Are Index Fund Investors More Vulnerable to Bubbles?

One of the most superficially persuasive criticisms of passive equity index investment regards its susceptibility to bubbles and fads.  Indeed, this ‘vulnerability’ is an inescapable feature of market cap based index investing –  if a certain subset of the equity market becomes wholly detached from its fundamental attributes and extremely overvalued, an investor in a market cap tracker of that index will see their existing exposure increase and additional cash flows allocated in a greater proportion to this area.  The dot-com bubble is often cited as an example of a period when a simple passive market cap index investment was a decidedly poor choice.

Implicit in this criticism is the view that active management is better suited to this type of environment and avoids many of the aforementioned issues that would beset market cap equity index funds.  The problem with this line of thinking is that it only looks at one-half of the equation – focusing on what happens to index funds, rather than the probable behaviour of many actively managed strategies.

Let’s assume that a bubble emerges in a particular segment of the equity market and persists for a number of years before the ‘inevitable’ denouement.  We are aware of the implications for market cap passive investments – but what can we assume about the active management industry against such a backdrop?

– Active funds participating in the bubble areas gain flows and popularity due to strong performance.

– Many active managers abandon their philosophy and process to keep pace with market.

– Active managers avoiding the bubble assets lose assets / their jobs.

– Index aware / closet tracker funds increase exposure to bubble assets to manage tracking error.

– Fund selectors bemoan the relative underperformance of dogmatic managers for failing to adapt to the ‘new paradigm’.

– Money flows from active manager laggards to active manager outperformers. Fund investors crystallise recent underperformance and lay the foundations for future underperformance.

– Quantitative performance screens of actively managed funds uniformly highlight funds that have participated in the bubble as the most ‘skilful’ and ‘consistent’.

– Quantitative risk systems will show that active funds are running too much tracking risk by avoiding the bubble stocks.

– A minority of active managers will withstand the underperformance and remain faithful to their investment approach, but not without haemorrhaging assets.  This select group will be lionised as the bastions of active management after the reckoning.

Bubbles are formed by a compelling narrative, which is validated and emboldened by abnormally strong returns.  The notion that there is some great divide between the susceptibility of active and passive investors to such a scenario is spurious – even only on the basis that the active management industry makes for a reasonable sample of the market and therefore in aggregate will suffer in a similar fashion.

The idea that active managers will be standing steadfast against an irrational and unsustainable bubble that occurs in an area of the equity market – whist passive index investors blindly chase returns – runs contrary to the nature of bubbles, and the incentives and behaviours that have come to define much of the active management industry.  Furthermore, all of the evidence points towards fund investors heavily favouring recent outperformers – which will be those active funds that have embraced the new fashion.

Investment bubbles are alluring and persuasive, and it is only hindsight bias that comforts us that they are easy to identify and avoid.  As active management seemingly becomes increasingly myopic and focused on performance chasing / asset gathering, the ability to avoid bubbles reduces – if such a situation persists for any length of time most simply have to participate.

Of course there are exceptions to this – that select group of active managers that have a clear philosophy, operate in a supportive environment and hold a willingness to diverge markedly from the index.  These are the type of managers that fund investors should always seek out, but they are also the hardest to own, particularly in the midst of a fervent and sustained bubble, through which they will come to appear outmoded and unskilled.

In theory, any material and sustained detachment of an asset’s price from its fundamentals should prove a boon for active managers; however, this makes assumptions about time horizons and incentives that are at odds with the behavioural reality. There is no compelling reason to believe that passive market cap equity investors are more vulnerable to bubbles than their active counterparts.

The (Other) Problem with Active Management

Active management is difficult.  Only a minority of managers outperform after fees over the long-term and it is difficult to identify those which will ex-ante. Whilst this dominant critique undoubtedly has validity, there is another major hurdle for active management, which relates to the perceptions and behaviour of fund investors.  It means that even if we can successfully isolate managers with skill, there are no guarantees that we will reap the benefits of it.

There is a paradox at the heart of active management; to justify its existence the focus should be on differentiated and high conviction approaches; however, the more genuinely active a strategy is the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors.  There is a justified clamour for high active share managers; but little consideration as to whether we are behaviourally disposed to owning such investments.

Let’s take an example; in a twenty-year period ending in 2007 a prominent active equity fund delivered an annualised return of 15.0% compared to 10.9% for its benchmark comparator. This meant the closing value of an initial investment in the active fund was over double that of a passive holding in the index.  This is clearly a compelling outcome (net of fees), however, it is also important to look at the return profile through a different lens; somewhat unfortunately, even as long-term investors we have to ‘experience’ the vicissitudes of shorter-term performance:

– Across rolling one year periods (shifting one month forward) the fund underperformed its benchmark on 34% of occasions.

– On 17% of the rolling one year periods excess returns were more than 10% behind the index.

– For 29% of rolling three year periods the fund trailed the index.

– On 16% of rolling three year periods the fund trailed the benchmark by more than 20%.

Highlighting these features is not designed to be a slight on the strategy; rather it is a reflection that even successful active funds will suffer protracted periods of challenge.  Indeed, if a fund is truly active and idiosyncratic then such spells of poor performance are inevitable and have to be withstood to garner the longer-term benefits.

Historic performance numbers seem anodyne written on the page and we often focus purely on the ultimate outcome delivered rather than importance of the path; yet it is crucial to consider what is likely to occur during those days, months and years of owning an underperforming strategy, and how it might influence our behaviour and decision making:

– Outcome bias will lead us to doubt the quality of the manager and find problems even if they possess significant skill, and nothing has materially altered in their approach.

– Myopic loss aversion will mean that short-term (relative) losses will weigh heavily, even if we are investing with a long horizon.

– A disproportionate amount of time and focus will be spent on the strategy through exacting periods – the emotional and cognitive load will be high.

– If the fund manager has a high profile they will be subject to significant industry media scrutiny, poring over individual decisions and highlighting every stock disappointment. Persuasive narratives will be formed about decline of the manager or style adopted.

–  For professional fund investors there will be constant scrutiny from colleagues, risk teams and clients.  Continual justification for the decision will have to be provided.

– The fund may suffer from outflows – do we want to be the last person remaining in the fund?

– Other flavour of the month funds / strategies will attract attention (many of which will be generating outperformance through sheer chance or some favourable style bias).

Then there is, of course, the additional problem that it might not be an ’admissible’ period of underperformance – something about the philosophy, team or process may have changed to its detriment, or our initial analysis about the skill possessed by the manager may have been incorrect. Thus, whilst we may retain belief in a struggling manager, we could be wrong and facing the worst possible situation – consistently expressing commitment to our initial view before finally capitulating and acknowledging a mistake (or concocting a rationale as to why now is the right time to sell).

It is far easier to buy outperforming funds and sell the stragglers – it is simple, appears ‘sensible’ and is behaviourally comfortable – this type of performance chasing is covered in a 2008 paper by Goyal and Wahal.  Conversely, it requires a great deal of fortitude to persist with a manager that is materially underperforming – even when we know that the shorter-term outcomes are not inconsistent with reasonable expectations given the approach adopted. The psychological and potential career pressures / costs of owning a high conviction manager and persisting with them through underperformance are stark.

If we are lucky, we will buy into a differentiated manager with skill who has historically outperformed (because, let’s be honest, nobody buys underperforming funds) and the pattern of excess returns persists with few meaningful blips. This, however, should be treated as an anomaly.  When owning a genuinely active fund we are likely to experience numerous and sometimes severe bouts of underperformance; unless, that is, we have managed to identify a style that is always in favour or a soothsayer who can foretell short-term market movements (I am still searching).

Much attention is lavished on the difficulties of identifying a skilful active manager with the potential to deliver excess returns, but that is only the beginning. As markets don’t provide consistent short-term rewards for the talented – you need to be able to hold for the long-term whilst bearing the inevitable periods of poor performance and all that entails. If you cannot, then you should avoid active management.

Key reading:

Goyal, A., & Wahal, S. (2008). The selection and termination of investment management firms by plan sponsors. The Journal of Finance63(4), 1805-1847.

The Death of Diversification

It has been a propitious period for equity investors; over the previous five years they have enjoyed stellar returns, depressed volatility and relatively few instances of material drawdown. The prolonged nature of this environment risks the abnormal coming to be seen as normal, and our bias towards what is recent and available leading to expectations becoming untethered from reality. This could have profound implications for how we perceive (or ignore) risk and how portfolios are constructed.

The success of equities on a risk-adjusted basis in recent years can be framed in a different fashion – the failure of diversification. Against a backdrop where equities have delivered strong performance with reduced risk (compared to history) there has been scant reward for holding assets that are regarded as diversifying or that may offer insulation in a more inclement economic landscape. Indeed, diversification has come at a cost.

There is a real danger that the current environment is leading investors to worry about the wrong things. Rather than believing that prudent diversification is evermore important because of the unusually strong results delivered by equity markets; we do the opposite and start to question the role in our portfolios of those assets that have failed to keep pace with the ascent of equities. In recent years very few assets compare favourably to equities – so why hold anything else? We spend far too little time critically assessing the things in our portfolios that are out/over performing.

Arguments in support of diversification are made all the more difficult by the fact that equities have exhibited such low ‘risk’ in recent years (by way of realised volatility and drawdowns), a scenario that inescapably breeds complacency. There are technical and psychological aspects to this problem. From a technical standpoint, it is possible to build equity heavy portfolios with low ex-ante risk (in terms of volatility) if their look-back period is only three or five years. From a psychological perspective, memories of the stress and fear that can at times characterise the ownership of equities have been all but extinguished. We can easily recall equities makeing consistent upwards progression, not them halving in value.

The unusually strong risk-adjusted performance of equities has also created a process versus outcome problem, where simply being long equity risk has been consistently rewarded, irrespective of whether it was a prudent course of action ex-ante. Our pronounced tendency to judge the quality of a decision or process simply by its outcome means that we will look more favourably on less diversified, equity-centric portfolios. The corollary of this is that the pressure of unfavourable performance comparisons could lead to diversified portfolios being ‘forced’ to assume more equity risk.

The idea of diversification is to create a portfolio that is designed to meet the requirements of an investor through a range of potential outcomes – it should be as forecast-free as possible. It is also founded on the concept of owning assets that not only provide diversification in a quantitative sense (through low historic correlations) but also sound economic reasons as to why their return stream is likely to differ from other candidate asset classes. Crucially, in a genuinely diversified portfolio not all of the assets or holdings will be delivering strong results at any given time, indeed, if all of the positions in a portfolio are ‘working’ in unison – it will feel like a success but actually represent a shortcoming.

That is not to suggest that we should persist with assets or positions in a portfolio simply because they are diversifying (or have not gone up as much as equities). Rather that we should always remember the long-term benefits of diversification, and consider the merits of all holdings in a portfolio based on their own characteristics and their role amongst a mix of assets or strategies.

Our obsession with outcomes, focus on spurious reference points and our desire for action, makes remaining diversified incredibly challenging. In an equity bull market, we often struggle to see the laggard assets in our portfolio as distinctive and differentiated – serving the role they were required for – we instead identify weakness and something that needs to be addressed. This is exacerbated by the fact that in such periods the returns of everything gets compared to equities – whether the comparisons are valid or not is irrelevant.

At this point in the cycle the temptation to abandon the concept of prudent portfolio diversification is likely to prove particularly strong; but unless a new paradigm is upon us, investors will be well-served remaining faithful to sound and proven investment principles.  Take the long-term view and remain diversified.

Things to Remember When Selecting an Active Fund Manager

These are simply some musings on active manager research; seemingly random, but hopefully linked by a common thread:

– The more PhDs in a team, the greater likelihood that a fund will blow up. This is tongue-in-cheek comment, but underlying it there is an important point about complexity. It is perfectly acceptable not to invest in a strategy because you don’t understand it. Furthermore, academic pedigree can easily make investors unnecessarily complacent about the robustness of a fund.

– Fund groups will always find some room in their strategy for you, capacity limits are more flexible than you think.  Incentives matter – you should never be reliant on an asset manager to tell you when they have reached capacity in a fund (particularly if they are listed) and, if you are waiting for them to tell you, it is probably too late.

– Although the majority of active managers underperform the market, the majority of slide decks produced by active managers will show them outperforming. The slicing and dicing of performance numbers is a constant wonder.

– Just because a Brinson attribution report shows a positive ‘selection effect’, it doesn’t mean there is ‘alpha’ – it is probably just a style bias. The term ‘alpha’ is banded around with abandon when discussing fund manager performance often without any clarity about what that actually means. Perhaps the most common is stock / sector decomposition – which tells you nothing about style / factor skews.

– The majority of excess return in fixed income strategies comes from assuming additional credit risk. Another attribution problem – this time for credit – is the persistent overweighting of credit risk (relative to the benchmark). Attribution for credit managers is fiendishly difficult but is an investment grade manager permanently overweight high yield skilful?

– Unless you believe that many fund managers can time the market (they can’t), then performance consistency is an example of luck or the derivative of a persistent style bias. It is rarely skill.  I still don’t understand the obsession with short-term performance consistency in the industry – the focus on this does much more harm than good in promoting the right type of active management.

– You will never really know the inner workings of the team running the fund you are researching. No matter the quality of your due diligence, your understanding of the characters, relationships and motivations within an external team will always be partial.

– Diversity for many (UK) asset managers means hiring white men from both Oxford and Cambridge. There is too much virtue signalling and not enough action on diversity in the industry.

– Ego / arrogance is not a necessary or positive trait for a fund manager. I often hear people absolve certain fund managers for being ferociously arrogant on the basis that they need to have high levels of confidence to ‘bet against the market’. This is nonsense – good fund managers will be wrong (a lot) and need both humility and a willingness to learn; believing that their views are unimpeachable or that they are infallible is the obverse of this.

– At least 90% of equity managers say they are buying quality companies (barriers to entry etc…) that are undervalued.  This should tell you something.

Is Volatility Risk?

I disagree with the majority of people I respect in the investment industry about volatility. This is an uncomfortable situation, as holding a view contrary to people more intelligent than yourself is rarely a sensible course of action.  Nevertheless, I shall persevere.

Most of the aforementioned investors have claimed at some point that “volatility is not risk”.  This is, of course, correct; risk is a multi-faceted concept, which no single metric can successfully capture, however, the implicit (sometimes explicit) extension of this argument is that volatility is not a valid measure of risk at all.  I do not believe this to be true.

The renunciation of volatility is often followed by the comment that “permanent capital impairment” is the only genuine risk. This view assumes that risk is based on the probability of the fundamental value of an investment being than less you paid for it.  The problem with this pure perspective is that it assumes that permanent capital impairment is solely about the asset and not the investor, and that the variability of an asset’s price through time is irrelevant.

From a behavioural perspective, volatility and permanent capital impairment are inextricably linked. I would assume that the most common cause of the latter is not a fundamental change in an asset’s intrinsic value but a decision by the investor to sell at an inopportune time.  The path of returns for any given asset is crucial; volatility is not simply about the variability of an asset’s price, but how those fluctuations impact investor behaviour and the resultant cost.

As volatility is a somewhat nebulous concept, it is worth considering what drives fluctuations in asset prices.  I tend to think of three related aspects:

1) A change in the fundamental value of an asset.

2) Uncertainty over the fundamental value of an asset and our behavioural reaction to uncertainty.

3) Investors reacting to the behaviour of other investors (momentum) or anticipating how they think other investors will behave. Markets are reflexive.

Investors do not experience volatility in isolation, it is not simply about detached price movements – there are inevitably accompanying narratives that lure us into action.  Volatility is circular; it is created by our behaviour – our emotion laden decision making, our myopia, our loss aversion, our recency bias – and in turn it drives our behaviour. It is often absurd and frustrating, frequently bearing no relation to sound fundamental investment thinking, however, it is a reality and it matters.

In addition to the behavioural nature of volatility, it is also heavily reliant on technical factors such as how an asset is priced and how it is traded. To take an example of this, let’s assume that an S&P 500 index tracker only provided liquidity windows every five years and the underlying components were revalued quarterly based on some form of DCF methodology.  Given that the holdings are identical would the risk differ from the market priced, daily liquid version we have available today? It is almost certain that the volatility would be considerably lower*.

Someone from the ‘permanent capital impairment’ camp would likely argue that this proves the flaw in using volatility as risk – the same assets can exhibit different levels of risk if judged by their volatility just by altering how they are traded and valued. However, the notion that volatility should be ignored because it is about more than simply the fundamental features of an asset seems spurious – a sensible theoretical concept that does not match reality. Investors have to experience price variability when holding investments and that has material implications for their behaviour and decision making.

Volatility is an imperfect measure of risk, particularly in regard to the distribution of asset class returns (non-normality) and assumptions around correlation. It is also backward looking and insensitive to valuation. It is certainly limited in the following circumstances:

– Investments with significant tail risk (such as selling insurance). Volatility is a poor gauge to the potential risk in such situations.

– Undiversified portfolios with high idiosyncratic risk.

– Assets with stale / slow pricing such as direct property and private equity.  Assets which are illiquid or aren’t daily traded often benefit from compelling Sharpe Ratios, simply because volatility is subdued relative to more frequently priced counterparts. This is never a fair comparison.  There is certainly a behavioural return premium attached to illiquid assets because it is harder to make stupid decisions when you are unable to trade.

We should be measured when conflating investment risk with any specific metric, it is heavily dependent on the individual, the environment, the instrument and the asset(s). Each method we employ will have limitations, take the following two examples:

1) Assume that the long-term volatility of global equities is 17% and you make an investment when realised volatility has been 17% over the previous three years.  In the subsequent three year period, global equities rise by 50% (primarily through valuation change) with a realised volatility of 14%.  Given that the historic volatility (three year) is  lower than when you made your investment, is the risk, other things being equal, now reduced? Given valuations are significantly higher it would be difficult to make this case, although using a simple (short-term) standalone volatility look-back would suggest so.

2) The probability of realising a loss over a 30 year holding period for global equities is low; from a permanent capital impairment perspective, does that mean that for those with a 30 year holding period holding equity exposure is close to riskless? ** To believe so suggests that the path, distribution and sequence of returns are irrelevant, as is how an investor may react to these factors.

Investment risk is nebulous and difficult to define – there is no unimpeachable means of gauging it. Volatility certainly has limitations and it is not ‘risk’, but can be an important measure of it.  One should never view risk purely through the lens of volatility, but ignoring it is equally naive – permanent capital impairment is as much a behavioural phenomenon driven by the individual human reaction to price fluctuations as it is about the fundamental value of any asset.

*We now have greater liquidity risk.

** Of course a 30 year time horizon is only such for one year, then it becomes a 29 year horizon.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.

Why Do Investors Focus on the Wrong Things?

“Nothing in life is as important as you think it is while you are thinking about it.” Daniel Kahneman

Which major investment issue were you thinking about on March 11th 2016?* You probably can’t remember even though, at the time, it seemed incredibly important.  Whilst most of us should be investing for the long-term, markets conspire against us; lurching from one obsession to the next, drawing our gaze and enticing us to take action.

As the news about a particular event or development takes centre stage, and experts hold forth about the potential outcomes, the notion of doing nothing can seem ridiculous.  The issues are, by definition, salient, recent and available; all factors which make it very difficult for us to have any reasonable perspective on their long-term significance.

It is not that matters such as war on the Korean Peninsula / peace on the Korean Peninsula or Italy leaving the EU are not meaningful (to take recent fascinations), but, from an investment perspective, there is very little most investors can do to benefit.  Each year there is a succession of topics that we become excessively diverted by, where the temptation to act is strong; but before we do, we should try to answer the following three questions:

1) Does it matter to returns?  Given that we tend to hugely overstate the importance of the issue that we are currently focused on, we are likely to assume far more things matter to long-term returns than actually do. It is vital to remember that the historic long-term returns of major asset classes inevitably include periods of tumult at least as significant as the one that currently has our rapt attention.

2) What is going to happen? Even if we are confident in the view that returns will be impacted by a given issue, we then have to predict what the outcome will be.  I think enough has already been said about our ability to forecast such things.

3) How will it impact markets? In the unlikely event that we have identified an event that will materially alter asset class returns and successfully envisaged the outcome, we then need to understand how markets will react.  Markets are reflexive and unpredictable. Do we really know how other investors will behave or what’s in the price?

In simple terms, such activity is incredibly difficult to get right, particularly on a consistent basis.  Even if we have the foresight to identify which events truly matter amidst the clamour – we then need to forecast a particular outcome and the response of markets.  Whilst some professional investors specialise in this activity, most of us should avoid such heroics.

This is easier said than done.  Financial markets create a cacophony of noise and a flow of narratives that we find irresistible; a vicious circle forms where even if we want to disregard an issue, we cannot because it is considered unacceptable to do so.  How can you be ignoring something that is so prominent and material?  Action and opinion are incredibly highly valued, even if their true worth is often negative.  Thus, we end up in a situation where investors spend the vast majority of their time on things that don’t matter and not enough on the things that do.  I imagine the breakdown of investor attention as being something akin to this (entirely unscientific):  


Having an asset allocation that is suitable for your requirements, considering valuations and thinking about how best to control your behaviour is the surest way to deliver solid results, whilst avoiding the most common investment mistakes.  Taking a long-term approach doesn’t mean you should set once and forget, rather think carefully about your time horizon when making decisions and don’t check your portfolio too regularly.  Doing nothing should be a strong default.

Investing for the long-term seems easy until you understand that it is comprised of many days and many more temptations.  Financial markets will do their utmost to lure you toward the rocks, be sure to tie yourself to the mast.

* This is a random date, I have no idea what particular issues I was being distracted by at the time.    

Noise Destroys Investments Returns as Much as Any Behavioural Bias

As noted by Jason Collins in his excellent behavioural economics blog, Daniel Kahneman’s next book is expected to focus on the concept of ‘noise’ and how it impacts our judgements.  Although often conflated with behavioural biases, noise is a distinct phenomenon that relates to the random variability in our decision making.  Whilst biases exhibit a consistency of effect (at least in direction, if not magnitude), noise is defined by the absence of consistency.  A watch that loses time each day is biased; a watch that can either gain or lose time during any given day is noisy.

In an article in Harvard Business Review, Kahneman, alongside his collaborators, discussed how individual choice is “strongly influenced by irrelevant factors” and gave examples of how professionals are prone to contradict their own previous conclusions.  The problem of attempting to grasp the idea of noise is that it is so amorphous – whilst we can at least develop a (limited) framework for defining and understanding biases, by definition noise is hard to isolate and anticipate. Noise can stem from entirely spurious factors – such as mood, weather or hunger – or variables that we perceive to be meaningful, but are in fact meaningless.  It is certainly possible to test whether noise exists in any given scenario – by observing decision making consistency – but this is only the start of understanding the issue.

Noise has profound implications for investors, but is often ignored or, at least underappreciated. It can be difficult to accept that our judgements can be shaped by erroneous, often farcically minor, factors.  Furthermore, we are often uncertain about the key variables that define any given problem.

In the realm of investment decision making, we can define two separate forms of noise:

  • When given the same objective data and relevant variables we are unlikely to make the same decision. This is consistent with Kahneman et al.’s article – even if we hold the meaningful factors constant, other irrelevant issues will lead to inconsistent choices.

  • We don’t know what the relevant information is and therefore make decisions based on what we perceive to be ‘signal’ but is in fact noise. This is such a major problem – one which the industry perpetuates – that it is difficult to know where to begin.

We could crudely define these as unconscious noise and conscious noise.  In the first case there are many factors that impact our decision making over which we have no real awareness and we would be reticent to acknowledge had any influence over us.  In the second case, the issue is uncertainty about what constitutes relevant information and what is superfluous noise – this will vary by context and discipline, but it is difficult to think of an industry with a greater ratio of noise to signal than asset management. Conscious noise is the oxygen on which the industry, in its current form, exists.

Second by second coverage of random market movements (with accompanying narratives), heroic forecasts (usually wrong), luck masquerading as skill, complex products and every decreasing time horizons are just a few of the factors that contribute to the maelstrom of noise that investors are forced to navigate.  Of course, this is good for the industry – simplicity and inaction are not typically an aid for revenue generation – but it fosters a situation where decision consistency becomes close to impossible for most investors.

Kahneman et al. proceed to argue that a “radical solution” for the problem of noise is the replacement of human judgement with algorithms, or a structured set of decision rules. They also acknowledge, however, that such processes are less effective in environments where uncertainty is high or where consistency is difficult to attain.

Can algorithms be effective  in muting the incessant noise in investment markets, and even exploit it, to improve decision making?  To a certain degree.  One effective and humble decision rule / heuristic, is portfolio rebalancing.  A structured and consistent approach to rebalancing a portfolio back to target weights is proven to be effective and cancels out a great deal of market noise.  It ensures both that your portfolio doesn’t stray too markedly from its desired allocation, and that you consistently sell assets that have become more expensive and reinvest in those that have become cheaper.  Whilst this might seem a simple course of action, rebalancing into assets that have struggled (amidst the prevailing negative market narrative that will inevitably accompany the poor performance) can be difficult without a formal / systematic decision rule.

The oft-mooted remedy to the problem of noise and inconsistency in human-led investment decisions is the movement to full automation and the use of complex algorithms / machine learning.  It deals, at least in part, with the aforementioned ‘unconscious noise’ angle as the feelings of the decision maker are no longer a direct issue, however, at some point human judgement will inevitably exert an influence – for example, in the decision to initially invest in a strategy or to redeem, thus it does not provide full immunity.

More importantly, algorithms do not necessarily resolve the issue over noise in regard to the use of irrelevant information.  Many an ETF has been created based on factors with no empirical credibility; therefore although the decisions within the process can be dispassionate, the very existence of such strategies is reliant on the fact that there is noise in the market.  Furthermore, even the most sophisticated systematic approaches are vulnerable to trading based on patterns than are simply a consequence of random market movements, with no structural, technical, economic or behavioural reason to exist or persist.

Even without full automation, there are means of dulling the noise in human-led investment decision making, such as checklists.  Whilst checklists are particularly effective in areas such as aviation and surgery where many of the checks can be simple and objective –  whether the correct leg is being operated on, for example – they can still improve discipline and focus around decisions with inherently more subjectivity. Formally reviewing a list of your key criteria prior to making an investment can serve to highlight noise driven deviations from your core process and also acts as a useful record for reviewing historic decisions.  Of course, using checklists when answers are subjective means the potential for manipulation is ripe, so it pays to be as rigid as possible when defining questions; however, even if this is not possible, checklists remain a useful means of reaffirming your investment principles amidst the market noise.

Noise is an inescapable feature of human judgement.  In random and uncertain investment markets its influence is profound. Although it is impossible to eradicate, acknowledging its presence and taking steps to simplify and systematise certain decisions can be an effective way of turning down the volume.

Key Reading:

Kahneman, D., Rosenfield, A. M., Gandhi, L., & Blaser, T. (2016). Noise: How to overcome the high, hidden cost of inconsistent decision making. Harvard Business Review94(10), 38-46.

Please note all views expressed in this article are my own and are not necessarily shared by my employer.