Paul Richards and I were having a conversation recently about whether AI technology was making it easier to spot lies and deception. He asked me how I thought a ‘truth machine’ would impact the asset management industry and I responded (with tongue somewhat in-cheek): “it would destroy it”. This was the inspiration for our latest Decision Nerds episode where we discuss lies, mistruths and obfuscation.

In the episode we cover:

– A top five countdown of our favour asset manager ‘fibs’.

– Research that shows that while investment analysts think they are good at knowing when they are being lied to, they really aren’t.

– Whether AI is really better than humans at detecting lies.

– Why industry norms are likely to penalise the most open and transparent asset managers.

– How would a ‘truth machine’ impact investors and asset managers.

And lots more.

You can play the pod via the link below, or access at your favourite pod places.

Decision Nerds – Lying

When an online poker firm published analysis of 120 million starting hands (hold ’em) played through its website, its analysis showed that of the 169 non-equivalent beginning combinations only 40 were found to be profitable. Furthermore, half of all profits were attributable to five hands (AA, KK, QQ, JJ, AK-suited). Given this skewed distribution of outcomes a winning strategy seems immediately obvious, but all is not quite what it seems. Why is this the case, and what does it mean for investors?

An initial glance at the data might lead us to believe that the optimal approach is simply to avoid making large bets until we are dealt a hand with a disproportionately high probability of success. The problem of course is that in a game of poker we do not make decisions in isolation – other players will observe and react to our behaviour.

If we were only placing bets of consequence when we had extremely strong hands, it would be incredibly easy for most players to spot this. Our seemingly optimal strategy would quickly become the obverse.

Similar to poker, there are not likely to be that many investment situations where the odds of a positive outcome are firmly on our side, but unlike poker most of us don’t have to worry about other investors directly anticipating our behaviour and compromising our returns. Does that mean investors are free to wait for those the most attractive of setups – the proverbial ‘fat pitch’?

Unfortunately, it is not that straightforward. There are three reasons why:

– We are not sure what a strong hand is: Identifying circumstances where the probability of superior performance is elevated is not simple. In poker it is evident when we have a strong hand, but in investing there is inherently more uncertainty and variability through time. (Somewhat ironically, the most attractive situations are likely to arise at times of valuation extremes – the exact point where we are likely to believe that the odds of a positive outcome are poor).

– We will misjudge when we have a strong hand: Our conviction will almost inescapably be driven by what has performed well in the recent past, particularly if it is supported by a persuasive narrative. This will create the perverse scenario where our confidence increases as the likelihood of a good result decreases. Unfortunately, we are more likely to bet big on a bad hand.

– We will play too many hands:  In poker we need to play more hands than might seem ideal to keep other players from predicting our behaviour; whereas in investing we trade more than we should because there is an expectation that we need to be constantly active. The investment industry rewards heat not light. Markets are noisy and chaotic, perpetually generating new stories and discarding old ones. Each month or quarter the focus will be on a shiny new topic, and we are expected to react. There is a bizarre value attached to being a busy fool, with very few investors afforded the luxury of time and patience.

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The inherent unpredictability of financial markets allied to our own behavioural foibles means that investors are vulnerable not only to playing far too many hands but also increasing our stake as the odds deteriorate. Although this is a path to poor returns it does give us plenty to talk about while we get there.

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My first book has 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).

A topic I have changed my mind on during my career is concentration in funds. I used to be strongly of the view that it was only worth taking active investment positions if they came with high conviction – usually in the form of concentrated positioning – otherwise, what’s the point? Although I came to realise I was wrong about this, I am aware that many people far smarter than me remain advocates of this type of approach. Why do I think it is a problem when they don’t?

Fund concentration is not the easiest concept to define. There are obvious examples such as very focused equity portfolios with large weightings in individual companies, but there is more to it than that. Concentration doesn’t have to be about position sizes in stocks, it can come through an extreme sensitivity to a certain theme, concept or risk factor. It is about our exposure to specific and singular points of failure.  Could one thing go wrong and lead to disaster?

The key concept to consider when thinking about the risk of concentrated funds is ergodicity. This is a horribly impenetrable term, but at its core is the idea that there can be a difference between the average result produced by a group of people carrying out an activity, and the average result of an individual doing the same thing through time.

Let’s use some simple examples.

Rolling a dice 20 times is an example of an ergodic system. It doesn’t matter if 20 people roll the dice once each, or an individual rolls the dice 20 times. The expected average result of both approaches is identical.   

Conversely, home insurance is a non-ergodic system. At a group level the expected average value for buyers of home insurance is negative (insurance companies should make money from writing policies). So, why do we bother purchasing it? Because, if we do not, we expose ourselves to the potential for catastrophic losses. The experience of certain individuals through time will be dramatically different to the small loss expected at the average group level.

Investing is non-ergodic. Our focus should therefore be on our individual experience across time (not the average of a group); this means being aware of how wide the potential range of outcomes are and the risk of ruin.

In concentrated funds, the prospect of suffering irrecoverable losses at some point in the future is too often unnecessarily high.

‘Risk is not knowing what you are invested in’

One of the most common arguments made by advocates of running very concentrated equity portfolios is that it is an inherently lower risk pursuit because we can know far more about a narrow list of companies than a long list. If we have a 10 stock portfolio we can grasp the companies in a level of detail that is just not possible if we hold 100 stocks, and this depth of understanding means that our risk is reduced. The first part of this is right, the second part is wrong.

The problem, I think, stems from the fact that there are two types of uncertainty – epistemic and aleatoric. Epistemic uncertainty is the type that can be reduced by the acquisition of more data and knowledge. Here the idea of portfolio concentration lowering risk makes sense. Conversely, aleatoric uncertainty is inherent in the system; it is the randomness and unpredictability that cannot be reduced. It doesn’t matter how well we know a company or an investment, we are inescapably exposed to this. The more concentrated we are, the more vulnerable we are to unforeseeable events.

While I think a neglect of aleatoric uncertainty is at the heart of unnecessarily concentrated portfolios, there are other issues at play. Overconfidence is likely to be a key feature. we may be aware that the range of outcomes from a concentrated approach is wide, but that may be desirous to us because we believe that our skill skews the results towards the positive side of the ledger. Given our ability to fool ourselves and the aforementioned chaotic nature of the system, this seems to be a dangerous assumption to make.  

Unfortunately, there is also an incentive alignment problem. A wide range of potential outcomes from an investment strategy becomes very appealing if we benefit from the upside but someone else bears the downside. This asymmetry is inevitably one of the reasons why high-profile macro hedge funds so often seem to be swinging for the fence with concentrated views. The often-severe downside of the negative outcomes are borne primarily by the client (a situation no doubt exacerbated when a hedge fund manager is already exceptionally wealthy).

Running a very concentrated investment strategy places an incredibly heavy onus on being right and also leaves us acutely vulnerable to unforeseen events unfolding that can have profoundly negative consequences. Exposing ourselves to such risks wilfully seems imprudent and unnecessary.

Investors are likely to overestimate how much they know, and underestimate how much they cannot know.

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– Being wary of concentration does not mean increasing levels of diversification are always beneficial. There is a balance to strike.

– It feels important to note that the risk of concentrated strategies can be diversified by combining them, but we should still consider what the concentration levels say about the investor who is willing to adopt such an approach.

—

My first book has 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).

Given how volatile and unpredictable financial markets are, thinking in probabilistic terms is an essential skill.  It allows us to acknowledge uncertainty, express our level of confidence clearly and gives us more freedom to change our mind. There is a problem, however. Expressing ourselves in probabilities doesn’t come naturally and is often actively disliked. At best it is regarded as spurious accuracy, at worst evidence of an absence of conviction. We value bold and singular predictions about the future, not caveats and caution. How do we encourage probabilistic thinking in a world that doesn’t want us to?

One idea I happened upon in Julia Galef’s excellent book “The Scout Mindset”, is the ‘equivalent bet test’, which is a decision-making tool described by Douglas Hubbard in “How to Measure Anything”. 

The concept is simple.

Let’s take a fairly generic claim that a professional investor might make. They think that the US ten-year treasury yield will rise above 5% before the end of the year. That’s great, but what does it actually mean? Are they certain that this will happen? (Given the historical accuracy of bond yield predictions, I hope not) Or are they only 51% sure? The difference matters a lot, but we have no idea. How do we find out? By creating an equivalent bet, where we are certain of the odds.

We say to our forecaster. There is now $100,000 at stake. We will give you this amount of money at the end of the year if your prediction on treasury yields is right. Alternatively, we will give you the same amount of money at the same time if you can pick a blue ball from a hat containing six blue balls and four red balls. You can only choose one of the bets – the treasury yield forecast or the drawing the balls from the hat.

If they decide to delve into the hat, then we know that their confidence in their bond yield forecast is less than 60%.

We can then adjust the ball selection bet to a point at which the forecaster is ambivalent about the two options. We then we have a reasonable guide to how confident they really are about their prognostications.

This is clearly an imperfect approach, a hypothetical $100,000 will almost certainly provide a different decision making response to a real sum of money, but it is likely to be broadly consistent and incredibly helpful.

Not only does the equivalent bet test encourage the forecaster to think about their judgment in probabilistic terms, it also provides a far greater level of clarity about both how confident an individual is and how well-calibrated (or not) they may be.

Whether we like it or not, we live in an uncertain, volatile and probabilistic world. Our decision-making approach should reflect this.

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Galef, J. (2021). The scout mindset: Why some people see things clearly and others don’t. Penguin.

Hubbard, D. W. (2014). How to measure anything: Finding the value of intangibles in business. John Wiley & Sons.

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My first book has 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).

Industries in which capital has become abundant and optimism unbridled often end up disappointing investors. Echoes of these capital cycle pitfalls are also evident in active fund manager selection. In the ‘alpha cycle’ a certain area of the market delivers high returns, stories then emerge not only about the compelling opportunities to be found but also about the savvy investors who are exploiting them. This intoxicating mix of unusually strong performance and seemingly irrefutable narratives draws increasingly large flows from investors who either believe the tales being woven or are compelled to chase the momentum. The more extreme this performance dynamic, the more investors are likely to mistake luck for skill, and the cyclical for the structural. Leading them to make the wrong decisions at a terrible time.*

It is a curious phenomenon that investors seem to behave as if capital flooding into a certain type of fund (whether that be investment style or market subset) is a prelude to higher returns in the future. Of course, there is the potential to capture an ongoing trend, yet from a fundamental perspective abnormally high returns are likely to be the result of assets becoming significantly more expensive.

Exceptionally positive performance now is drawing returns from the future – we are not going to make them again. We just act as if we will.
 
At the heart of this alpha cycle problem is our propensity to believe that what is cyclical is in fact a structural shift.  We are prone to see an active manager delivering strong performance in an in-vogue area of the market as someone with durable skill, rather than simply benefitting from largely unpredictable tailwinds that will at some point reverse. The most dangerous situation is when we begin to believe that there has been a permanent change in markets (XYZ is the only way to invest) and a particular active manager is the exemplification of this approach.  Here we have the glorious opportunity to be wrong twice – about both markets and skill.

As flows into a certain style of active manager increase, so too does the clamour to invest and the belief that it is the obvious thing to do (performance doesn’t lie). As our prospective future returns dwindle, our conviction increases.

At points of performance extremes, whether an active manager has skill will become irrelevant. If they are investing in part of the market enjoying euphoric sentiment and following a period of unsustainably high returns, any edge will be overwhelmed by the almost inevitable reckoning.

Selecting active fund managers who have enjoyed prodigious tailwinds comes with twin challenges. First, we are likely to grossly overstate the presence of skill (we cannot help but conflate performance with skill). Second, even if they do possess an edge, it is unlikely to matter because the odds of investing successfully in an area that already has stretched valuations and delivered exceptional performance are poor. 

We might argue that a fund manager has the ability to navigate such situations adroitly. Rotating out of areas that have delivered spectacular results and into less glamorous segments. Perhaps. Yet most managers have stylistic features or characteristics that almost inevitably leave them exposed to certain market trends. Furthermore, the type of fund managers that will attract the most attention during a particular cycle are likely to be the purest representation of whatever has been working.

The problems of the alpha cycle do present a potential opportunity. Fund managers with an out of favour approach who are investing in an unloved part of the market are likely suffering from poor performance and holding assets with far more attractive valuations. Even if they don’t have skill, the odds of a good outcome might be compelling (certainly better than investing at peak cycle).

There is a problem, however. We are very unlikely to believe managers somewhere near the trough of the alpha cycle have any skill, they are also likely to be haemorrhaging assets and they may be in danger of losing their job. It is never just a cycle remember; these are always profound structural changes at play.

I have framed the problems that stem from the cyclical nature of investment returns as an issue with active funds – it is not. These same behaviours exist across asset classes, regions and sectors. It is just that active funds have the additional danger of skill being used to justify unsustainable performance.

Investors need to adopt the mindset that unusually strong returns are a prelude to lower returns in the future and behave accordingly.

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* I use ‘alpha’ in this article in the broadest possible sense – general outperformance, rather than anything more technical.

—

My first book has 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).

One of the most common questions I have heard through my investment career has undoubtedly been: “what’s the catalyst?” I have definitely asked it myself a few times but have tried to abstain in recent years. Most discussions around catalysts are an effort to anticipate what will change the view other investors hold about an asset – a pretty challenging task. We appear to believe that because catalysts seem obvious after the event, they must be predictable beforehand. This is a dangerous assumption.

There are two types of investment thesis – one about something that is already performing well, here a catalyst is unnecessary because we just need to extrapolate; the other is about something that isn’t working right now, and then a catalyst seems to become essential. The desire to identify a catalyst probably stems from our bias toward believing that current trends will persist, coupled with our discomfort at being uncertain – we want to know exactly how and when something will change.

It is worth taking a step back to consider what it is we are typically doing when identifying a catalyst.

There are three elements:

1) Predict an occurrence.

2) Predict how other investors will react to it.

3) Hold other things constant.

There are problems in each of these components – we are poor at making predictions about future events, we aren’t great at forecasting the reaction of other investors, and things are never constant. Other than that, we are all set.  

Catalysts are asking us to specify in advance a specific driver of a change in the return profile of an asset or security. This is no easy task.

Although I am generally sceptical about catalyst predictions there are certain instances where it is more reasonable, particularly with micro-level decisions. For example, if an investor were to suggest that a company selling an underperforming unit could be a catalyst for higher returns to shareholders – this would seem specific and defensible (difficult but defensible).

The broader an investment view – I think US equities will start to underperform because X will happen – the more fanciful it seems. It just becomes far too complex. (I have looked back over my twenty-year career and found 476 catalysts identified for Japanese equity outperformance).

As with most things in investment decision making, the obsession with catalysts is, in part, a time horizon issue. If our horizon is appropriately long-term, we don’t need to predict what specific catalyst will change a certain investment’s fortunes, we can wait for the gravitational pull of fundamental factors to take hold (assuming we are right). The shorter our horizon the more sentiment matters – we are explicitly attempting to guess the behaviour of other investors, so we need a view on what might change that. (Short-term investing is hard).

It is safe to assume the success rate for identifying catalysts for potential shifts in the return profile of an investment is pretty low. We need to be right twice – about changing performance and the precise reason it will happen. The first one alone is hard enough.

If we are in the business of specifying catalysts, it would be prudent to keep a record of the judgements that we make through time. We may not like what we find.    

At the start of this piece, I said that “catalysts seem obvious after the event”. The critical word here is “seem”. In most cases it is incredibly difficult to confidently specify the exact causes of a change in the performance of an asset even after it has occurred. We can certainly tell a great (and simple) story as to why something has happened, but the truth is almost always more intricate. If we cannot do it with the benefit of hindsight, trying to do it with foresight feels unwise.

Will there be a specific catalyst that alters the return profile of an asset? Maybe. Can we identify it in advance? Probably not. Do we need to? No.

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My first book has 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).

𝗛𝗼𝘄 𝗺𝘂𝗰𝗵 𝘁𝗶𝗺𝗲 𝗱𝗼 𝘆𝗼𝘂 𝗴𝗶𝘃𝗲 𝗮𝗻 𝘂𝗻𝗱𝗲𝗿𝗽𝗲𝗿𝗳𝗼𝗿𝗺𝗶𝗻𝗴 𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗺𝗮𝗻𝗮𝗴𝗲𝗿?

1. Hire a manager after a period of strong performance.

2. Watch in discomfort as you don’t experience that performance, maybe the opposite.

3. Spend a huge amount of thinking time and emotional labour working out why it wasn’t your fault.

4. Sack the manager.

5. Rinse and repeat with potentially similar outcomes.

Now that might not be you, but it is a story that plays out regularly.

Experiencing underperformance is one of the unavoidable realities of hiring an active manager. And it’s painful for everyone; clients, managers and advisers. And badly managed pain creates some predictably bad outcomes for all parties.

One important and manageable issue is time horizon mismatch. And this is what Paul Richards and I explore in the latest episode of Decision Nerds (link in comments). We explore:

𝗪𝗵𝘆 𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗲𝗱𝗴𝗲 𝗶𝘀 𝗻𝗼𝘁 𝗲𝗻𝗼𝘂𝗴𝗵 – managers need an appropriate amount of time to let their edge play out (if indeed they have one at all). It may be longer than you think.

𝗧𝗵𝗲 𝗕𝘂𝘅𝘁𝗼𝗻 𝗜𝗻𝗱𝗲𝘅 – a simple way of articulating time frames that can help everyone.

𝗘𝘃𝗲𝗿𝘆𝗼𝗻𝗲 𝗵𝗮𝘀 𝗮 𝗽𝗹𝗮𝗻 𝘂𝗻𝘁𝗶𝗹 𝘁𝗵𝗲𝘆 𝗮𝗿𝗲 𝗵𝗶𝘁 𝗶𝗻 𝘁𝗵𝗲 𝗳𝗮𝗰𝗲 – we posit that most people’s ability to predict how they will deal with the pressure of underperformance won’t reflect reality when things get tough.

We talk about the distinct behavioural pressures facing clients, advisers and managers and what they might consider doing to make things easier.

Available in all the usual places and below:

https://www.buzzsprout.com/2164153/14941612-underperformance-everyone-s-got-a-plan-until-they-re-hit-in-the-face

When investors consider the financial market impact of rising geopolitical risks the key underlying principle should be the late, great Daniel Kahneman’s maxim that: ‘nothing in life is as important as you think it is, while you are thinking about it’. That is not to suggest that such issues don’t matter, it is simply that they are likely to be less influential on our long run objectives than we think, and even if their impact was to be material our ability to navigate such situations well is highly questionable. Quite simply when we focus on issues that are high profile and salient, we tend to make poor decisions.*

When a geopolitical risk arises our natural tendency is to immediately become foreign policy experts, and also believe that we can confidently link complex and imponderable political situations to financial market outcomes. It is hard to overstate quite how difficult this is.

As is typical for investors, we treat each new event as an isolated incident and develop a convenient amnesia about similar situations in the past, which have either had limited long-term consequences, or where the impact was incredibly difficult to foresee.

It is not enough for something to matter, we must be able to predict it with some degree of confidence.

So, how should investors deal with geopolitical issues and the emergence of other high profile risks?

To keep something of a level-head amidst the noise and tumult, a checklist can be helpful.  We should consider the following:

1) Do I have confidence in predicting the outcome of the current situation?

2) Do I believe I can predict the financial market implications?

3) Are any of these financial market implications likely to be material over my investing horizon?

4) Does my portfolio remain appropriately diversified for a range of different outcomes?

5) Has there been any change to my investing objectives?

In most situations and for most investors, the checklist should result in there being a limited response to emerging geopolitical risks and other types of potential market shocks.

This sounds easy, so why is such an approach difficult to apply?

There is, of course, the incessantly damaging perception that if something is on the front pages, investors should be ‘doing something about it’, but there is an even more pernicious problem. At some point a geopolitical risk will have a major financial market impact, and we cannot face the prospect of having done nothing about it.

The fear of doing nothing whilst something important is unfolding is a real one, and leads many investors (often professionals) to make incredibly poor choices. When considering this conundrum, we need to ask ourselves two questions:

1) Even if we assume that an event will have a meaningful impact on financial markets, how confident are we that we can manage it adroitly? It is a herculean assumption that we will make good choices through a period that is likely to be chaotic, stressful and unpredictable.

2) Will we know in advance which of the many such geopolitical events will be genuinely consequential?  On the very solid assumption that we won’t, this will mean that we must constantly trade around such situations – just in case it is the one that matters.

Although it might be quite difficult to acknowledge, anyone who has lived through financial markets for any period of time will know that Kahneman’s maxim is right. We lurch from one potential major risk to the next, almost always overstating its importance and each time making some ill-judged predictions. Investors need to worry less about geopolitical events, and more about the poor decisions we will make because they are the focus of our attention.  

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* Hopefully, it goes without saying that when I am writing about how much such issues matter it is purely from a financial market perspective. The human costs and implications are often profound and far, far more important than any investing consequences that may transpire.

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My first book has 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).

Behavioural finance has a problem. People talk about it a lot, but use it a little. If anything, improvements in technology and communication has made good investment behaviour even more challenging. Both the temptation and ability to make bad choices has never been greater. The central issue that behavioural finance faces is that – at its core – it is asking investors to stop doing things they inherently and instinctively want to do (and are in many cases are paid to do). That is an exceptionally hard sell.

If we take a deliberately simplistic approach to grouping some of our most problematic investing behaviours, we can see what makes adhering to the lessons of behavioural finance quite so tough:

We do things that are emotionally satisfying and anxiety reducing: Many of our actions – such as selling poorly performing funds or assets, or reacting to short-term market events – make us feel much better in the moment.

We do things that play to our ego: We want to believe that we are better than other people and this overconfidence leads us to engage in activities with horrible odds such as market timing,

We do things because of what other people are doing: We are social animals and take decisions because we want to be like other people or compare favourably to them.

We do things that are easy: We are cognitive misers and prefer simple explanations. That’s why we are so keen to translate a complex financial world into simple stories.

We do things that had evolutionary benefits: This one could really cover everything. Most of our worst investing behaviours are effective evolutionary adaptions and useful in many other contexts. Worrying about the short term and obsessing over recent events is great for our survival but not so good for meeting our long-term investing outcomes.

Viewed through this lens it is easy to see why encouraging people to think more about their behaviour is such a challenge. We are asking them to do the following:

• Stop doing things that give them immediate satisfaction and reduce stress.
  
• Accept that they are not as smart as they think they are.
  
• Stop looking at what other people are doing.
  
• Accept that markets are complex and unpredictable.
  
• Ignore most of what has your attention right now.

The idea that applying behavioural finance concepts is easy is nonsense. It is far far easier to give in to our ingrained dispositions which are natural and make us feel good – that’s why everyone does it. Improving our investing behaviour means going against our own instincts and often what other people are doing.

What makes matters worse is that the industry encourages and validates our natural and problematic behaviours. Lots of value accrues to turnover, stories, short termism and irrelevant comparisons. When I say value, I mean fees – not performance.

Another issue is that applying behavioural finance concepts has no immediate payoff, so it can be difficult to articulate its true worth. Any value that will accrue will take time and there is no obvious counterfactual. There is no benchmark for the poor decisions we would have made without it (a problem made harder by the fact they we will never accept that we would have made those poor decisions).

It is important to remember that behavioural finance would be redundant if it were easy; if it wasn’t hard it wouldn’t be useful.

Applying behavioural finance well is a skill. One that involves developing a plan that will ask us to act against what we think is our better judgement. We will struggle to evidence its value and there will be times when it looks like it doesn’t work at all – “why did you tell me to sit through a bear market when I could have got out at the top!?”

Absolutely integral to accruing the benefits of understanding and managing our behaviour is moving away from the idea that it is about simply doing nothing and ignoring markets. This might work for some but for most it is not realistic. Instead, it is about defining which types of behaviour add value and identifying those which are destructive ahead of time. This requires constant work and effort. It is not solely about creating disciplines but also continually reaffirming why they are in place. The concepts will be incessantly stress tested by fluctuating markets and ever-changing narratives.

Our default state is to disregard the lessons of behavioural finance. It is simply how we are wired. There are, however, huge benefits to be unlocked if we can take the time and effort required to engage with them. Our behaviour remains the most important factor influencing our long run investing outcomes, let’s not ignore it.

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My first book has 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).

Although investing is far noisier and uncertain than most card games, it is also an activity where understanding the odds is critical. While investors may feel uncomfortable talking about their decision making in probabilistic terms, it is inherent in everything we do – whether we are explicit about it or not. Much like assessing our chances in a particular game of cards, active investors should be asking themselves three questions before making a decision:

1) What are the odds of the game?

2) Do I have skill?

3) What hand have I been dealt?

Let’s take each in turn:

What are the odds of the game?

This is simply judging the expected long run success rate of an activity – on the assumption that I am an average player. If my objective is to win at a game, I want to play the one where the odds are most in my favour.

For active investors this is about seeking to identify the structural inefficiencies in a market that might create advantages relative to an index tracking approach. Although these dynamics might change through time, they should move at a glacial pace.

To take a simple example of what this could mean – I might assume that the odds of success for an active equity fund manager are better investing in Chinese A shares than US large cap equities. This is because the former has more retail participation and may price new information less efficiently (amongst other things). This may not be true (there are certainly reasons why active investing could be harder in the Chinese domestic market), but such issues should be at the forefront of our thinking.  

This is clearly not an easy judgement to make and there will be no precise answer, but it makes no sense to invest actively without first at least attempting to consider the odds of achieving a positive outcome.

Do I have skill?

The structural odds of a game are our starting point, but they will be impacted by the presence of skill. A poker player with evident skill should win more over time. The problem for investing is that skill is difficult to judge and far, far more people think they have it than actually do.

Skill can be quite an emotive term, so it is probably better to frame it as an edge. If I am going to engage in an investment activity with average or underwhelming odds, then I need to have an edge to justify participating.

Investors have terrible difficulty talking about skill and edge, but it is essential to do so. It might be analytical, informational, behavioural or something different entirely, but it must be something. If my choices are consistent with me believing I have an edge, I need to be clear about what I think it is.

What hand have I been dealt?

Sometimes the structural odds of a game, or the influence of my skill in playing it, can be dominated by whether I am dealt a great or terrible hand.

As an investor I can think of these as cyclical or transitory factors that influence my chances of outperformance. This is nothing to do with the perennial promises of it being a “stock pickers’ market” or other such empty prophecies, but rather factors like observable extremes in performance, valuation or market concentration that arise at different points through time and may have a material impact on my fortunes.

The best recent example of such a scenario would be in 2020 when a select group of high growth, actively managed equity funds had delivered staggering outperformance against the wider market. They had generated astronomical returns and held stocks that traded on eye watering valuations. Investing in such funds at this time (which investors unfortunately desperately wanted to do) is the same as being dealt a terrible hand in a game of cards.  It overwhelms everything else – the overall odds of the game and our level of skill become irrelevant. The probability of achieving good outcomes from such starting points is inescapably low.

Of course, such a situation is even worse than being dealt a bad hand in a game of cards because investors – buying into the story and beguiled by past performance – will play it like it is a great hand.

The sad truth is investors are more likely to go ‘all in’ with an awful hand and fold a great one.

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Investors seem to dislike thinking in probabilities. In part this is because it can feel like we are applying spurious accuracy, but more because it can betray a profound uncertainty about the future, which jars with our general overconfidence. Despite this discomfort, we cannot escape the fact that we are playing a probabilistic game. We will never get to the right answer, but it would help our decision making greatly if we at least tried to carefully consider what our odds of success might be.

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My first book has 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).