not that we made a wrong call on a particular market or macro-economic event, it is that we were viewing the world through an entirely incorrect frame. An investor whose initial experience was in the 1970’s is likely to have an entirely different model for thinking about interest rates and equity markets, than someone who has only experienced the most recent decade.

The major challenge for investors is that markets are complex adaptive systems – how they function through time will evolve. Applying one overarching frame is unlikely to be a successful approach. We need to understand the frames that we use which are likely to prove robust through time (short-term market movements are unpredictable noise) and those which are subject to change (bond yields always fall if equities are weak).

It is important for investors to think more explicitly about framing – why we see the world or the situation as we do. There are three key benefits:

1) It allows us to better challenge our own views. Our beliefs about a subject are likely the result of the specific frame we are using. We need to worry less about the information we are observing and more about the lens through which we are looking upon it.

2) It enables us to understand the perspectives of others. It is easy to disregard the viewpoints of people we disagree with, without ever attempting to understand the frame they are using.

3) It can assist us in encouraging good investment behaviour. How can we influence people to become long-term investors? Think about the frames they are applying and try to shift them.

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Tom Sawyer did not just change the framing of his task by highlighting how much he enjoyed it, he applied the scarcity principle. We desire things more and ascribe them a higher value if we believe they are scarce.

The perception of low or restricted supply increases the demand and price.

The concept of scarcity and how it influences our behaviour is critical to how we consider the value of different assets or investments. It is an idea that has seemingly become increasingly relevant in recent years.

In simple terms we can think of an asset or object as possessing value for three reasons:

1) It has some use or utility.

2) It provides us with a cash flow (often related to its utility).

3) It is scarce.

If something has no or little utility and does not generate a cash flow, then its value is likely to come from scarcity. It seems unlikely that something that is abundant and has no use will be of value.

To create value without utility, we need scarcity.

Of the three drivers of value, scarcity is the exception. This is because its perceived worth is not driven by the asset itself but entirely by the perceptions others hold about it. Whilst the value of all assets are impacted by the beliefs of others, most are underpinned by utility or cash flows.

Why can scarcity create value, or at least the perception of value? Social proof is perhaps the critical element – our view is informed by the behaviour of others. It must be valuable because everybody else thinks it is.

The information we take from the actions of others is compounded by the fear that we are being excluded – limitations in supply make us view the situation through the frame of loss. What is it we are missing out on?

The more boys from the town turned up to help paint Aunt Polly’s fence, the more other boys wanted to join the queue.

As much as scarcity value is about other people, it is also about us. Scarcity is deeply intertwined with signalling – the decisions we make to manage how we are perceived. Items that are rare or difficult to attain are attractive because they say something about us, about the group we belong to. Nobody buys an expensive, branded t-shirt because it has significantly more utility than a simple option, they do it because they want to signal something. Here there is a circular relationship between scarcity and price. The higher the price of something the more scarce or difficult it is to obtain, which makes it worth more as a signalling tool.

The other vital element of scarcity is the narrative. Not all items or assets that are scarce are deemed to be valuable, particularly if they are useless. So, the story matters. The story also becomes more powerful the more the perceived value increases. Price change begets story begets price change. And so, the cycle continues.

Assets with a value driven solely by scarcity can be dangerous for investors because there is no supporting worth or utility. We are beholden to the behaviour of others. Yet, we should not be too dismissive of a factor that can exert a huge influence on the behaviour of financial markets and asset prices.

—

Tom Sawyer elegantly uses the framing of scarcity to transform the perception of his situation and change the behaviour of others.

He had discovered a great law of human action, without knowing it – namely in order to make a boy covet a thing; it is only necessary to make the thing difficult to attain.

He changed the frame. What frame are you viewing the world through?

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Twain, M. (19876). The Adventures of Tom Sawyer,

Suspend your disbelief for a second. Imagine you have been gifted $1m, the only proviso is you must split the amount between an equally weighted 30-stock portfolio of US listed companies selected by Warren Buffett and a 30-stock portfolio of US listed companies selected by…me. You get to keep the amount staked on whichever portfolio produces the highest return.

Where would you put your money?

Of course, it is impossible to take any view on likely outcomes because we are missing a vital piece of information – the time horizon. When considering luck and skill in investing this is the most important thing. It changes everything.

Let’s say the time horizon was just a single day. The odds of my portfolio beating Buffett’s must be 50%. One day’s stock market movement is nothing but random noise. $500,000 each seems a prudent approach.

What if the length of the bet is increased to one year? The chances of my portfolio might be a little less than 50% but only modestly. Nobody can accurately and consistently predict in advance what will happen in equity markets over the next year. Fundamental company attributes are unlikely to matter that much compared to events, narratives and flows. The result would not be far from a coin toss.

How about three years? This is an important timespan because it is often the period over which fund investors hire and fire active managers. We should expect some advantage to arise from Buffett’s acumen and experience here, but the results would still be extremely variable and hugely influenced by sentiment, rather than the aspects of a business Buffett cares about.

We could use base rates to help us size the bet. Between 1988 and 2019 Berkshire Hathaway outperformed the market on c.60% of rolling 3-year periods.[i] A $600,000 stake towards Buffett would seem sensible.

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The tangential point here is that on the time horizon adopted by most fund selectors, Warren Buffett would have been sacked on multiple occasions over his staggeringly successful investing career. Past performance can be a terrible decision-making tool.

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Now, back to the bet. 

Finally, let’s try a 10-year time horizon. We are getting into the realms of long-term investing. Company fundamentals should matter more. Skill should start to exert a material influence. But how much?

Let’s go back to base rates. Over the same period as previously mentioned Berkshire Hathaway outperformed the market on close to 90% of rolling 10-year spells. We might now have more confidence placing $800,000 or $900,000 on Buffett’s side of the table.

Time horizons matter.

When thinking about the bet; don’t worry too much about my limited capabilities in stock picking, just assume that I design my 30-stock portfolio to look as much like the market as possible. Also, it doesn’t have to be Warren Buffett – just a highly skilled stock picking investor. The message will be the same.

So, what is the message?

1) Conversations about luck and skill in investing are irrelevant unless we specify a time horizon. For most styles of investing, the longer the time horizon the more skill will influence outcomes. Whatever the time horizon, however, the results will never be devoid of chance.

2) Investing is a bizarre activity. Over reasonably lengthy time horizons (one year, three years and more) people without any discernible skill will produce better results than the most skilful individuals in the field. There are very few activities that are structured in this way.

We hugely understate the role of luck in investment outcomes. Humility is a pre-requisite for good investing. Sensible decisions will appear mistaken – a lot.

3) Active fund investors have their time horizons all wrong. Attempting to identify skill and then worrying about one and three-year performance is entirely futile. We are doing little more than playing roulette (particularly if we acknowledge that we are unlikely to identify the greatest investor of their generation in advance). A focus on short run horizons will doom us to making persistently bad decisions based on the unpredictable movements of markets.

If there is any chance of success investing in active funds, we must extend our time horizon. If that is not possible, we should not be using them.
 

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[i] Daily: Firing Warren Buffett | UBS Global