Investment Risk is about the Extreme and the Unseen

When an event such as the coronavirus pandemic hits markets, investor attention is inevitably drawn to the damage that can be wrought by high impact, unpredictable episodes. This is understandable as such occurrences can have disastrous financial consequences.  I touched upon managing the risk of ruin in my post on ergodicity[i], and Morgan Housel recently addressed the tail-end consequences of risk in typically eloquent fashion[ii].  Yet whilst it is important for investors to prepare ourselves as best we can for such scenarios; we should not focus solely on the extreme, arresting, outlier happenings.  There are investment risks that we face that are small, slow and creeping – often going unnoticed –  but compound to result in unnecessarily poor outcomes.

The tail risks investors face are problematic both because of the scale of their impact and their unpredictability.  We know that they are inevitable but we are never entirely certain what form they will take.  Most of us prepare for the next ‘extreme’ market event by taking steps that would have protected us from the previous one.   Whilst incredibly painful when they occur, a combination of appropriate time horizons, sensible investment disciplines and measured behaviour means that investors can withstand most extreme events.

At the opposite end of the spectrum from these conspicuous, striking risks are those risks that cause harm through time because we are prone to ignore their deleterious impact.  This can be because they are small and incremental; taking time to grow into something material – if we ever realise, it is too late.  Or they can be risks where we are making a temporal trade-off.  We carry out actions that make us feel better now, but increase the risks faced by our future self.

Risks that we don’t notice:  The most obvious example of an often unseen risk is high investment fees. In any given day, month or year high fees are likely to seem inconsequential, if they are noticed at all.  Yet the compound impact over a lifetime of investing can be staggering.  This is far from a dramatic, extreme event but more like a slow water torture.  The risk here is that we fail to meet our investment objectives, or are materially worse off than we could have otherwise have been.  It is not dramatic, or eye-catching, and many will not perceive it as a risk during or even after its realisation.  This does not mean that it cannot be profound.

Risks that make us feel good in the present, but at a great future cost:  There is a vast array of investment activities that can fall within this category.  Perhaps the most material is a failure to begin our long-term savings early enough.  Here we are liable to make our lives better now (by having more disposable income), but worse in the future because we diminish the influence of compounding.  This risk of undersaving in our younger years is one which we may either not realise at all or fail to appreciate its magnitude.  It is particularly pernicious because assuming the risk (either knowingly or unknowingly) makes our life more enjoyable in the present.

Another prominent ‘feel good today / repent later’ risk is overtrading.  Whenever we trade in our portfolios it is likely to make us feel better; very few investors are comfortable transacting in a way that causes immediate discomfort (value investors being a notable exception).  Whether we are chasing the latest momentum trade, switching to a flavour of the month active manager or raising cash in a period of market turmoil; we are probably doing things we feel good about in that specific moment.  Yet if we work on the safe assumption that most of us are terrible traders; the aggregate impact of all those trades is likely to leave us materially worse off.  Of course, we don’t perceive this to be a risk to our long-term outcomes because with each trade we think we are improving our situation (otherwise we wouldn’t be doing it).  The risk here is not about a single large trade blowing up our portfolios (which falls into the extreme category), but the compound impact of the performance chasing, the market timing and the costs incurred.  How many of us will look back and say: “I would have been better off if I had just left it alone”?

Exposure to catastrophic incidents is certainly a crucial consideration for all investors – whether they be the general (e.g. financial crises) or the specific (e.g. frauds) – but is not only the extremes that should concern investors.  Risks that seem small and inconsequential at any given point in time, can compound to have ramifications that are just as significant.



We Need To Talk About Ergodicity

You have a gun which holds six bullets, but only has one in the chamber.  You use it to play a game of Russian roulette with a group of 19 other people.  Each of you takes one turn in spinning the chamber, holding the gun to your temple and pulling the trigger.  If you are successful you win £1m, if not, well, then you die. Whilst this may not be an appealing proposition, your chance of death is relatively low (17%), and potential for becoming a millionaire high (83%).  It is also far more attractive than an alternative version of the game where instead of playing with a group, you play on your own.  In this instance there are still 20 turns but each time the gun is directed at your head.  The odds on the outcome for you in this instance are not so favourable.

These contrasting approaches to Russian roulette are a typical example of ergodicity[i] [ii]. A system is deemed ergodic if the expected value of an activity performed by a group is the same as for an individual carrying out the same action over time.  Rolling a dice is an example of an ergodic system.  If 500 people roll a fair six-sided dice once, the expected value is the same as if I alone roll a fair six-sided dice 500 times.

The Russian roulette example is a non-ergodic system.  The expected value of the group differs sharply to the average of an individual carrying out the action through time.  In the group situation the average outcome is to live and become wealthy.  As an individual performing the activity through time – on average – I am dead.  In a non-ergodic system the group expected value is deeply misleading as it pertains to individual experience.

Although these may seem like somewhat frivolous examples, the concept of ergodicity is incredibly important.  Much of classical economics assumes about human behaviour is founded on the expected average outcome of the group (see Expected Utility Theory).  This works under the assumption that most environments or situations are ergodic, when in fact this is not the case.  The best starting point for understanding ergodicity economics is this article in Nature, by Ole Peters[iii].

Given the implications for classical economics, the idea of ergodicity is also incredibly important for behavioural economics.  Many of the ‘biases’ identified in this field are expressed as violations of the assumptions made in classical economics and therefore deemed irrational.  Yet what if the starting assumptions are incorrect in the first place? What if much of what classical economics says about decision making is based on the average outcome of a group; when my ‘rationality’ is best judged by considering my individual experience through time?

Ergodicity is not the most intuitive concept, so let’s take another example – home insurance. If we assume that insurance companies make a profit from selling us insurance on our houses, then surely it doesn’t make sense for anyone to buy insurance for their home?  The insurance company is making a profit, those buying insurance must be making a loss.  Yet this negative expected loss applies to the group average, the situation is different for the individual.  The experience of the group is irrelevant to me as an individual.  What I care about is the impact on my wealth through time – there is only one of me.  The risk of ruin from my house burning down is what matters.

The concept of ergodicity is also critical when thinking about major issues such as inequality. Let’s take the standard economic measure of economic growth – GDP – what does that tell us about individual experience? Very little[iv]. GDP is a group measure.  Therefore we have another situation where the average outcome of the group can be very different to any individual’s experience.  We could therefore enter a situation where economic growth numbers (measured by GDP) appear impressive, but they mask the fact that inequality is burgeoning – wealth is accumulating to a select, small group, whilst more individuals suffer (surely this couldn’t actually happen!?).  Focusing on extreme cases of success in non-ergodic systems can be incredibly deceptive.

Ergodicity and Behavioural Economics

Given the subject matter of this blog, it is perhaps worthwhile exploring a couple of examples of where the concept of ergodicity has implications for ideas in behavioural economics.  One of these was explored by Jason Collins.  In his blog[v] he looked at the following scenario, which draws on work from Ole Peters and colleagues:

“Suppose you have $100 and are offered a gamble involving a series of coin flips. For each flip, heads will increase your wealth by 50%. Tails will decrease it by 40%. Flip 100 times.”

This type of bet is often rejected by individuals, despite the expected gain being 5% of wealth at each flip.  Declining this type of bet is often put down to risk aversion.  But is turning down a bet with a positive expected value such a bad idea?

Collins ran a simulation of 10,000 individuals flipping the coin 100 times each. Whilst the average wealth reached $16,000, the median was only 51 cents. 86% of the population saw their wealth decline.

A bet that looked good on average actually led to catastrophic outcomes for most, whilst a select, fortunate few made huge amounts of money.  Again, the average outcome of the group was meaningless to most people.  And, as Collins goes on to explain, if you increase the number of coin tosses eventually everyone will end up financially ruined.

There is inevitably a lesson here for investors about the destructive power of negative compounding. And from a behavioural economics perspective there is also a valuable insight into why seemingly irrational decisions (turning down a bet with a positive value on average) can be viewed as rational when considering the experience of a given individual over time.

Probability Weighting 

Ergodicity can also matter when we consider how we ‘weight’ probabilities when making decisions.  In a recent paper Ole Peters and colleagues[vi] explored a key tenet of cumulative prospect theory – that people overweight the probability of rare events with extreme outcomes.

The authors argue that far from being an error of judgement, a propensity to ‘exaggerate’ the likelihood of low probability extreme events is a reflection of greater uncertainty.  Individuals have less information about uncommon events (their historic frequency is low) and therefore a greater potential for error in their assumptions.  This feature allied to the risk of ruin from an extreme event means that adopting a cautious approach to such likelihoods is prudent.

The idea of increased uncertainty about probabilities for rare, ruinous events is a compelling argument as to why a seeming overstatement of probabilities may not be an error of judgement.  There are, however, other pertinent issues to consider around how individuals gauge probabilities.  Rather than simply overstate the likelihood of extreme events, there is evidence that in certain circumstances individuals ignore certain high impact risks, seemingly applying a zero probability weighting to them.  Kunreuther’s work on insurance showed that individuals often don’t buy disaster insurance until after they have experienced a loss from such an event[vii].  My contention would be that an individual’s judgement about the probability of a low likelihood, high impact event is intertwined with its salience and availability.  We are less likely to ‘overstate’ the probability of an event if we have never observed it, or if it lacks any emotive qualities.  Our perception of risk needs to be over some ‘threshold’ for us to consider it at all.  We can’t worry about everything.

What Are the Implications for Investment Decisions?

There are a range of areas where considering ergodicity could influence investment making; not least in the sizing of ‘bets’ and the potential use of the Kelly Criterion, but that will be for future posts.  A simple example of where ergodicity might be important is in portfolio construction.  Let’s assume we are allocating to ‘alternatives’ in our portfolio and have modelled them on the basis of them delivering a 4% annualized return with 7% volatility (remember this is hypothetical).  Is the average expected return of a group of hedge funds that meaningful?  Not really.  This is a non-ergodic system – we are interested in the path of returns for the individual funds that we select; the average result of the group might match our forecasts (unlikely), but we could still end up with very poor results.

Concluding Thoughts

Given that the field of behavioural economics was forged on the identification of limitations in the assumptions of classical economics; it seems reasonable that ideas central to the amorphous field of ‘behavioural economics / science / finance’ should also be held up to scrutiny.  Whilst we should always be cautious about attempting to identify ‘one big idea’ that explains everything; the concept of ergodicity is crucial lens through which we should be observing decision making.  We need to talk about it more.








What Lessons Should Investors Learn from the Coronavirus Bear Market? (Part One)

Although it feels like painful events such as bear markets are an unpleasant reality best quickly forgotten, they are incredibly important for investors.  Our decision making during such difficult periods can easily define our long-term outcomes.  Whilst our present inclination might be to focus on the specifics of the coronavirus we should instead consider how we can learn the right lessons about both our investments and our own behaviour during periods of severe market stress.  We can then be better prepared for the next bear market, whenever it may arrive.

Here are some lessons I think are important.

In a low interest rate environment we will have a love / hate relationship with cash: When rates are on the floor, very few people are comfortable holding cash.  For most investors it generates a low nominal return and often a negative real return, plus a fee is levied for the pleasure of owning it.  These paltry or negative returns become even more painful when all other assets are delivering strong performance.  In times of true market stress however, cash can become the only asset that investors want to hold.  This will make us start to question why we and others weren’t holding more of it.

This presents something of a conundrum.  In a low rate world, cash is likely to prove a material drag on returns, and the longer a bull market persists the more unpalatable holding it will become.  Yet it is incredibly valuable in times of extreme market dislocation.  So what is the answer? Well, we could just hold low cash when the market is rising and then increase our exposure before the market falls (this is a joke).  The only option is to have a sensible long-term view on its role in a portfolio (given its risk profile) and be content with that.  If we want to own a meaningful level of cash permanently, then we can’t complain when our portfolio lags in a bull market. Conversely, if we believe it will be of long-term detriment to own exposure to an asset that may produce a negative real return then that is likely to leave our investments more vulnerable in markets like those we have seen for spells of 2020.

Investment returns are not normally distributed, and prolonged periods of subdued volatility do not mean it is a good idea to increase your exposure to risk assets: These seem like obvious points to make but they are often ignored during a bull market.  Investment results come with more periods of sharply negative observations than one would assume from a normally distributed set of returns.  Irrespective of how low realised volatility has been there will always be wretched bouts of performance, which render any ‘information’ gleaned from periods of below average volatility meaningless.

The related issue regarding volatility (I have written about its use as a measure of risk here) is that during sustained spells of depressed realised volatility, there is often an overwhelming temptation to hold more risky assets.  Whilst a low volatility backdrop persists this can be an effective means of increasing returns and also looks fine when run through a backward-looking risk model; but can suddenly become incredibly problematic when volatility erupts.

Drawdowns are an inevitable feature of long-term investing:  Investing in any form of risky asset (above cash) involves drawdown risk. An extended period with few material drawdowns does not mean that this risk has been extinguished.  As a rule of thumb, I would say that for a diversified portfolio of liquid traditional assets the absolute minimum expected drawdown over a market cycle should be 2x the expected long-term volatility.  This is a base level because, as mentioned earlier, returns are not normally distributed – there is a negative skew – 3x volatility is probably a more reasonable expectation, depending on the assets / strategies involved.  My sense is that we tend to underestimate the potential for drawdowns in our portfolios so it is crucial to be realistic about this from the outset.  To generate strong long-term returns and enjoy the benefits of compounding we need to be financially and behaviourally disposed to bearing such risks.

Illiquidity is not diversification:  Just because something doesn’t price, does not mean it is providing diversification to a portfolio.  As I (and others) have mentioned before, the major advantage of illiquid assets is that the inability to trade limits our propensity to make bad short-term decisions. This is a behavioural premium created by structurally compelling us to be long-term investors (obviously with the caveat that a bad investment is still a bad investment).  Ignore anyone saying that their private equity holdings have ‘held up well’ during a market sell-off. 

Some alternatives are not that alternative: Low bond yields have pushed more investors into ‘alternative’ asset classes and strategies in order to ‘enhance’ portfolio diversification.  The market downturn has highlighted three crucial aspects around this for investors to consider: i) Some apparent diversification is just a different pricing methodology.  ii) Some strategies appear diversifying until a severe bout of market / economic weakness arrives and diversification disappears just when you need it. iii) Even if assets are genuinely distinctive from other traditional assets, when there is a stampede for cash, everything can get trampled. 

We need to have a plan:  Making plans for torrid market conditions is a crucial element of prudent long-term investing.  It is probably the only thing that will protect us from the confluence of newsflow, negativity, anxiety and stress, which lures us toward poor choices.  Of course, we cannot prepare for specific eventualities – here is what I will do in a global pandemic – but we do know that severe declines in asset prices will occur at some unpredictable juncture.  Even acknowledging this (and writing it down) can help.

We need to have a plan we can stick to:  Investment plans are incredibly important, but also fiendishly difficult to follow.  In a bull market it is easy to say: “when valuations become more attractive (markets fall) I will increase my exposure to equities”.  The problem is that when we make such commitments we neglect to consider how it will actually feel at the time it happens.  Markets will be declining for a reason.  News will be uniformly terrible. Are we sure that our plan was sensible? Hasn’t everything changed? Sticking to our plan will be the last thing we want to do. Plans need to be clear, specific, realistic and, as far as possible, systematic.  Make the decision before it happens. 

Base rates are ignored even more than usual in periods of stress:  During the recent market turbulence high yield spreads moved to 1000 over.  Historically, this has been a good time to own lower quality credit for the long-term, and on a five year view has typically led to strong returns.  We can call this the base rate or our outside view.  Despite the importance of this information we are prone to ignore it, particularly in times of stress.  Rather than consider the relationship between starting valuations and future long-term returns; we focus on specific, salient issues (the inside view) – the virus, the default rate, the energy sector travails.  It is not that this information is irrelevant, but that we weigh it too heavily in our long-term considerations. 

We should always start with the base rate / outside view (spreads being wide is good for long-term returns) and make any adjustments we feel are prudent based on the prevailing backdrop.  Instead, we start with the inside view – the particulars of the current scenario – and the salience and availability of that tends to overwhelm any consideration of base rates, or the things that are likely to matter more over the long-term.

It is hard to make good long-term decisions:  Our obsession with the present makes it close to impossible to implement sensible long-term decisions.  Time horizons contract dramatically and savagely during market declines.  The quality of the choices that we make will be judged over the next week or month (rather than the usual quarter).

People will want action!  As uncertainty increases and markets fall there will be an inevitable clamour for activity.  Things are happening – what are we doing about it?  Whether or not what we are doing is likely to be beneficial in the long-term or is even part of our investment process is likely to fade into insignificance.

For the vast majority of investors sitting on our hands, or making very modest adjustments based on pre-existing plans is the right thing to do.  The problem is nobody else thinks it is, and it might see you out of a job. 

Some people will look stupid, some will look smart:  Most of it is luck and randomness.  When recessions and bear markets arrive there are always heroes and villains.  Some will be lauded for their foresight (and perhaps have books and movies produced about them) others will be castigated for their folly.  Outcome bias grips us hard.  There will always be a few skilful exceptions, but even then we don’t know if the individuals involved will repeat such feats (history would suggest not).  If you work on the assumption that most investor results during such periods are the result of luck and sheer chance, you will have the odds on your side.

Recessions will happen, and for reasons we have not predicted:  There are plenty of things that people ‘know’ are a waste of time in the investment industry but keep on doing anyway – one is speculating about recessions.  Experts cannot predict when they will develop or what the cause will be.  We shouldn’t waste our time trying to forecast the next one. (I am assuming that nobody leaving their homes for months means that we are in one now, but I am no economist). 

It is difficult to tell whether changing market structure, or the nature of the pandemic caused the pace and severity of the asset price decline:  The speed and severity of decline in risky assets was likely in part due to changes in market structure, but not all arguments are equally valid.  A reduced willingness for investment banks to warehouse risk seems likely to be a contributory factor; the growth in low cost index investing wasn’t.

Whilst the structural arguments have some merit, the nature of the market drop was also due to an unprecedented economic stop and huge uncertainty around a global pandemic.  There were (are) some deeply negative economic consequences from the coronavirus outbreak and nobody had (has) any confidence about what probability to ascribe to them.  Does the recent decline provide information about how market bear markets may occur in the future?  Yes.  Will they all look like this one? No.

We are not epidemiologists. Even if we were, we still wouldn’t be able to time markets:  Let’s be clear about short-term market calls in this environment.  It means taking a view on the progression of the virus, the fiscal / monetary response, the economic impact of that response, the prospects for businesses, the reaction of individuals, and, crucially, the behaviour of other investors.  Good luck.

The virus and its consequences will be used to support everyone’s pre-existing beliefs:
 The virus will change the beliefs and behaviours of very few people.  When I say ‘very few’, I really mean nobody.  Growth investors will tell you that societal changes following the virus will bolster the prospects of tech companies.  Value investors will say the fiscal response means that inflation and rate rises are inevitable providing a catalyst for the long awaited resurgence.  MMT advocates will say their ideas have been validated, naysayers will forecast the coming inflationary reckoning.  Active investors will say dispersion is high and the time is right; passive investors will say they held up just fine in a bear market.  Everyone has an angle and everyone will use the same information to bolster their own contradictory views. 

Decisions we make in periods of stress will have profound implications for our long-term results:  If an investment decision makes you feel good immediately, it will probably make you feel bad in the long-term.  In periods of market weakness, the temptation to do what will make you feel better now can be overwhelming.

Things will happen that we had never seriously considered:  An economic shutdown / negative oil prices. These weren’t in forecasts or captured in risk models. 

Depending on the progression of the virus and its market / economic impact, there may or may not be a part 2 of this post (hopefully not). 

10 Questions ESG Investors Must Consider

The coronavirus outbreak has diverted attention away from the drive towards ESG-focused investing that had become the dominant narrative in the asset management industry.  Yet whilst its prominence may have temporarily dimmed; it will almost certainly be one of the defining issues for investors over the next decade.

Although I am supportive of the determination to make ESG factors critical to investment decision making; I worry that professional investors have become focused on the outcome (achieving some form of ESG badge) rather than the process required to get there.  Asset managers frequently proclaim that ESG is ‘in their DNA’ whilst keeping a straight face and fail to acknowledge that it is one of the only routes they have to maintain high margin active management business (alongside private markets).  Every investment process now ‘integrates’ ESG because they have to, even if it is unclear what influence these factors really have.  In many cases ESG has become a tick box or a label. This is a disservice to the complexity of the subject and what the core principles of ESG investing are designed to achieve.

 Whilst the issues to consider are myriad, below are some of the most important questions around ESG investment philosophy that need to be considered by all involved:

Are you willing to sacrifice investment returns? Although it is wonderful to work on the assumption that you can ‘do good’ and improve your financial returns this should not be the founding principle of any ESG-focused investment.  When applying portfolio restrictions that constrain choice you must be reducing your ex-ante return expectations – otherwise they would not be a constraint (of course it might turn out that they improved returns after the event).  Whilst ESG investment is about far more than limits and restrictions; even if we move towards ‘Sustainable’ and ‘Impact’ strategies there is not an insignificant probability that investing in a manner that has material environmental and societal benefits may diminish your investment return.

Every investor in this area needs to ask how they would feel if their investment strategy underperformed a broad market benchmark for a sustained period.  At its core making a decision to invest with an ESG mindset should be based on the notion that you care about more than simple financial results and understand the possible consequences of that from a return perspective.  Three years of underperformance from ESG factors should not lead you to recant your beliefs.  Part of accepting a broader definition of what ‘returns’ means is being able to understand the positive non-investment outcomes that your portfolio might deliver. 

Do any ESG elements constitute a risk premia? It is possible, but there is nowhere near sufficient evidence to prove it.  The strongest case to be made is that within the governance component there are elements that are intertwined with the quality factor, which can be considered a risk premia.  Broadly, however, it would seem a stretch to assume that ESG factors deliver excess return for their level of risk, and provide some form of external societal and environmental benefit in addition.  Of course, in specific cases this might be true, but it is unlikely to be broadly applicable.  Furthermore, as ESG factors become an increasingly vital element of investment decision making it is likely that investors will be willing to hold certain securities at higher valuations, and therefore with lower expected investment returns.

Should ESG assessments be absolute or relative? It is important to understand the heterogeneous nature of ESG scoring and assessment.  One of the most critical is the distinction between absolute and relative.  Are you comfortable investing in companies that are the best in their industry, even if the industry is poor in certain ESG aspects – the best airline, for example?  Or do you think about ESG in absolute terms – how strong is a potential company on ESG factors relative to everything else?  The latter option offers a level of ‘purity’ to an ESG philosophy but brings with it a cost in terms of a lack of diversification.

Should you worry about where a company is now, or where it is going? Another crucial consideration is around what could be referred to as ESG momentum.  Should you focus on companies that rate highly from an ESG perspective now; or also incorporate those companies that may fare poorly at present, but are showing signs of positive change?  If a key aim of ESG investing is to bring about a broader shift in corporate behaviour, then giving some reward to positive change seems prudent.

Should you divest or engage?  This requires careful thought. Of course, there are certain companies that you may wish to avoid from a pure values perspective – controversial weapons, for example – but is it always best to relinquish investments that are deeply questionable from an ESG perspective, and what do you achieve by doing so?  My initial thinking on this was that divestment could be an effective means of bringing about change, primarily on the basis that if carried out in significant magnitude it could materially increase the cost of capital to that business.  However, as Izabella Kaminska at FT Alphaville eloquently argued[i]by divesting you lose all influence and any chance of bringing about material change.  Furthermore, you allow other investors (perhaps those with purely financial motives) to invest with more attractive return prospects, and tacitly permit the company to continue absent any shareholder pressure to alter its activities.  The question therefore should not simply be to divest or not, but if I remain invested what influence can I exert (alongside others) and how might this change the business.?  Also, if I don’t invest, who does?  The problem with this last question is that it provides a get out of jail free card, which allows anyone to own anything.  Therefore it is crucial that you are able to justify and evidence your ability to influence a company. 

Is active or passive the best approach?  Although a perennial favourite for ESG deliberations, it is a false dichotomy.  The real question is about whether a rules-based decision making approach (such as an ESG index) is sufficient or do you require additional qualitative judgement to run an ESG oriented strategy?  Even this distinction is limited by the fact that ESG indices will involve qualitative assessments both in the construction of the benchmark and the underlying scores that inform it.  Unlike in broad asset class decisions a simple active versus passive choice doesn’t exist; it depends on your objectives and requirements.

Are the multiple ratings services a problem? We are likely all well-versed in the fact that the major firms in ESG ratings adopt significantly different approaches in their company assessments resulting in a worryingly low correlation between scores from different providers.  The same portfolio could have positive or negative ESG characteristics depending on the lens through which you choose to analyse them. The problems with this lack of consistency are often highlighted as a profound weakness of ESG investing; but we should also consider an alternative scenario where one firm held the ability to define what represented ‘good’ from an ESG ratings perspective.  The idea of being beholden to a single judge in this regard is equally unappealing. There is at least some benefit to the diversity of thought embedded in numerous ESG ratings services, and there is far more subjectivity in defining ESG quality than credit quality, for example, so this divergence is likely a feature rather than a bug.  Clearly it is important for investors to understand the different methodologies and assumptions, and also use their own.

The other issue with ESG ratings is the spectre of Goodhart’s law – when a measure becomes a target it ceases to be a good measure.  Whilst ESG scoring will likely encourage companies to improve and potentially lower their cost of capital there will inevitably be gaming.  Firms will look at what is being measured and almost certainly target specific areas to improve their ratings.  Although companies seeking to increase their ESG score is a positive; a close eye will need to be kept on loopholes in the ratings, and situations where optics supersede substance.  One indirect benefit of the aforementioned issue of multiple scoring approaches is that it reduces the ability to game or target specific metrics – because of the very inconsistency.  

Is ESG investing in a bubble? An investment bubble needs a compelling narrative, widespread participation and a complete disregard for valuation. ESG has momentum and a compelling story, but not the broad and complete disregard for valuation and future returns.  The danger for ESG investing is that because it is about more than financial returns there can be a tendency to make valuation subordinate to other issues.  Furthermore, flows into ESG can create a self-reinforcing problem, where strong appetite for positive ESG stocks encourages more investors to convert because past performance is appealing.

The fact, however, that ESG is such a nebulous term and the ratings highly subjective means that a widespread bubble is unlikely and actually very difficult to define – what would a bubble in ESG look like?  More possible is that there will be certain areas of the market captured in the drive towards ESG that will (and have already) moved to unsustainably lofty valuation levels.  The other potential ramification is an increasing valuation gap between positive ESG stocks and those that are uniformly excluded or commonly score poorly.  I did think for a time that things could not get much worse for value investing, but the move to ESG is another potential headwind*.

How do you balance principles and diversification? Your ESG philosophy will have a significant bearing on the level of diversification you are able to achieve in your portfolio, and it is important to be clear about the sacrifices you are willing to make.  For example, in a multi-asset fund are you willing to own sovereign bonds?  In an equity fund are you comfortable excluding swathes of the market and being narrowly exposed to certain styles, sectors and industries?  There are trade-offs to be made and you need to be acutely aware of the investment implications of these.

What matters and how much does it matter? Implicit in any ESG score or rating will be assumptions about what issues are important and how important they are.  An overall ESG score will incorporate a hugely disparate group of factors, from carbon intensity to board level gender diversity, which are almost impossible to compare in any reasonable fashion.  Furthermore, judgements are being made about the relative importance (or weighting) of each factor at an E, S and G level, and also regarding the underlying metrics that fuel the headline scores. 

The use of the ESG definition as a coverall term for such a diverse group of factors and issues is almost certainly a net positive as it brings focus and direction to a movement that could otherwise be unwieldy and disparate.  It also offers welcome simplicity to a horribly complex and subjective area that could leave many afflicted by decision paralysis.  Those benefits notwithstanding, we should be aware of the implicit assumptions and judgements we might be making. 

It is easy to be cynical and critical about aspects of the growth in ESG investing and the motives of some involved in it.  Yet whilst it should be held up to scrutiny, there is also the possibility that we allow perfect to become the enemy of the good.  For all of its faults and limitations the move towards ESG influenced investment decision making in recent years is very likely to be of long-term benefit to us all.  For it to continue to evolve and improve it is important that we are realistic about the investment implications of any ESG approaches we adopt, and ensure that we are willing to understand what underlies simple definitions, scores and labels.

* Or opportunity, depending on your time horizon.


Long Toilet Paper / Short Equities – Why We Panic Buy and Sell

Panic is an overwhelming feeling of fear that can dominate our decision making.  It typically begins with a significant and sudden change in circumstance.  The outbreak of coronavirus has provided numerous examples of decisions that are seemingly fuelled by stress and uncertainty; from the bizarre stockpiling of toilet paper to the dramatic daily moves in equity and credit markets.  From a financial market perspective discussion around the recent explosion in volatility often centres on changes to market structure, liquidity and leverage.  But panic buying and selling is primarily a behavioural phenomenon – what are its main causes?

Scarcity: Panic purchases are often the result of a current or future scarcity of a good or service.  The case of toilet paper hoarding is an issue driven by self-perpetuating scarcity – where the very scarcity is caused by other peoples’ perception of it.  This type of panic can persist even when nobody can remember its initial causes.  It feeds on itself. 

Whilst the scarcity issue is obvious when it comes to the panic purchases of toilet paper, it is also evident in financial markets.  Although the asset or security may not be scarce features of it may be; for example, the ability to transact at a certain price, or any price.  An assumed or real limit on the ability to sell can induce panic – like the shout of “fire” in a packed theatre, we fear that the exit may not be available to us all.

Other people: Panic buying and selling is always about how we react to the behaviour of others (and how they react to us).  This comes in a number of guises:

The ‘wisdom’ of crowds: Panic can be caused by the assumption that there is information in the behaviour of others, and the greater the number of people engaging in certain activity the more we believe that they possess knowledge that we do not.  The problem is that crowd wisdom tends to arise in situations when there is a level of diversity of thought and an independence in how people in the crowd have reached a view.  When panic buying or selling occurs, the reverse is true.  The behaviour of the group is a result of individuals reacting to the same, very narrow set of information, or simply following others.  The wisdom of crowds swiftly becomes madness. 

Thresholds: In a related fashion, sometimes we simply act because other people are, even when we are not aware of what is driving the initial behaviour.  Sociologist Mark Granovetter described a threshold model, where a decision made by an individual to engage in an activity is led simply by how many other people are doing it.  Each individual will have a different threshold for engaging in ‘mob’ behaviour, which is the point at which “the perceived benefits to the individual of doing the thing in question, exceed the perceived costs”. 

Failing conventionally:  The notion that our propensity to join mass group behaviour is related to some form of cost / benefit threshold is intertwined with our preference for ‘failing conventionally’, which is a huge influence on the behaviour of professional investors.  The management of career risk and the desire to protect assets means that the behaviour of others matters profoundly, irrespective of whether we agree with or understand it.  Even if our behaviour is extremely irrational from any fundamental investment perspective, it can be supremely rational for us as individuals.  We are less likely to lose our job doing what everybody else is.  If you are going to be wrong, don’t be wrong alone.

Removing worry: As panic is a result of fear and anxiety, the actions that come as a consequence are typically carried out in an effort to relieve it.  Our decision making becomes centred on a single goal – removing the worry. The greater the uncertainty and the less control we feel we have the sharper the urgency for us to act.  Panic buying and selling occurs when the cause of the worry is shared by many people, which results in numerous individuals taking similar actions.  As with the other primary causes of panic, these actions become self-reinforcing – the desire of others to reduce their own worry, serves to create and increase fear in others.

What is the easy way for investors to mitigate the fear and uncertainty around the financial and economic impact of coronavirus?  To sell risky assets and hold cash. Although it may be a damaging long-term decision, this is outweighed by the palpable short-term relief.  Even with the puzzling toilet paper hoarding there are similar factors at play – once we have filled the garage with 600 rolls, we no longer have to expend energy worrying about the issue.  

Contracting time horizons: One of the most important features of behaviour under stress for investors is how our time horizons contract.  In the midst of panic our concern becomes singularly focused on what is happening right now; we are gripped by the fears of today and abandon any thought of the future.  Whilst in certain situations in life this can be considered an  effective adaptation for meeting our long-term investment objectives such myopia can be staggeringly damaging 

Emotional decision making: Our attitude toward a given risk is heavily influenced by its emotional salience.  How we perceive both the likelihood and magnitude of a threat can be dominated by its prominence (or availability) and how it makes us feel.  As Cass Sunstein discusses in his work on probability neglect, if something provokes a strong emotional reaction then we tend to disregard how likely that risk is to occur and focus on its potential impact (usually the worst case scenario).  When decisions are made in a state of panic risk becomes about how we feel, not think.

Panic buying and selling represents the very worst of our investment behaviours – it is emotion laden, focused on the short-term and driven by the behaviour of other people. Whilst it can have incredibly harmful long-term consequences for investors, it offers the often irresistible allure of making us feel better and worry less, immediately.  We need to avoid such behaviour, but telling ourselves not to engage in panicked decision making doesn’t work.  We need to take concrete steps to avoid it.  These include:

  • Having a clear and appropriate investment plan.

  • Using decision rules.

  • Systematising investment decisions (rebalance and reinvest)

  • Thinking about difficult market conditions in advance (pre-mortem).

  • Checking our portfolios less frequently!

Such steps provide no guarantee that we will resist, but they give us a fighting chance. 


Granovetter, M. (1978). Threshold models of collective behavior. American journal of sociology, 83(6), 1420-1443.

Sunstein, C. R. (2002). Probability neglect: Emotions, worst cases, and law. The Yale Law Journal, 112(1), 61-107.

How to Deal with the Behavioural Challenges of Bear Markets

It is at times of severe market stress that our worst behavioural impulses come to pass. Whilst the recent losses in the value of portfolios are undoubtedly painful; the poor decisions that we will make as a result of the torrid environment will likely prove more damaging to our long-term outcomes.  

Against such a turbulent market backdrop, which behavioural issues should we be most concerned about?

Myopic Loss Aversion:  Short-term losses are difficult, but they are also an inevitable feature of investing in risky assets.  Indeed, the high long-term returns from equity investment are a consequence of their volatility and the potential for severe losses – to enjoy the benefit you must be behaviourally disposed to bearing exacting periods.  For most investors (particularly younger ones) it makes sense to reframe the issue – rather than markets falling precipitously we should think about the likelihood that long-term expected returns from risky assets are now materially higher.

Recency:  Our obsession with recent and salient issues means that they overwhelm our thinking.   Whether it is trade wars, Brexit or coronavirus.   This is not to say that such issues are not important but from a long-term investment perspective they are less vital than we think and feel they are at the time.  Try to make investments on the basis that we have to leave them untouched and unseen for the next ten years.

Risk Perception:  We are poor at judging risks.  We are prone to ignoring certain threats whilst hugely overstating others.  Our judgement about the materiality of a risk tends to be driven by its availability (how aware we are of it) and its emotional impact on us.  The coronavirus is a particularly pernicious risk for investors both because the magnitude of the impact is highly uncertain and it is deeply salient.  We also need to be clear about what risks we are considering when making an investment decision – is it the risk of short-term losses, the risk of being whipsawed by volatile markets, or the risk of failing to meet our long-term objectives?

Narratives:  Although we should be driven by evidence many of the investment decisions we make are founded on compelling stories.  In times of profound uncertainty this flawed feature of our decision making becomes highly problematic.  It is incredibly uncomfortable to acknowledge that we have no clarity around a major issue such as coronavirus; so we construct stories to relieve our discomfort.  These narratives help us ‘understand’ what has happened, but also, more damagingly, give us undue confidence about what will happen in the future.  It is better to admit that we don’t know, rather than concoct a story.

Overconfidence:  In the past three months everyone has become an expert in virology, despite having no previous grounding in the subject.  It is okay to have an opinion, but the vast majority of people are guessing, and nobody knows the near term market or economic impact of the virus.  We shouldn’t make investment decisions that suggest we do.

In these environments making sensible long-term investment decisions is highly likely to leave us looking foolish in the short-term.  This doesn’t mean, however, we should not make them.  Remember if we are looking to invest in assets that appear to have become materially cheaper it is almost certain that we will not call the bottom and things will get worse filling us with regret.

The advantage of being able to invest for the long-term is at its greatest when it is the hardest thing to do.  The only way to benefit from this is to have a sensible investment plan that is clear about objectives and the decision making process.  Sticking with this through tough times can provide a major behavioural edge.

Why Are We More Worried About Coronavirus than Climate Change?

Whatever your view on the scale of the response to the outbreak and spread of coronavirus it is an issue that is provoking both fear and action.  Although the behaviour of governments, financial markets and the general public is not necessarily irrational; it is interesting to contrast it with our apparent indifference toward the catastrophic long-term effects of climate change. What is it about human nature that makes us mobilise urgently against coronavirus, but be afflicted by apathy and indecision when it comes to global warming?

The nature of a risk matters greatly in how we react to it.  Coronavirus can be considered a present threat over which there is a great deal of uncertainty about its scale and impact; there is a significant possibility that its long-term impact is negligible.  Contrastingly, climate change is (predominantly) a future threat, but there is a high level of confidence that its long-term impact (without intervention) will be catastrophic for humanity.

It is our tendency to significantly overweight the importance of what is happening now relative to the future that is perhaps the largest impediment to our hopes of successfully mitigating climate change risks.  Our reaction towards the coronavirus outbreak is an excellent example of our predilection to focus on a near term negative payoff (even if the potential negative consequences are highly uncertain), whilst at the same time neglecting to attend to a large negative payoff in the future (even if grave consequences are certain).  As much as anything our failure to deal with climate risks is a temporal problem.

Our bias towards the present is also accentuated by political incentive structures.  This is a particular challenge for democracies – where the frequency of elections / brevity of terms in office mean that politicians are focused on actions and activities that will see them retain power in the short-term.  If they make the electorates’ life more difficult it reduces their chances of being re-elected; even if the imposition of discomfort now is designed to deliver incalculable benefit in the future.  As heretical as it may sound, there are valid questions to be raised about whether a democratic system with regular elections is suited to dealing with an issue that requires short-term sacrifice for long-term benefits.

Dealing with climate change is about trade-offs.  Are we willing to suffer near term inconvenience and friction in our lives, for a benefit in the future that may not directly impact us and seems somewhat abstract  Unfortunately, judging by current progress, the answer seems to be no.  With coronavirus the trade-off is more balanced because we are accepting some inconvenience now to ward off a present and personal threat.

There is undoubtedly a selfish quality in how we react to the relative risks of coronavirus and climate change. Although I am sure we care about ‘future generations’ they seem remote and removed.  Contrastingly, the potential victims of coronavirus are ourselves, our families and friends; which give us far more urgency in our actions to combat it.

Our reaction to the coronavirus risk is also driven by its salience.  The implications of contracting the virus are vivid and emotive; we can directly observe the current impact.  How we feel about a situation and how available it is to us can lead us to greatly over or understate the risks involved.  Climate change by contrast suffers from its most significant costs being in the future, whilst being difficult to clearly envisage or even link directly to our own actions.  Even with incidents such as the recent wildfires in Australia – where it is seemingly unquestionable that the severity of these is a result of global warming – the inability to draw an unequivocal direct causal link between our own behaviour and the consequences gives us leeway to remain apathetic.

The unfortunate lesson for climate change that can be drawn from our response to coronavirus is that we will act* but only when its implications are current, salient and affecting us directly.  By which stage it will likely be too late to undo much of the damage.  Part of the solution to climate change must therefore be acknowledging the behavioural problems we have in dealing with future risks, which means creating policies that force us to suffer short-term cost for the long-term good.

* Clearly actions are being taken and behaviour is changing, but not enough to meet the targets of COP 21, for example.

Investors Should Not Be Making Forecasts About Coronavirus

You have to have some sympathy for those strategists working at asset managers and investment banks who spent the tail end of last year writing lengthy outlook pieces for 2020.  Although the tomes produced always have an inbuilt redundancy; the onset and spread of coronavirus (COVID-19) has upended all forecasts in a particularly dramatic and rapid fashion.

For investors the staggeringly swift reshaping of the prevailing investment narrative should have served as a sharp reminder of the futility of short-term forecasts.  The complex and adaptive nature of financial markets means that making predictions about the near future with any level of specificity is an utter folly.

Unfortunately, as investors hastily recalibrate their market expectations they have not become more circumspect about forecasting imponderables – quite the contrary.  As the perceived risk has heightened there seems to be an increased production of speculative prognostications.  Most asset managers are now producing their own viewpoints on the potential ramifications of the virus.  There is puzzling need for detailed opinion pieces from financial market practitioners about an incredibly uncertain topic about which they have no specialist knowledge.

It is not only opinions that are sought after when the market environment becomes challenging, but actions also.  In periods of tumult trading is required to show that these new risks are being addressed and accounted for.  The biggest danger for investors is the temptation to engage in heroic trades; either removing risk entirely on basis that there will be severe economic and market ramifications from the virus; or conversely increasing risk substantially because the market has overreacted.  The outcomes here are binary: one group will receive praise for their sagacity; the other will be seen as reactionary and injudicious.  Both sides are merely guessing.

If investment decisions are being made related to the progression of the outbreak, it is worth considering the complexity of such predictions.  It is far more than anticipating the spread of a virus (which in itself if an improbable feat); but the second and third order effects – the decisions politicians will make, how people in those countries will behave and, crucially, how investors will react.  Even if we had perfect foresight of how the virus would evolve over the coming months, it would still be impossible to confidently predict the market and economic implications.

The new coronavirus outbreak inevitably creates a tail risk of severe economic dislocation and market weakness, but nobody can possibly have any confidence in the probabilities around such sharply negative outcomes occurring.  The idea that we can correctly gauge whether financial markets are accurately ‘pricing’ such uncertainty is entirely spurious.

Although the coronavirus outbreak (and the reaction to it) has the potential to precipitate an economic slowdown, earnings recessions and severe market decline (from a purely financial perspective); being a long-term investor means continually facing such risks.  It is simply that the virus is currently the most salient and available potential cause of such a scenario.  We should have a portfolio that is commensurate with our willingness to withstand them; from both a financial and behavioural perspective.

Any communication related to this issue should be focused on the general principles of good investment behaviour during times of stress and volatility. Not specific commentary about a virus over which nobody has even a modicum of certainty over future developments.

Sensible investment rules such as diversification, rebalancing and adopting a long-term approach are only prudent because financial markets and human behaviour are so unpredictable.  If we had greater confidence about the future they would be entirely unnecessary.  Now is is not the time to abandon them.

Avalanche Accidents and Investment Risk

What does the assessment of avalanche risk have to do with how we make investment decisions?  At face value very little; the stark and exposed nature of the former could hardly seem further removed from detached and abstract financial markets.  Yet there are parallels.  Both situations require us to make complex choices in uncertain environments, potentially exposing us to significant threats.  Furthermore, in order to deal with the profound uncertainty we are prone to apply unsuitable mental shortcuts or be unduly swayed by our behavioural biases; often with damaging consequences.

I was drawn to the avalanche risk analogy by a recent article by Heidi Julavits in the New York Times Magazine where she described her experiences at an avalanche school[i].  This led me to research carried out by avalanche expert Ian McCammon[ii].  In a paper, published in 2004, McCammon details what he believes to be the main decision making errors that lead individuals to expose themselves to significant risk of an avalanche accident.

In the paper he reviews 715 recreational accidents between 1972 and 2003, and attempts to categorise the central causes of the incidents as a range of ‘heuristic traps’.  These are rules of thumb that are often useful in everyday life but deeply flawed if applied in an incorrect situation.

McCammon’s research was designed to understand why so many accidents occurred when (in hindsight) the risks were vividly apparent.  His description of this puzzle will resonate with anyone who has endured ‘difficult’ experiences in financial markets:

In hindsight, the danger was often obvious before these accidents happened, and so people struggle to explain how intelligent people with avalanche training could have seen the hazard, looked straight at it, and behaved as if it wasn’t there.”

I am not sure that McCammon’s use of the term heuristic is entirely accurate; most of what he describes are behavioural tendencies rather than rules of thumb.  Definitional matters aside, the similarities between some of the issues identified by McCammon and those experienced by investors are stark.

McCammon identified the following six ‘heuristic traps’:

Familiarity: In McCammon’s description, the problem of familiarity arises when we become complacent in our behaviour because of repeated exposure to a particular environment.  This can serve us well for the most part, but leaves us sharply vulnerable to change.

As investors we become rapidly conditioned to the prevailing regime; believing that the recent past will persist. Given how difficult it is to make forecasts about future states this tendency is understandable (our best guess about tomorrow might be what happened today). Yet shaping our behaviour and decisions based on what has worked in the past – whether it is about the economy, expected returns or correlations – can expose us to severe risks when the environment shifts.   

Consistency:  The notion of consistency utilised in the paper is similar to commitment.  Once we have made an initial decision or taken a particular view we find it difficult to reverse course and tend to ignore new information.

Perhaps one of the most powerful drivers of our investment behaviour is our inability to recant past views or acknowledge mistakes (as opposed to blaming others or circumstance).

Acceptance:  Acceptance is similar to signalling.  In a social context we engage in behaviour because of how we believe it will reflect on us; usually in order to gain respect or acceptance from others.

For professional investors in particular, the desire to be seen in a certain way by clients, colleagues, peers and superiors can have a profound impact on our behaviour.  It undoubtedly leads us towards complexity over simplicity (to prove our intelligence) and activity over passivity (there is a strong desire to be seen to be doing something).

Expert Halo:  We are often in thrall to experts and can overstate the value of their knowledge, or assume that their ability stretches far more broadly than it actually does.  We are also unwilling to challenge their views.

The randomness and uncertainty in financial markets makes identifying experts somewhat tricky.  We are frequently guilty of misjudging an individual’s circle of competence; if someone has outperformed the stock market for a number of years we are happy to hear them opine on any subject, no matter how tangential it may be, and may follow them into previously uncharted areas.  We are also quick to see expertise and skill, whilst dismissing the role of luck.   

Social Facilitation:  Related to the idea of acceptance detailed above; social facilitation refers to the manner in which our behaviour may change when in the presence of others.  In particular, McCammon states that our willingness to exercise our skills or take more risk is greater than if we were alone.

The idea of social facilitation does not simply mean that people are directly in our presence when making a decision; even the implied presence of others can influence our behaviour. Our actions are likely to alter if we believe that we are being evaluated or our performance being judged. Professional investors may, for example, make different decisions for their public funds then their personal accounts, other things being equal.

Scarcity:  The attractiveness of an achievement, activity or product tends to be greater when it is scarce.  The fear of losing an opportunity, particularly to another person, can often drive inappropriate risk taking behaviour.

Our willingness to chase performance or become involved in the latest fad or bubble is closely linked to McCammon’s notion of scarcity. We are often fearful of missing out on the outsized gains that have been (and may continue to be) enjoyed by others.

Whilst it is interesting to understand the potential behavioural drivers of the mistakes we make, it is also crucial to acknowledge that whether we are traversing terrain with avalanche risk or making an investment decision we are actively embracing risk and uncertainty.  That means there are always a range of potential outcomes (with a proportion of them negative).  In both domains there is a huge amount of randomness involved.  Although it is important to consider the robustness of our judgements, a negative outcome (even a deeply negative one) is just one of the paths across a distribution of possible results.  We can make prudent decisions and suffer from bad luck.

Towards the close of the paper McCammon states that:  “the challenge is to encode knowledge into simple, easily applied decision tools”.  This is the most vital point of his work.  Whilst the research is focused on ‘heuristic traps’ it is not a critique of quick and simple decision making, but rather a call to ensure that the quick decision tools utilised are appropriate for the situation.  In highly intricate and unpredictable environments, applying simple decision rules or heuristics can be invaluable. We just have to ensure that we are using the correct ones.


[ii] McCammon, I. (2004). Heuristic traps in recreational avalanche accidents: Evidence and implications. Avalanche news68(1), 42-50.

Why Do We Chase Past Performance And What Can We Do About It?

“Money flows into most funds after good performance, and goes out when bad performance follows.” (John Bogle)

We have all seen the wording discretely appended to mutual fund marketing stating that ‘past performance is no guide to future results’. Despite the ubiquity of this message we struggle to heed its warning.  Instead, we operate in the powerful grip of outcome bias; where we assume that good results must be the consequence of skill and will persist, and that poor results are a prelude to ongoing disappointment. This leads to the damaging behaviour of performance chasing, where we sell our holdings in laggard fund managers and reinvest in recent winners.

Whilst such an activity may offer near term relief, it often comes with a long-term cost.  In unpredictable financial markets relying on historic performance as a primary measure for quality is fraught with problems.  There is no better example of how misleading past performance can be than the tale of a pharmacist turned fund manager.

Jayesh Manek was born in Uganda in 1956 and, after moving to the UK, studied to become a pharmacist at Brighton College before opening his own pharmacy in west London.  He had great success in this field and eventually sold the chain of stores he had built, Dallas Chemists, to Alliance Unichem in 1999.  His real passion, however, was for investing.  A fact demonstrated by his success in a fantasy fund management competition run by The Sunday Times, which offered a £100,000 first prize.

In 1994, Manek beat thousands of entrants to win the stock picking contest after turning a paper £10m into a staggering £502m.  Remarkably, he managed to repeat this feat in 1995, growing another £10m into an impressive, though modest by previous standards, £58m.

Manek had a predilection for small cap growth companies, and was ideally placed to benefit from the emerging bubble in technology stocks.  It has also been suggested that he astutely exploited loopholes in the competition by making multiple entries[i], materially increasing his chances of success.  But, in the face of stellar outcomes, we can often treat such details as something of an irrelevance. The results were leading us to believe that a major new investing talent had been unearthed, operating above a pharmacy in Ruislip.

Emboldened by his unprecedented success and the publicity surrounding it, Manek took the inevitable next step of launching his own fund; offering investors the opportunity to benefit from the acumen that had seem him twice crowned a champion stock picker.  The story of pharmacist to fund manager not only captured the attention of the investing public, he also received £10m from revered investor Sir John Templeton.  Manek had the validation, the captivating narrative and a track record of success – what could go wrong?  Plenty, as it turned out.

Manek’s foray into fund management didn’t immediately turn sour.  In the early years of his fund he persisted with his penchant for speculative, high growth stocks, which had brought him great such success in the competition.  As Manek himself noted “at its peak, the fund was 75%-80% in technology”[ii]. From launch in 1997 to the height of the technology bubble, the fund outperformed the UK stock market by 152%.

The strong initial performance only served to bolster his reputation, and his fund grew to in excess of £300m.  As the fervour for technology companies imploded however, so did Manek’s fund.  In the three years from its peak at the end of March 2000, it fell in value by 75%.  The poor results did not stop there and its travails continued in the years that followed, before its belated closure in 2017.  Over its twenty year life Manek’s fund proved to be a disastrous investment, falling in value by 56%, whilst the broad UK stock market delivered 236%. This yawning performance disparity meant that Manek was landed with the unfortunate sobriquet: ‘Britain’s worst fund manager’[iii].

The experience of Manek is a stark reminder of the dangers of making inferences about both skill and future returns from historic investment performance.  Manek not only had the unique achievement of consecutive victories in a fund management competition, he delivered dramatic outperformance with real money in his eponymous fund for two and a half years.  Yet this sustained period of material stock picking success proved a prelude only to years of disappointment. Given how misleading past performance can be, do we really rely on it when selecting active managers? The evidence would suggest so.

Chasing Past Glories

In a 2008 study[iv] Amit Goyal and Sunil Wahal observed the investment decision making of 3,400 intuitional investors between 1994 and 2003, which included 8,755 active manager selection decisions across assets totalling £627bn.  The researchers were seeking to identify patterns in the hiring and firing of fund managers.

The results were clear. The institutional investors typically appointed new managers following a period of strong excess returns, only to witness the outperformance evaporate in the following years.  This behaviour not only applied to new manager purchases, but also firing decisions.  Managers were frequently relinquished after a period of poor results often to witness an upturn in fortunes.

What is of particular note in this study is the type of investor on which it trained its focus.  These were not inexperienced, individual investors, but large institutions benefitting from sophisticated and seasoned insights from trustees and investment consultants.  Investment practitioners who should have been well aware of the problems inherent in performance chasing, yet still they succumbed.

The findings of this research were corroborated in a broader context in a study conducted by Itzhak Ben David, Jiacui Liu, Andrea Rossi and Yang Song[v].  They analysed flows into US mutual funds between 1997 and 2011 and sought to observe the determinants of flows across a range of risk factors.  The two primary drivers identified were Morningstar ratings and recent returns. Whilst the Morningstar rating evolved through the evaluation period, it is a quantitative metric based on peer group relative outcomes (risk and return).  In other words, it is a measure based largely on past performance.  The authors argue that investors seek: “easy to follow signals”.

It is not only that performance chasing is reliant on data that provides no guide to future returns, but that strong performance in one period can be a forebear of poor future returns.  Research by Brad Cornell, Jason Hsu and David Nangian found[vi] that managers with recent weak performance earned higher benchmark relative returns in the future than those that had outperformed.  The tendency of mutual fund returns to experience mean reversion shows that our propensity to sell stragglers and buy recent winners is not just pointless; it is often the exact opposite of what we should be doing.

Whilst performance chasing is endemic in mutual fund selection, it is not necessarily deliberate.  Although some of us will explicitly target historic returns, many will consider a broad range of factors and undertake a rigorous due diligence process.  The problem is as soon as we observe past performance it shapes our view on every other aspect of our research.  The judgements we make about factors entirely unrelated to performance are indelibly tainted.  We chase performance even when we are not consciously attempting to.

This damaging behaviour is driven by outcome bias.  Its influence over our decision making is not just that it gives results pre-eminence over all else, but that it changes the way we perceive the other relevant issues.

The Origins of Outcome Bias

The classic origin study for outcome bias was carried out by Jonathan Baron and John Hershey[vii]. They asked participants to rate the quality of a hypothetical medical decision:

A 55 year old man with a heart condition was offered a bypass operation that would improve his standard of living and increase his life expectancy; however, 8% of patients who undertook such an operation died.  The decision was taken by the physician to carry out the operation.

Participants were presented with this scenario twice (amongst an array of different questions) with a single difference – in scenario one the patient lived and in scenario two they died.  Despite the result being irrelevant to the quality of the decision, and it being the same participant making the choice, the scenario that ended with success was rated as being a significantly superior judgement.

Outcome bias has also been shown to be hugely influential in areas where we might expect our views to show more stability – our ethics and values. Francesca Gino, Don Moore and Max Bazerman carried out a study[viii] where they presented participants with a range of scenarios featuring ethically dubious behaviour.  In one case this involved a company knowingly selling a toy containing harmful chemicals that was hazardous to children. The ethical condemnation of this activity by participants was far greater when the outcome was negative – six children died – than in the positive version, where no children were injured.

Even when it should be inconsequential, results have a material influence on the views that we hold and the judgements that we make across many domains, and investing is no exception. Indeed, there are features of financial markets which make us particularly vulnerable to its more damaging consequences.

Outcome Bias and Randomness – A Potent Cocktail

Although it is easier to observe the negative elements of outcome bias, in many aspects of life it can be viewed as an effective adaption.  A shortcut to making quick judgements based on limited information.  I can with some confidence assume that a carpenter has skill by observing their finished item. I don’t need to watch her work with a chisel for hours.

The challenge for investors is that outcome bias is only useful when we can be confident that a good process will consistently result in positive results.  If outcomes are unstable or subject to randomness then they become hugely misleading. Unfortunately, we don’t adjust sufficiently for this when using outcomes to inform our judgments (we are poorly calibrated).  We can even be swayed by outcomes when an activity is purely and categorically the result of pure chance.

In a 1975 study[ix], Ellen Langer and Jane Roth asked a group of Yale University students to predict a sequence of 30 coin tosses. Although the overall outcome for each participant was fixed to be right 50% of the time, the study was designed so that half of the group enjoyed early success with their predictions and the other half struggled at the start.  Emboldened by indications of their otherworldly foresight, those who were correct with their initial guesses were more likely to consider themselves to be better than average at predicting the toss of a coin.  Startlingly, 40% of the students also believed that they could improve with practice (which reflects well on the ethos of Yale students, though not necessarily their grasp of probabilities).

The coin toss example is consistent with Langer’s broader research on the ‘illusion of control’, which is the idea that we consistently believe that random events are under our own or someone else’s influence.  If we are prejudiced by the outcomes of a coin toss (where the randomness is certain), our desire to see order in the vacillations of capricious financial markets is a given.

Whilst the result of a coin toss is pure chance, active fund management combines some fortune and some skill.   Although exactly how much luck or skill is involved is itself highly uncertain, our performance chasing behaviour suggests that we greatly overstate (either directly or indirectly) the role of skill.  On an individual basis the influence of outcome bias on our investment decisions is profound, but we also need to consider how our collective susceptibility to the bias serves to compound the problem.

The Collective Impact of Outcome Bias

When we discuss behavioural biases it is typically about their influence on us as individuals, however, it is important not to neglect their impact on group behaviour. What does it mean if we are all subject to outcome bias?   If the majority of investors are in the grip of outcome bias and engage in performance chasing behaviour as a result, then taking action that is contrary to that becomes impossible for most professional investors.  Imagine the reaction of your clients and colleagues to investing money with a poorly performing fund.

Investing in underperforming managers and selling strong performers might be a beneficial strategy over the long-term, but it comes with profound career risk.  It is acceptable to buy an outperforming manager that subsequently struggles – this is what we are all prone to do.  Investing in a poor performer that continues to deliver weak returns is likely to be seen as unpalatable. Wasn’t it obvious that they had no skill?

Attempting to mitigate outcome bias and prevent performance chasing behaviour means overriding our natural instincts and also having a willingness to fail unconventionally.  Neither of these is simple, but that does not mean there is nothing we can do.

How Can We Prevent Performance Chasing?

Outcome bias cannot be switched off.  Whilst awareness is a starting point, it is evident from our continued performance chasing behaviour that it alone is insufficient.  We need to make clear and focused interventions to change our behaviour:

1) Stop Using Performance Screens: Mutual fund performance screens are ubiquitous across the investment industry, and I have never worked in a team where they have not been employed in some form. Wealth managers, investment consultants, ratings agencies all use some form of historic performance screen to rank funds.  Whilst each will differ based on the metrics and time horizon used, they are all fundamentally doing the same thing – assessing funds based on past performance.  They are a behavioural disaster.

Outcome bias and the performance chasing behaviour that follows is difficult enough to avoid even if you are not actively employing tools that encourage it.  Investors will argue that it is difficult to reduce such large universes of funds without some kind of performance filter, and also that it is only a starting point. However, we know that observing performance in this way will have a dramatic impact on the decisions we make. Virtually any other way of cutting down a potential investment universe would be better.

2) Create decision rules: A simple step to avoid performance chasing behaviour is to create fixed decision rules that strictly prohibit it. For example, you might state: “We will not purchase a fund that has outperformed its benchmark by more than 10% over three years”. This sounds straightforward but is fiendishly difficult to apply given that it runs counter to our typical approach to selecting active managers.

It will prohibit buying of those anomalous managers that continue to generate strong returns even after a stellar run. On average, however, it should be an effective means of avoiding the cost of purchasing active managers with a high potential for severe mean reversion.

3) Go Passive: The best behavioural interventions are the simple ones. Anything that requires behavioural discipline or continued effort raises the prospect of failure. Given this, what is the best way to avoid performance chasing in active mutual funds?  We can restrict ourselves to buying only passive market trackers.  This changes the context of the decision and entirely nullifies the influence of the bias from our fund selection decisions at least.

4) Specify the activity in which you believe skill exists. When investing with an active manager, we are taking the view that the underlying manager has some form of skill. We tend, however, to be very vague about what we actually mean by this.

When seeking to identify whether a fund manager is skilful, we need to be specific about the activity in which someone may possess it.  If we suggest that they are skilled at ‘beating the market’ then we are entirely beholden to whether performance is good or bad, irrespective of the reason.  If we instead make precise claims about where they may hold an advantage – for example, in identifying companies where the potential earnings growth is greater than market expectations – we can at least begin to assess whether the outcomes are directly related to an explicit process.

There is no such thing as a ‘skilled investor’ as much as there is a ‘skilled surgeon’ – I wouldn’t be entirely comfortable with even the most skilled urologist performing brain surgery on me.  When discussing skill always ask – skilled at what, exactly? Then test it.

5) Understand how much randomness there is an activity. In his book ‘The Success Equation’[x] Michael Mauboussin suggests an intuitive check for resolving the quandary about gauging whether a particular activity is more subject to luck or skill – simply ask the question: is it possible to fail deliberately?

Take a lottery – it is impossible to purposely fail when playing; provided the ticket is correctly completed, the probability of success cannot be impacted by the combination of numbers selected, and the result is entirely arbitrary. Contrastingly, chess is a game dominated by skill, with limited influence from chance or randomness; it is easy to intentionally lose a game by recklessly sacrificing key pieces.

The more randomness there is in any given activity, the higher the threshold must for claiming that skill exists. Always apply the ‘can you fail deliberately’ test.

6) Extend your time horizons: Our susceptibility to outcome bias is greatly influenced by the time horizons involved. Whilst investment management is always a combination of luck and skill, the length of the assessment period alters how much we can glean from performance alone.  If we assess investment performance over one day it can be considered to be pure luck, but as we extend the period skill can exert more of an influence.  You can still be lucky over ten years, but the outcomes should be less influenced by chance.

We would not necessarily expect Warren Buffett’s stock picks to beat those of my six year old daughter tomorrow, but over a decade we would.  The fact, however, that over a ten year period you couldn’t be 100% certain that the world’s most revered stock picker would beat the returns of a six year old tells you a great deal about the problems of performance chasing and outcome bias.

Unfortunately, if anything we are seemingly becoming more myopic in our investment judgements. Three years is considered long-term, and performance is increasingly assessed over ridiculously brief periods of time such as one month and one quarter. If you are assessing outcomes over such time horizons you should understand that they are likely devoid of meaning.

Performance chasing behaviour is, of course, not isolated to our selection of active fund managers.  It is readily apparent in how we invest in everything from major asset classes to individual stocks. It is also not entirely driven by outcome bias.  There are a multitude of factors at play; including our willingness to extrapolate recent history into the future and our susceptibility to a good story.

Active manager selection decisions are, however, the perfect breeding ground for outcome bias to run amok.  The use of past performance to guide judgements seems to offer some sense to a highly uncertain environment – accepting that past performance is largely random may lead to some difficult introspection.  Its importance is also embedded in the system. It is what everyone cares about – boards, clients, trustees, risk teams, CIOs – it is measured and therefore it matters, and usually a great deal to your career.

This is not to say that outcomes do no matter.  Of course, all investors are seeking better long-term results for their clients.  The problem is not that we care about performance, it is that we have become reliant on historically noisy data to make unsubstantiated or plain incorrect inferences about the future.  If we want to invest in active managers, we need to think far more about decision quality and process, and far less about yesterday’s performance.




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[v] Ben-David, I., Li, J., Rossi, A., & Song, Y. (2019). What Do Mutual Fund Investors Really Care About?. Fisher College of Business Working Paper, (2019-03), 005.

[vi] Cornell, B., Hsu, J., & Nanigian, D. (2017). Does Past Performance Matter in Investment Manager Selection?. The Journal of Portfolio Management43(4), 33-43.

[vii] Baron, J., & Hershey, J. C. (1988). Outcome bias in decision evaluation. Journal of personality and social psychology54(4), 569.

[viii] Gino, F., Moore, D. A., & Bazerman, M. H. (2009). No harm, no foul: The outcome bias in ethical judgments. Harvard Business School NOM Working Paper, (08-080).

[ix] Langer, E. J., & Roth, J. (1975). Heads I win, tails it’s chance: The illusion of control as a function of the sequence of outcomes in a purely chance task. Journal of personality and social psychology32(6), 951.

[x] Mauboussin, M. J. (2012). The success equation: Untangling skill and luck in business, sports, and investing. Harvard Business Press.