Article written by Joe Wiggins, Director of Research at St. James’s Place
Are poor short-term returns from a long-term position a fault or meaningless noise? What about underperformance from holdings in a diversified portfolio that would have fared well in a different future? Misdiagnosing what a mistake is may well be as damaging as simply being ignorant to them. To avoid this, it is helpful to think about investment mistakes in three ways – those related to beliefs, processes and outcomes:
Almost certainly the most commonplace, but least appreciated, cause of investing disappointment are mistakes of belief. This is where our foundational belief or philosophy is flawed.
Let’s take an example. We adopt an investment approach that is designed to tactically allocate across asset classes based on a three-month view. After a period of implementing this strategy, it is very likely that our performance will have been underwhelming. Our instinct will be to try to remedy the situation by adjusting the process – refining the inputs and our implementation – but the process isn’t the issue, rather it is the idea that asset class performance is predictable over such short horizons. If our beliefs are wrong from the outset, adjusting the process is not going to provide a solution.
Mistakes of belief occur when we incorrectly believe that what we are trying to achieve is reasonable and feasible. This leads to us engage in investment activities where the probability of success is extremely low. Why do we do this? The obvious answers are overconfidence and perverse incentives. We either hugely overstate our ability to succeed in an activity, or we are paid for it, so we do it even if we realise that it is not a good idea.
The real challenge of erroneous beliefs is that they are so difficult to change. When we alter our investment process it can be regarded as a welcome evolution or refinement – we are taking a positive step to get better. When we change our investment beliefs we risk tarnishing our reputation and identity (which is why it so rarely happens).
Even if our investment beliefs are credible and sound we can still err. A process mistake is where there is some flaw in the way in which we implement our beliefs.
The typical cause of bad outcomes from a mistake of process is technical. Here there is a weakness in our analysis of the information or use of it. What we believe is true, we just have failed to implement it well.
It may be perfectly reasonable to believe that we can lose 10lbs over the next 6 months, but if we have no idea how to design a sensible diet and exercise strategy, we are probably not going to achieve it. There is a belief and process gap.
The other type of process mistake is behavioural. This is about our ability to enact and maintain a plan. This is a serious problem for investors. We can have a sound set of foundational beliefs and a robust process but fail because we have underestimated our own behavioural limitations. This is not just an issue for individuals, but also for institutions who spend a great deal of time refining processes but seemingly little on whether the decision-making environment is supportive of the desired approach.
We have the perfect plan for losing 10lbs, but have entirely ignored the behavioural challenge of going to the gym or not eating that cake.
One of the toughest parts of being an investor is that there is no clean and consistent link between our beliefs and processes, and the outcomes we receive. We can make smart, evidence-based decisions and end up looking clueless; or appear to be a genius from making an ill-educated punt. Financial markets are fickle and unpredictable; talented investors will experience plenty of bad luck and see lots of things that look like mistakes but really aren’t.
The key danger of outcome mistakes is that they can lead us to give up on an investment strategy that works because we either misinterpret the results or struggle to accept the reality that good long-term investing comes with plenty of pain. There are four types of outcome mistake where we do the right things, but get the wrong results:
1) Bad luck: We simply suffer from misfortune. The more chaotic and unstable an environment, the more things can transpire against us.
2) Goal mismatch: A frequent issue for investors is where we compare our results against something that we were not even targeting. The most common example is worrying about short-term performance when we have long-tern objectives. This is akin to running a marathon and judging our success after the first mile.
3) Cost of sensible diversification: Well-judged diversification means being positioned for a range of different outcomes, not trying to maximise returns based on a single vision of the future. Being diversified requires holding positions that look like mistakes.
4) Natural failure rate: Even if we have solid beliefs and an incredible process it is likely to have an element of failure built into it. If we can score 90% of our penalty kicks or covert 75% of our 50+ yard field goals then we are delivering exceptional results punctuated with the occasional failure. The more difficult an activity, the more good operators have to accept mistakes, and, crucially, avoid overhauling their approach when they occur.
If there is randomness and uncertainty in an endeavour, identifying and dealing with mistakes will always be difficult. For investors, a perceived failure could be the result of a profound flaw in our thinking or simply an inevitable feature of a sensible investment approach. So, what can we do about it?
We should begin by defining what it is we believe and setting reasonable expectations; these are the foundations of any investing approach and without them we really don’t have much of a hope. With these in-place we must make sure we record and review our decision making through time. This means detailing and maintaining a clear rationale for our choices at the point at which we make them; and crucially avoiding the trap of judging past decisions through the horribly biased lens of hindsight.
It is easy to believe that investors are prone to ignore thinking about their mistakes because it is too psychologically painful, while this notion certainly has merit the truth is far more complicated. Our starting point shouldn’t be trying to identify our own mistakes, but defining what mistakes actually are.
This article was first published on Joe Wiggins' Behavioural Investment blog. We would also like to draw your attention to his book "The Intelligent Fund Investor". The book examines the beliefs and behaviours that lead investors astray and shows how they can make better decisions. You can purchase a copy here.