Horses for Courses

Horses for Courses

“He’s like a man with a fork in a world of soup.” – Noel Gallagher on brother Liam, (Q Magazine, April 2009)

The best job hires (of all sorts) rely on a good match between a candidate and the skills required to meet the particular challenges of the role – what is most important is not (necessarily) the best person – one needs the right person. We can see this (negative) phenomenon in the world of sport (where one football manager “failed”, because he brought a different “mindset” to that which pervaded previously) and in the world of business, where former General Electric executives have had very mixed fortunes when they moved to new jobs. If the characteristics of the candidate and the requirements of the job do not “match”, (i.e. the strengths and weakness of the candidate are not what is needed in this particular situation), success is very unlikely to occur [1].

So it is with investing; one of the problems that investors face is adopting an investment strategy that is right for them. The best investment strategy in the world is of no use if one cannot stick with it when it (inevitably) goes through hard times. It is thus crucial that one can live with the chosen investment strategy, when it fails to work (as it will) occasionally.

How does this apply in the world of investment? One needs to ‘Nosce te Ipsum’ (or “know thyself”, for those of you who are non-residents of Delphi).

There are several critical emotional elements that investors must deal with when constructing and investing in portfolios;

1) Going “Active” (the neglect of probability) – the endless barrage of adverts and appearances on financial television gives the impression that sage advice about future market (and individual stock) returns are readily available; all that is true (except the “sage” bit!). The chronic under performance of Active managers is both well known and consistent, but investors appear “anchored” to the belief that a “star” fund manager can beat the market (no doubt helped by the financial media who tout those that do so relentlessly), despite the reality that predicting future share price movements in inherently impossible (and for one active manager to do so REQUIRES another to lag by an equivalent amount in aggregate). To do so, one must have a set of holdings that is different to that of the market, which implies that they will under perform (assuming an equal chance of both occurrences) at times too. Throw in the odd investing “error” [2] and returns can easily fall away quite sharply. Remember in whose interests fund managers are working – it probably isn’t yours. Their marketing is aimed at convincing investors that they are the ones to trust to generate above-market returns. but they take no risk, as they have no money of their own on the line. Do not be tempted by their siren song, or one might find oneself shipwrecked – unfortunately many are.

2) Performance Chasing (aka the bandwagon effect ) – it is said that nothing makes an individual more uncomfortable than others making money while they are not, (which is why Cryptocurrencies have boomed among individual investors and of course subsequently busted). FOMO (Fear of Missing Out) is a powerful force (comparison is the killer of contentment). It takes mental strength to avoid the urge to follow others’ investment strategies when they are doing well (and since one may not know the investment rationale for that policy, it is very hard to know when that hypothesis has started to fail).

3) Going “All In” (or Overconfidence) – if one is convinced that an asset/share or Index is “bound” to rise, it appears logical to invest as much as possible therein. But “hindsight bias” prevents us from accepting that what appears to have been a sure thing was, in reality, nothing of the sort. There are many possible causes of rises in shares/bonds/cryptocurrencies etc. and market explanations are always ex-post, rather than ex-ante. This is of course related to 2) above, as an actual price rise always increases investor confidence in its continuation. In contrast, diversification, risk control etc. seems “boring” and out of keeping with the image portrayed on TV of free-wheeling, red-braces clad City traders making millions on sharp price rises and falls. Though it may take longer to see results than day-trading commodity futures, diversification works better in the long run, but you need to have patience; there will always be something in one’s portfolio that is not working at any given time. The key is to look at the big picture and recognise that they don’t all need to do so – it is the aggregate return that counts, the whole, not the individual parts.

The above examples are by no means an exhaustive list of potential pitfalls that investors can fall into (which of course is where advisors come in); EBI portfolios’ strategies may not be suitable for everyone if the investor is not psychologically suited and prepared for them. Many do not (or cannot) stick with them. They are not easy to follow nor do they promise untold wealth. If they did, everyone would already be rich, as someone would have already found a way to monetise them – if we knew how to do it we would no longer be in business (but in Barbados). If one cannot stick to the plan, it will fail and lead to disappointment and disillusionment. The key, therefore, is to adopt a strategy that one can live with, which requires that it is in keeping with the individual investor’s psychological makeup.

Investing should be dull – we all have lives to lead and better things to do; one must be able to step back from the (random) noise generated by 24/7 market prices and allow your investment processes to work. It is (somewhat cynically), believed that the best way to make £1 million in the stock market is to start with £2 million and those that do generate untold riches are overwhelmingly the exception rather than the rule. This will be increasingly pertinent given that 20-year returns ending in December 2018 have been surprisingly poor, at only around half the average of all 20-year periods since 1928. Whether mean reversion takes its course or not is, ex-ante, unknowable: it is more important how well we play the investment hand we have been dealt than the hand itself. That becomes much easier if the game and the player are of similar mindset.

[1] Winston Churchill, for example, spent long years in the political wilderness, partly as a result of his belligerence and inflexibility, but that was precisely what was needed in the 1940s. Success or failure is often more to do with the environment (or context) in which the individual works rather than that person’s talents etc. Are, for example, Theresa May’s talents what we need now to sort out the Brexit imbroglio or is there someone else whose (possibly more limited) abilities are better suited to this precise situation? (Answers on a postcard please – she seems the sort of “negotiator” that would come out of DFS with a full-price sofa).

[2] One year ago this week, Ray Dalio (a renowned Hedge Fund manager) said that “if you’re holding cash, you are going to feel pretty stupid”. Cash was the only positively-returning asset class of 2018.