Before you stop reading, I promise this is not another SVB explainer. While (too) much ink has been spilled detailing the bank’s failure; it is often useful to take a step back from tumultuous market events and consider our own behaviour. What happens to us during such stressful periods and what does it tell us about how we deal with investment risk?

Our time horizons contract – The key danger for investors during periods of market stress is the contraction of our time horizons. Even if we have a long-term orientation, we quickly start to worry about the immediate future. All our carefully considered behavioural plans can be torn asunder, as we seek to remove the anxiety we are feeling right now.

We focus on one thing – It is not just that our time horizons contract, but our focus narrows. The attention of virtually all investors turns to one thing, typically at the expense of issues far more important to our long-term fortunes.

We feel like we must act – Never is the most damaging investor urge of ‘something is happening in markets; we must do something to our portfolio’ more powerful than during a concerning and unexpected market event. It feels like everything is changing, so our investments must also change. We never let our failure to predict what has just happened stop us predicting what will happen next.

We are all ‘after-the-fact’ experts – When a significant market event that nobody predicted occurs, hindsight bias runs amok. Many people have now cogently explained the risk inherent in the SVB model, not many did so before it failed. While everyone is busy discussing what transpired, it is worth reflecting on why nobody expected it.

Uncertainty hasn’t increased – During stressful periods in markets it is common to hear people comment that markets are now ‘more uncertain’. This makes no sense. Markets are always uncertain. If we felt more confident in the future before the surprising occurrence with SVB then it turns out that we were wrong. We simply don’t know what is going to happen tomorrow.    

Market / economic predictions are tough – I don’t recall reading many 2023 market forecasts which mentioned the failure of a major bank. The problem with complex, adaptive systems is that things change / events happen and that alters everything. Let’s stop making short-term market predictions.

The most meaningful risks are the things we don’t see coming – Both how we think about and model risk is conditioned by what we have seen and experienced. The most profound and material risks are the ones that we do not anticipate.

Risks are either understated or overstated – We are prone to treat risks in a binary fashion. Either completely ignoring them or hugely overstating them. We tend not to buy flood risk insurance until our house is under water.

We focus on risks that are available and salient – The risks that we focus on are those that are available (in recent memory) and salient (provoking emotion). This is why rising interest rates after a period of secular decline has been so problematic (see SVB, or LDI in the UK). It is easy to be complacent about risks that have not come to pass in a long time (perhaps in our living memory).

This risk is now available and salient – Now the type of risk encountered by SVB has become available and salient it will be at the forefront of our thinking and decision making – we will see it everywhere. Unfortunately, the next major risk event is likely to be something that is not.  

Exciting stories overwhelm risk awareness – A useful rule of thumb is that the more compelling an investment narrative – the more adulatory front pages and gushing stories – the greater the hidden risks. There are two reasons for this. First, good stories can leave us blind to detail. Second, when a captivating story is working or making money, it can feel too costly not to join the party.    

Unexpected market events are anxiety inducing and provoke some of our most damaging behaviours. It will be in most investors interest to focus less on the current issue and more on our response to it. Sensible investing principles – such as taking a long-term perspective, systematic rebalancing and being appropriately diversified – are designed to deal with situations like these. Let’s not forget them.  

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

In 1907 English polymath Francis Galton published an account of a forecasting competition that had taken place at a country exhibition in Plymouth the year before. He described how 787 participants had attempted to win prizes by correctly guessing the weight of a slaughtered ox. After reviewing the entries, Galton observed that the median guess was within 1% of the actual weight.[i] This remains one of the foremost examples of the idea of the wisdom of crowds, whereby combining a diverse array of independent opinions can lead to robust forecasts, often superior to those made by any individual.

The notion of the wisdom of the crowd is often applied to equity markets, particularly those arguing that they are (at least close to) efficiently priced. Unfortunately, the conditions for the wisdom of crowds to function do not hold for public equities. In fact, the behaviour of the crowd – in a variety of ways – creates inefficiencies rather than removes them. The inevitable presence of inefficiencies, however, does not make markets easy to beat or mean that we should even try.

For the purposes of this piece, we can assume that efficiently priced means to reflect the best collective estimate of an asset / markets’ value based on all available information. It is easy to see why the wisdom of crowds is a compelling description of how equity markets operate. We have a vast array of distinct investors making independent judgements. Doesn’t that get us to a similar situation to Galton and the Ox? Not quite.

As investors know only too well, crowds are not always wise. There are several characteristics required before we can begin to value their wisdom. [ii] The three most relevant are:

– Diversity of opinion: There does not necessarily need to be different information but, at least, the same information interpreted differently.

– Independent judgement: Views must be reached without the influence of others.

– There must be a means of collecting diverse opinions: There needs to be some means of aggregating group perspectives.

While equity prices are certainly an excellent way of collating the individual judgements of a participating group; applying the wisdom of crowds to equities breaks down when it comes to independence and diversity of opinion.

Although it may seem that the sheer number of participants in equity markets guarantees that prices reflect a varied range of perspectives, there will be times – particularly during market crashes or bubbles – where investor focus becomes trained on a very narrow set of ideas. In addition to this, it is at such times where investor decisions are most likely to be influenced by the behaviour of others. Extreme events in markets will be generated and sustained by the shared stress, fear and excitement of the crowd.

This destructive crowd behaviour leads to what we can think of as acute or episodic inefficiency. Where the price of an asset or security can diverge wildly from any reasonable assessment of fair value because the crowd / market has lost its independence and diversity of opinion.
 
It is not simply these bouts of dramatic crowd behaviour that prevent the market being efficiently priced. There is something else. Galton’s ox and other similar examples (such as judging the number of sweets in a jar) work because everyone involved is trying to guess the same thing. To believe that equity markets are efficiently priced because of crowd behaviour assumes that all or most of the crowd are attempting to make decisions based on their estimate of the fair value of the underlying securities. But they are not.

There are a huge range of motivations as to why investors make purchase and sell decisions, which have little relation to any assessment of long-run fair value. Investors might be passively following a market cap index, they might be chasing price momentum, they might be attempting to assess which company has the best earnings revisions prospects over the next 12 months or simply predicting how other investors will react to the latest news. All are valid approaches, but none require the estimation of a security’s fair value.

We can think of this situation as akin to Galton’s ox scenario, but where each participant is guessing the weight of a different animal – one a pig, one a sheep, another a goat. There is no reason to believe the average of such estimates will get us close to the weight of an ox.

Contrary to the aforementioned acute inefficiency, this is a chronic inefficiency. Where we should not expect the views of the crowd to equate to fair value (at any given point in time) because different people are forecasting different things.  

How might these two types of inefficiencies interact? Markets are typically in a state of chronic inefficiency where prices fluctuate based on the behaviour of investors with differing objectives, but with some slight gravitational pull from fair value. This will be punctuated with occasional bouts of acute inefficiency where investors (the crowd) move in concert and focus on a particular issue or story.  

If crowd behaviour means that there are both chronic and acute inefficiencies with markets unlikely to approximate fair value, does that mean everyone should be an active investor? No. Markets being inefficient does not mean they are easy to beat.

Episodes of acute inefficiency create the greatest opportunities in terms of the level of divergence from fair value, which will often be extreme. Exploiting them is, however, no easy task. It will be incredibly difficult for us to escape the pull of the crowd or the specific issue that is the focus of their attention. Even if we do manage to separate ourselves, we have no means of predicting when the behaviour will abate. Avoiding the madness of crowds can be painful and costly.

Although taking advantage of chronic inefficiencies may not be as emotionally exacting as escaping the fervour of a crowd, it remains a herculean challenge. Not only do we have to have a means of identifying some reasonable range of fair value for a security or an asset; we have to wait for it to be realised. If investors in aggregate are not attempting to find this fair value (because they are investing for other reasons) there is no reason for it to reach it anytime soon. So we need analytical prowess and (a lot of) patience.

The idea of the wisdom of crowds tells us more about why markets are likely to be inefficient (at times extremely so) rather than efficient. It also provides insights as to why taking advantage of that inefficiency is quite so difficult.

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[i] A 2014 paper by Kenneth Wallis “Revisiting Francis Galton’s Forecasting Competition” found some discrepancies in the original work that actually served to strengthen Galton’s theory as the mean estimate of 1197lbs was found to have exactly matched the weight of the ox.

[ii] See James Surowiecki’s excellent  “The Wisdom of Crowds” for more detail on the conditions required for a ‘wise’ crowd.

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

I am in a forecasting competition and asked to predict global iPhone sales. I can choose to make an estimate over one of two time periods – either the next three months or the next ten years. Which would I prefer? This is a simple decision – the next three months. There will be far less noise and uncertainty over the quarter then there will be over the decade. This aligns with Philip Tetlock’s work on super-forecasting, which suggests that predictions for the near-term are likely to be more accurate than those we make for the distant future. Does it therefore follow that investors are best placed to focus their attentions on the short-term? Almost certainly not. In fact, where we do have to make forecasts, it typically is in our interest to take a long-term view. Why is investing an exception?

Before exploring this idea further, it is worth starting with a caveat. Forecasting most things is difficult and we are notoriously bad at it. Predicting the behaviour of a complex adaptive system such as financial markets is particularly challenging. Our default setting should be to avoid it, where at all possible.

But as investors we must make certain types of projections, even if we don’t realise it. When we build a portfolio the decisions we make (how much to allocate to equities? How much to bonds?) are underpinned by expectations about the future. Not all forecasts are created equal however, even when they are about the same asset class.

Let’s take equities. In very simple terms if we want to take a view on the prospects for global equities then there are two things that matter: sentiment (how other investors ‘value’ them) and fundamentals (the earnings stream we receive through time). The importance of each element alters dramatically depending on the time horizon applied.

The shorter the time period the more sentiment dominates outcomes. This creates a prediction problem. It is close to impossible to hold confident views about what events will occur and how market participants (in aggregate) will react to them. The amount of noise and randomness is pronounced, and the range of potential outcomes vast.

As the horizon extends, however, the fundamental factors start to matter more. The compound impact of earnings begins to overwhelm the influence of fluctuating sentiment. If we are making a ten year forecast for an asset class, we are thinking about the accumulation of cash flows / earnings over that entire period, not just what they are by the end of it.

The influence of multiple years of earnings should mean that the range of outcomes narrows as our time horizon increases. In the graph below we can see the breadth of annualised returns for global equities since the late 1980s:

A one year horizon is the point of peak sentiment driven uncertainty, which then tapers materially as the period extends.

If we are investing in global equity markets today, we know the starting yield, the valuation and can set a prudent expectation for growth (long-run global GDP). It is reasonable to expect our returns to gravitate towards this over the long-run. There are clearly no guarantees here and there remain profound uncertainties. We should, however, have more confidence in these types of assumptions than in what might happen in equity markets over the next year.

Although it is more likely that we will enjoy success in making long-term asset class return forecasts, it is important to define success. We are not going to predict ten year returns accurately to 2 decimal places (or indeed 1); one of the few things we can be certain about is that such point forecasts will be wrong. This does not mean, however, that long run views are without value; there are many situations where they get the odds on our side.

Take the below three examples. These are all scenarios where I would prefer to make a ten year to a one year prediction:

• Setting a sensible range of expectations of where asset class returns will reside: I would expect the dispersion of returns to narrow as the time horizon moves past twelve months.
  
• Ranking asset classes by relative preference: I have no idea about how equities will fare compared to government bonds over the next year, give me ten years and I will be far more confident.
  
• Judging the likelihood of positive absolute performance: The odds of positive returns from most traditional asset classes improve as our time horizon extends.

The benefits of adopting a long-term approach when setting return expectations is reliant on being diversified. If we are heavily concentrated (for example owning a single stock) we should not expect the spread of potential outcomes to contract materially as our time horizons extend because of the ever-present spectre of idiosyncratic risk.

Whenever we make a forecast we should seek to understand what the most influential variables are and how unpredictable they are likely to be. For investors making decisions based on short-run asset class performance it is critical to be aware that outcomes will be incredibly noisy, driven by erratic sentiment and have a wide range of potential paths. Although imperfect, extending our time horizons can give us a little more confidence.

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

It is often stated that the key to strong long-term investment performance is the ability to compound good short-term results. Although avoiding near-term disasters (such as severe permanent losses or extreme volatility) is imperative for all investors; the idea that an acute focus on the immediate future when managing our investments will lead to positive outcomes over long-run horizons is deeply flawed. There is a paradox at the heart of our investment behaviour whereby the more we care about what happens in the short-term, the worse our long-term performance is likely to be.

Although the precise definition of long and short-term investing horizons is somewhat hazy, let’s assume that short-term is under three years and long-term is over ten years (we can ignore the piece in the middle for now).

For most investors the core tenet of successful long-term investing is about making sensible, evidence-based decisions that put the odds on our side and then letting it play out. Although this sounds easy, it is far from it.

Whichever investment strategy we adopt, whichever funds or assets we hold, they won’t work every quarter, every year or even every three years. They will all go through spells of poor performance where negative narratives abound and our concerns will be pronounced. The temptation to change course will often prove overwhelming.

This is not about active versus passive investing. All approaches will come under scrutiny. We need only look at the number of obituaries being written for the 60/40 portfolio following an unusually difficult 2022. Investors of all churches will have to withstand periods of scrutiny and doubt in order to meet their long-run objectives.

The underlying problem is one of continually unhelpful feedback. Long-term investors receive constant feedback on their choices in terms of short-term performance and the narratives that accompany it. We perceive this to be meaningful information but it is nothing more than distracting noise.

Smart long-term investment decisions will often spend plenty of time looking like stupid ones. If we cannot endure this reality, we are likely to be drawn toward the dangerous allure of short-term performance chasing.

Trying to manage short-term performance is both exciting and exhausting. Exciting because we feel good about latching onto the latest fad or trend; exhausting because markets are fickle and unpredictable.

Caring about how we compare to others over the next quarter or next year will inevitably lead to poor outcomes. As we constantly chase our tail, predict the unpredictable, pursue grossly overplayed themes, buy at the peak, and sell at the trough.  

If such myopia is a sure route to poor results, why is it so prevalent? There are three primary factors at play:

1) It relieves stress and anxiety: Doing nothing for lengthy periods as a long-term investor is tough, particularly when we are receiving negative near-term feedback (our performance is disappointing). Making changes based on what is working right now makes us feel so much better.

2) We mistake short-term market noise for information: We are overwhelmed by a constant stream of data releases, opinions and, of course, fluctuating returns. The functioning of financial markets makes us believe that things are changing and that our portfolios must change as a consequence.

3) Our incentives are aligned with taking a short-term view: For professional investors, in particular, our incentives are almost inevitably aligned with adopting a short-term perspective. It is the safest way to build a career, stay busy and not lose our job / assets. People are happy with the short-term decisions we make as they will be pro-cyclical (buy the winners / sell the laggards) and we will have a story to tell. We won’t see the long-term costs because by the time they come to fruition we will most likely be in another job.

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Aside from a select few who wish to dabble in short-term market timing (best of luck), the vast majority of investors would be better off in focusing on the long-term. Unfortunately, that is far easier said than done. Both our behavioural wiring and the febrile nature of financial markets makes short-termism our default setting. If we are going to be long-term investors, we need to have a plan for how we are going to do it.

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

If you are a staunch advocate of index funds then the answer to the question of whether meeting active fund managers before investing with them is a waste of time is unequivocally yes. So, to avoid another active versus passive debate, let’s assume we have to invest in an active fund – is meeting with the fund manager necessary and does it improve the odds of success? During my all too long career fund manager meetings have been something of a sacred cow – of course you must see the ‘whites of their eyes’ before handing a fund manager your money, it would be madness not to. But is this true?

The received wisdom around the value of meeting fund managers is so pervasive that I have rarely seen any alternatives proposed – aside from the occasional and dreadful performance (chasing) fund screen. Of course, different people have different approaches to such meetings – some are happy to simply be presented to, while others prefer to grill a junior analyst on their forecast for operating margins in the smallest stock in the portfolio – but most seem to miss a critical factor. Whenever we enter into an interaction with another individual the decision we make will often be overwhelmed by a range of unconscious behavioural factors. We ignore these at our peril.

What are the main behavioural problems we are likely to encounter when meeting with a fund manager?

Halo effect – Perhaps the most challenging behavioural issue of fund manager meetings is the halo effect. This is where we allow a positive view of one aspect of an individual to impact our assessment of an unrelated trait. A fund manager is a compelling, articulate presenter – surely, they must also be a good investor?

Outcome bias – Even though past performance is a poor guide to future returns and the presence of skill; we are likely to find the answers of an outperforming fund manager persuasive and an underperforming manager weak. In this sense, fund manager meetings can serve to perpetuate destructive performance chasing behaviour.

Selection bias – Successful fund managers who raise assets are likely to be good presenters and confident communicators. It will have helped them through every stage of their career. The bad presenters are probably more interesting propositions – they have had the odds stacked against them in getting to where they are.

Reading people – Part of the appeal of meeting fund managers is to gauge whether they are trustworthy and credible. Yet most of us hugely overstate our ability to ‘read people’, understand their motives and separate fact from fiction.

Perpetuating tropes – We inevitably hold a range of misguided archetypes and tropes about what characteristics individuals in certain roles should possess. One of the reasons why so many fund managers are men (aside from deeply-ingrained societal issues) is that we are beguiled by gendered traits such as overconfidence and charisma – despite them being unrelated to being a successful investor. These traits are often well in evidence in traditional fund manager meetings.

People we like – Although it is difficult to accept, we will hold more favourable views of investors that we like as people.

Reciprocity – Another issue that we struggle to believe would influence us is the power of reciprocity. If someone does something for us, we feel compelled to return the favour, often in ways that are entirely incommensurate. Small gestures can have a huge impact and is a spectre that looms over relationships fund investors may have with asset managers.  

Charisma – Charisma hides a huge number of ills and a fund manager meeting is the perfect forum to mask a lack of competence with personality. There is nothing more dangerous to an investor than a lucky fund manager with charisma.

Information / confidence – There is often a conflation between the depth of research undertaken on a fund manager (“we have had 15 meetings with them”) and the quality of the resulting decision. There are two problems here. First, we can easily lose sight of what variables matter because we are subsumed by irrelevant detail. Second, past a certain point, more knowledge simply leads us to hold more confidence in our view without it becoming any more accurate. In this situation, increased information reduces decision quality.  

Information asymmetry – Inherent in the interaction in a fund manager meeting is an information asymmetry. The fund manager should know more about the securities they invest in than we do. Yet I have attended countless meetings where a view on a fund manager is formed based on how well they ‘know their stocks’. Unfortunately, rote knowledge of securities is not a necessary or sufficient condition for being a successful investor.    

Storytelling – An effective fund manager meeting (from the perspective of a fund manager) is an exercise in storytelling. It is designed to make us focus on the inside view at the expense of the outside view – that is to concentrate on the specifics of the fund manager in question, not the general probabilities attached to successfully finding a skilful active fund manager. “Who cares if the odds are 1 in a 100, that was a great meeting”.

Sunk costs – In a fund manager due diligence process, we must always be aware of the impact of sunk costs. Turning back or changing our minds after so many hours spent in meetings is a difficult thing to justify to ourselves and others.

Front stage / back stage – One approach some fund selectors take when assessing a fund manager is to observe team meetings to see how interactions take place and decisions are made first hand. This is viewed with scepticism by many who argue that if a team are being watched then it is not a genuine interaction. Yet these same critics are often happy to sit in a standard fund manager meeting, which is surely more artificial. The simple fact is that – as sociologist Erving Goffman noted – we all have a front stage and a backstage self. The waiter in a restaurant behaves differently when they are serving us to when they are in the kitchen. All fund manager meetings are performative, and we will never know the true functioning of a team unless we work at the organisation.

Management of self – It is not just the fund manager that performs in a meeting, it is the fund selector also. They might be in awe of the fund manager, who will often have more money and power than they do. They might even be in the meeting alongside their own boss or client. The temptation is often strong to ask questions that might reflect well on them, rather than those that help make a good decision. ‘Intelligent’ but empty questions are easily favoured over ‘simple’ but searching ones.  

A problem for other people – There is one overarching factor that amplifies the damage caused by behavioural issues and that is our ingrained belief that they don’t affect us: “Other people? Maybe. But they have never influenced my decisions.” Until we accept that they do, it will continue to undermine the effectiveness of fund manager meetings.

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The regard in which fund manager meetings are held is such that I have never heard any reasonable alternatives proposed, indeed suggesting such things might be regarded as heresy. But let’s try.

How about instead of a face-to-face meeting with a fund manager, we reserve time with them and ask them to respond to a set of bespoke questions by hand. They have to do it themselves and on their own. If we were assessing a group of fund managers, we could even blind the responses.

I can hear the howls of protest about the loss inherent in such a method. There has, however, been such little progress in this area nor acknowledgement of the behavioural pitfalls of the current approach that fresh ideas are needed.

One less controversial method to help enhance the value of fund manager meetings is simply for fund investors to be clear about what it is they care about. It is so easy to become lost in a sea of noise. The most effective way to alight on this is to ask ourselves – if I could only know ten things about a fund manager before investing with them, what would they be?

It is not simple to define, but can lead to a much sharper focus. Having an agenda is not enough, we need to be trained on what matters and why.

Would I want to invest money without meeting a manager? Probably not, but perhaps it is just because I have been conditioned to believe it is essential. What is critical is that fund manager meetings are based on evidence pertaining to the factors that we believe are important. We should also always be underweighting what is said and overweighting what is done.

Are fund manager meetings a waste of time? No. Is it a waste of time or worse if we don’t acknowledge or deal with the behavioural biases that we carry with us into those meetings? Almost certainly.

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

I started my investment career in 2004. Although equity markets had begun their recovery from the damage wrought by the dot-com bubble, the scars were still evident. All too regularly I saw client portfolios with tiny, residual holdings in once-celebrated technology funds – stark reminders of costly past decisions.  With the wonderful clarity and confidence that only hindsight can bring, I remember thinking how I would never be swept up by such lunacy and, in any case, it was unlikely to happen again – investors will have learnt their lessons. One look at the all too recent obsession with ape JPEGs, made up currencies, (empty) shell companies and, once again, stratospherically valued technology businesses would tell you quite how naïve I was.

Why is it that we can have such vivid and painful investing experiences but go on to repeat the same mistakes?

The central problem for investors is about behaviour and stories. One of them changes and the other doesn’t.

Lessons Not Learnt

GMO’s Jeremy Grantham was once asked what lessons investors would learn from the 2008 Global Financial Crisis, he replied: “In the short-term a lot, in the medium-term a little, in the long-term, nothing at all. That would be the historical precedent.” 

Part of this phenomenon is down to the half-life of painful investment episodes. Memories fade and scars heal. There is also always a new set of younger investors, unburdened by the baggage carried by the previous generation – ready to learn the same lessons anew.   

Yet this is not sufficient to explain the unerring cycle of mistakes. Most investors live through multiple spells of mania, greed, panic and despair. And, even if they haven’t, there is plenty to read about it. Despite the evidence, our behaviour doesn’t change.

Something Really Is Different This Time

The reason that it is so easy to discard the lessons of history is that the story is always fresh. We can reject the behavioural failings of the past as an irrelevance – this is a new situation and the old rules do not apply. Our focus is always on the persuasiveness of the narrative of the moment – it is how we interpret the world – rather than our behaviour.

Sir John Templeton’s famous comment about the danger to investors of the four words “this time it’s different” is absolutely true as it pertains to the nature of investor behaviour – that doesn’t alter. Yet our willingness and ability to repeat those poor behaviours arises only because the story is different each time.

The story changing allows our behaviour to remain the same.

Incentives (Always) Matter

No discussion of investor behaviour can be complete without a consideration of incentives. New stories allow and compel us to ignore behavioural lessons, and incentives act to leverage this effect, exacerbating the disconnect.

Investment narratives are wrapped up in a virtuous / vicious circle alongside performance and social proof. A captivating story, strong (or weak) performance and the behaviour of other investors creates a self-reinforcing loop, where one element validates the next. High (or low) returns seem to further corroborate the story and persuade more investors. And so it continues.

At some point most people get captured by the gravitational pull of this interaction. Whether it is the pain of poor performance, our neighbour making more money than us or the threat of losing our job. We become incentivised to behave poorly.

We don’t need everyone to believe in a story for it to overwhelm sensible investment behaviour, just enough so it becomes in almost everybody’s interest to go along for the ride.   

Is Our Behaviour Getting Worse?

Although our behavioural characteristics don’t change, there is a risk that the impact is becoming more severe. Why? Because there is more stimulus and more opportunity.

Financial markets are narrative generating machines. Not only does modern technology mean that we have more stories being created than ever, but they are effortlessly disseminated and amplified. Add to this the ability trade in an instant and we truly have a toxic behavioural concoction.  

There are no easy solutions here. It is not simply that we do not learn from our investing mistakes, but that we are likely to make more of them.

It is undoubtedly harder than ever for investors to behave well.

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

Imagine we are attempting to design a stock picking model that will outperform the market over the next ten years. After a great deal of forensic research and testing we finalise our approach. Although we couldn’t know this in advance, the system we devise is optimal – there is no better way of tackling the problem we are trying to solve. Given this, what are we likely to do with the investment process we have developed over the coming years?

Change it and make it worse.

Even if we design a perfect investment approach the temptation to tinker and adjust is likely to prove irresistible. Why is it so difficult to persevere even when we have a sound method?

There is a mismatch between short-term feedback and long-term goals: If the objective of our investment process is long-term in nature; using short-term performance as a means of assessing its robustness is likely to be at best meaningless and at worst entirely counter-productive. All investment approaches will endure spells in the doldrums and reacting to these with constant process modifications is a certain path to poor results.  

The need to always be doing something: Keeping faith with an investment process for the long-term means a lot of time doing nothing. This sounds easy but is anything but. Financial markets are in a constant state of flux, perpetually generating new and persuasive narratives. Temporary fluctuations in markets often feel like a secular sea change when we are living through them. The urge to act is strong.

Doubting the process: When our approach suffers from poor short-term performance there will be intense pressure to change. This will be through internal doubt (what if my process is broken?) and, for professional investors, external pressures – ‘you are underperforming, do something about it’. Changing our process can make us feel better (less stressed, pressured, anxious) even if we don’t believe it is the right thing to do.

Feeling in control: The instability and uncertainty in financial markets can be deeply disconcerting; process adjustments can, erroneously, feel like we are wrestling back some form of control.

Overweighting recent information: Recency bias means that we will tend to overweight the importance of current events and heavily discount the past. Given the inherent variability of financial markets over short time periods this will mean we are continually tempted to adjust our process based on what is happening right now.

Overconfidence: Our ability to have a positive impact is hugely overstated. If we have a prudent investment approach to start with, improving it is not likely to be easy. We will inevitably grossly exaggerate our ability to implement changes that will improve our odds of success.

Optimising not satisficing: Our desire to adjust and attempt to enhance our investment process is driven by a belief that we should be optimising – finding the very best solution. While this is a noble aim in theory, the profound uncertainty of financial markets makes it dangerous in practice. An eternal and elusive search for the best investment process is likely to lead to at least as many bad decisions as good ones. Satisficing – adopting a strategy that is good enough – and maintaining it is likely to be the best route for most of us.

Intellect over behaviour: Our process changes will tend to be focused on the intellectual pursuit of finding new sources of information or applying them in different ways. Scant attention seems to be paid to the behavioural challenges of investing. The most robust investment approach will be torn asunder if we don’t have the fortitude to persevere with it.

It may seem as if I am suggesting that we should never attempt to improve our investment process. This is not the case. Striving to learn and develop is vital. It is critical to understand, however, that our tendency will inevitably be to do too much, often at the wrong time. We need to have an appropriately high threshold for change.

Never underestimate the advantage gained by an investor who has a sensible method and can stick with it.

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

Outperforming fund managers are dangerous for investors. Performance is cyclical and often mean reverting, and we tend to invest after periods of unsustainably strong returns. If these features aren’t damaging enough, there is another problem. If a fund manager has a strong track record we listen with rapt attention to everything they say about anything. If their returns are poor, we disregard their words. This may sound sensible but it is anything but.

We can see this phenomenon with certain growth / quality orientated active fund managers in recent times. As they generated stellar returns for a decade, we were hanging off their every word. Happy to treat them as sagacious on whatever subject they chose to opine on. Now performance has deteriorated our reaction to their utterances is more likely to be: “why would we listen to this idiot, haven’t you seen their returns over the past year?”

This mindset set is steeped in two behavioural issues: outcome bias and the halo effect.  Outcome bias means that once we see the result (in this case fund performance) we jump to a conclusion about the quality of the process that led to it. The halo effect is where an individual’s success in one field means that we (usually erroneously) hold a positive view of anything else they turn their hand to.

This is a toxic combination, which leads us to pay attention to people we shouldn’t and ignore those we should take heed of.

Why is it such an issue?  

There is a huge amount of luck involved in investment outcomes: From the unique life experience of a star fund manager to the early morning ice bath routine of a successful entrepreneur, we cannot help drawing a causal link between an individual’s success and their past actions. Yet so often the outcomes we see are nothing more than a mix of luck and survivorship bias, this is particularly true in the field of fund management.

Fund manager performance is cyclical: For even the most talented investor their fortunes will move in cycles. Periods in the sun will inevitably be followed by spells in the doldrums, even if the long-term trend is positive. Our use of performance as a marker for credibility means that we will frequently see the words of the prosperous chancer as more convincing than someone with genuine expertise.

Expertise is particular: Skill in investing, where it exists, is narrow and specific. Yet once a manager is outperforming, they have the freedom to confidently pronounce on any subject within the universe of financial markets (and sometimes far wider than that). Not only do they pontificate on these issues but we are willing listeners – their track record doesn’t lie! The pinnacle of this behaviour is where a fund manager – through some combination of hubris and necessity – shifts into an entirely different area to the one in which they forged their reputation and investors follow in their droves. This always ends well. 

We use past performance as a heuristic. In this context, as a quick and simple shorthand to give us an easy answer to the complex question: Should I pay attention to what this person is saying?

Amidst the squall of investment voices that surround us applying a (industrial strength) filter is essential, but if past performance is fickle and ineffective how do we go about it? There are three simple questions we should be considering:
 
1) Is it a relevant subject? The critical starting point is asking whether the subject is even worth our time. Is it something that matters to our investment outcomes and where expertise can exert an influence? If it is someone speculating on what will happen in markets over the next three months, we can happily disregard it.

 2) What are their motives?  We should always be sceptical in listening to a perspective from someone who is trying to sell us something, but this is not as straightforward as it may seem. If an investor genuinely believes in what they are doing, then they will inevitably be seen as “talking their book” but what else would they talk? It is not always easy to separate a knowledgeable advocate from a slick salesperson. The best differentiators are probably consistency, humility and depth.

3) What is their circle of competence? Judging an individual’s circle of competence is essential, and there are two aspects to consider. First, we need to understand the specific expertise they may possess. We should be as precise as possible here – “investing” does not count! Second, we must gauge why the individual has pedigree and credibility in their field, particularly relative to others.  

This approach may not quite be as effortless as checking whether a fund manager has produced stellar performance before deciding whether to pay attention, but it is likely to be more effective. The fact that there are far too many voices distracting investors is problem enough, we don’t need to compound the situation by listening to the wrong ones.

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

The long-term struggles of active funds versus index funds is primarily a problem of fees. There are other factors that influence the success rate of active strategies – most notably, in equities, the performance of small and medium sized companies relative to their larger counterparts – but it is the compound impact of highs costs over the long-term that causes most of the damage. Attempts to create charging structures that diverge from the simple % of assets under management model are typically focused on the use of performance-based fees, but in the vast majority of cases these (somewhat counter-intuitively) increase the negative asymmetry experienced by investors. Too often we pay lavish short-term rewards for underwhelming long-term results. To improve the odds of active fund success, the fee model needs a rethink.

One of the most egregious problems faced by fund investors is the problem of scale. As the size of a fund grows its profitability for an asset manager increases materially. Not just in terms of the revenues generated, but the profit margins. High operating leverage means that the marginal cost of an additional $100m invested into a $10bn fund is low. It is in the interests of asset managers to keep growing their largest funds.

There are two major difficulties that this model causes investors. First, is that the benefits of scale rarely have a material impact on the costs that they incur. As fund size grows and costs are spread across a greater revenue base this results in an improved margin for the asset manager but rarely a meaningful fee saving for the investor. Second, above a minimum threshold the growth in assets of a fund reduces the potential for future excess returns. Rising fund size means that the opportunity set is reduced, flexibility is compromised, and liquidity deteriorates.  

We are left with a situation where the investor faces a lower probability of outperformance whilst the profitability of a fund for an asset manager increases.

This is a major incentive problem for asset managers and creates a jarring misalignment with the objectives of their investors. Undoubtedly it is one of the primary reasons that funds are so rarely closed due to capacity constraints.

Is there a way of mitigating this problem and improving the situation for fund investors?

One option is to apply a $ revenue cap. How would this work?

A fund would launch with a standard fee level, let’s say 0.5%; but there would be a provision stating that all revenue earned over a certain amount ($Xm) would be reinvested into the fund. This would mean that above a given threshold of assets under management the benefits of scale would accrue to the underlying investors and provide compensation for the cost of asset growth in terms of declining performance potential. It would also greatly reduce the incentives of asset managers to ride roughshod over capacity concerns.

The advantages of such an approach are clear, but what are the potential drawbacks:

– Asset managers might increase fee levels to compensate for the cap. This is certainly possible but would only serve to further inhibit future performance.

– Asset managers may launch more products to mitigate the impact of capped costs, in particular launching similar / mirror versions of the constrained strategy. The last thing anybody needs is more funds.

– It might subdue innovation and development as large, ultra-profitable funds are no longer able to subsidise fledgling ventures or research. I am not sure I believe this is a genuine problem even as I write it.

– There may be technical difficulties (documentation etc…) if the size of a fund declines and investor fees increase. This doesn’t seem to be an insurmountable hurdle, but fee variability is not ideal.

A $ revenue fee cap is clearly going to be unattractive to the largest and most profitable asset managers, and this is not the only way that the current fee model can be improved. It is, however, an area that is ripe for disruption and where there is significant potential to improve both investor alignment and outcomes.

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

Although many people do it, making forecasts about how financial markets will fare in 2023 is an entirely pointless endeavour. What we can predict with some confidence, however, is how investors will behave – that doesn’t change much. So, what will we all be doing in 2023?

– We will spend a lot of time dealing with an event that hasn’t yet occurred and which will not matter to our long-term returns.

– We will make changes to our portfolios based on what happened in 2022. Not because it makes sense from an investment perspective, but so we can avoid having painful conversations about underperforming funds and assets.  

– We will speculate that an asset class or investment strategy is dead and no longer works.

– We will forget that we once said an asset class or strategy was dead after it makes a dramatic resurgence.

– We will become an ‘expert’ on an issue that we don’t currently know anything about.

– We will view what occurs in 2023 as inevitable, after it has happened.

– We will wonder what an underperforming fund manager is “doing about” their poor returns.

– We (alongside 7,534 other people) will spend a lot of time writing meaningless, short-term market commentary that few people will read, nobody will remember and pray that ChatGPT will soon come to our rescue.

– We will check markets and our portfolios far too much.

– We will have even less time to think than we anticipate.   

– We will tell somebody that the free time in our diary wasn’t an available slot for a meeting, but actually an opportunity to do some work.

– We will talk in certainties, not probabilities.

– We will speak confidently about short-term market performance as if it isn’t just random noise.

– We will extrapolate whatever happens in 2023 long into the future.

– We will not spend any time on how to improve our behaviour or think long-term, even though it always seems like such a good idea.

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We know that these behaviours are damaging, but it is difficult to stop them. It is in our interests to play the game. It is more lucrative and less personally risky to be part of the problem. We either feed the monster or get eaten by it.

What should investors be doing? Thinking, reading, walking, ignoring and trying to appreciate how much of the behaviour that is expected of us is of detriment to our long-term results.

If nothing else, we should all spend 2023 trying to give off a little less heat and a little more light.

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.