Why my Mum Beats all CIOs

The following is a guest post (of sorts). Its a speech delivered to an industry audience by a friend of mine back in 2009.

Some of the specifics may be a little dated after 8 years (e.g. whatever happened to Intech?) but each of the 27 question’s posed by my friend’s “mum” remain as relevant as ever. They remain pertinent because, after 8 year, most superannuation funds still invest this way.

My friend’s mum doesn’t have to worry about any of those things. All she has to worry about is achieving a total return after taxes without taking any unnecessary risk.

Some reader’s may find these views provocative (to say the least). That is understandable because they threaten the status quo. But sometimes we need to ask the difficult questions. In the words of Socrates, “every great and noble steed who is tardy in his motions owing to his very size” requires a “gadfly” to be “stirred into life”.

Without further ado; here’s why my friend’s mum is a better investor than most CIOs.

Why my Mum Beats all CIOs

My initial view is that the way super is managed in Australia is not well aligned to members interests and that it doesn’t surprise me that the results are both ordinary and not necessarily what the members want. For example:

  • A cash plus strategy to a layman means cash plus!
  • Super returns over longer periods of time do not seem to have significantly outperformed cash.
  • I’m pretty sure that most members would gladly accept lower returns in the good times for some protection in the bad times.
  • It appears that there is very little excess return and what there is is unlikely to be true alpha

What I am going to highlight today is a number of issues that I have encountered and some potential solutions.

Even though I am expressing my concerns in a tongue-in-cheek manner and using my mum as a hypothetical retail investor, the issues in my view are nevertheless pertinent and real.

I warn you in advance that there are some very good reasons why you should take what I say with a grain of salt.

Not the ordinary disclaimer where I say that the views expressed are mine alone (which they are) and that I wasn’t here, you weren’t here and I didn’t say anything but more something like “my views are so aberrant that many think that I’m a complete crackpot”…

… Additionally, it is part of my job description to be negative. Whereas a business development manager is mostly telling a good story (maybe a fairy tale) suggesting that one should invest with his organisation my job is to say no to over 95% of the opportunities that are presented.

I wonder what came first, the chicken or the egg?  Has my job made me a glass half empty kind of guy? Or was I always this way and therefore suited to being a CIO?

There is perhaps one good reason that you may want to hear what I have to say and that is that this. Sometimes my strategies do work and my record of investing over 30 years is pretty good…

… My mother is an excellent investor. She doesn’t listen to me but maybe does pay some attention to my dad…

… Sometimes she does some strange things, like buys shares in Arnotts just because she liked getting a large biscuit tin every Christmas.

But mostly she just makes sound, sensible, long-term investment decisions that are totally aligned to her needs and have worked in the past and in my view will continue to work.

My mother is a zoologist and a mathematician who has spent many years raising 4 children and helping with 10 grandchildren. She is layman in relation to finance.

So how come she had had much better results than most, if not all, superannuation funds?

Is it because she is so good or because the funds have just over-complicated and over-engineered something that should be straightforward.

I put forward the hypothesis that it’s the latter.

Here are a number of issues that I have identified where I think super funds could do better and the 20 (actually 27, my lucky number, buts what’s a few more between friends) questions that my mother might ask.

Why do most super funds look so similar, namely 70/30?

Surely a 70/30 fund is not appropriate for all that many members?

Surely one should have an eye on future retirement income (similar to liabilities for a DB fund) and employ some form of liability driven investing?

Maybe DB style investing with its longer term horizon is a better way of managing super?

Why do funds continue to use active managers in traditional asset classes when the data conclusively shows that at least 75% underperform before fees?

Why play a game when the odds are worse than even money?

In the case of some alternative asset classes despite the attraction of higher potential alpha the odds are even more stacked against you.

For example, only the top 10% of private equity managers achieve results that are superior to listed markets.

Why do funds emphasise relative returns?

After all, you can’t eat them!

More importantly, why do funds give out mandates where losing 40% of a client’s money when the index falls 50% is seen as good? (i.e. we can’t blame the manager in this instance who has lived up to his end of the bargain).

Why do funds classify high-yield credit as fixed interest and within ‘defensive assets’?

High yield credit is clearly a de facto equity bet and my data suggests a correlation (r-squared) of between 0.6 and 0.7.

So if one did like credit why not classify it as a ‘growth asset’? (Assuming of course positive returns!)

And, why not think about investing in equities instead of high-yield credit?

(Usually I think equities are a better bet but right now I prefer credit to equity on a risk-adjusted basis. Maybe credit will even outperform equities in an absolute sense over the next short while?).

If managers can tell cheap and expensive stocks then why can’t they tell cheap and expensive asset classes?

The Frank Russell used group used to say “Son, its time in the market, not market timing!”

Now, even they have a strategist to look at selective tilting.

Surely it makes sense to buy low, sell high and therefore not to buy high!

Why do super funds listen to mathematicians?

After all, they would say that on average we all have one testicle!

More importantly and seriously quantitative analysis suggested that high valuations (high equity prices and low credit spreads) were OK given low volatility and low default rates.

If only they had read a history book and realised that the period 2002-2007 was the outlier and that pre 2002 and post 2007 are more usual.

However, I am glad that pointy heads were embraced by funds management as how else would they get laid.

Why do funds pay active fees for portfolios that have large amounts of redundancy and are de facto at least 50% passive?

Our analysis of a standard multi-manager portfolio suggests that upwards of 50% is redundant. I’m sure you can understand why we would replace an expensive, underperforming, redundant portfolio with a large amount in a passive management style.

Why do funds invest in hedge fund-of-funds?

It was obvious that pre 2007 that most FOF exhibited an alarmingly close correlation with each other and with equities.

Was it that by some miracle that all of their uncorrelated alpha with large diversified portfolios yielded such similar results (a 1 in 6 million possibility) or was it that it was just some form of commoditised (exotic) beta?

You work it out!

Believe it or not, one of our managers still insists that there was no beta in its FOF!

Why do managers buy stocks that they don’t like?                                                       

Why did managers buy a lot of expensive alternate assets that didn’t really diversify risk?

As Keynes says, the only thing that rises in a crisis is correlations.

If one adjusts for timing of valuations its pretty clear that many so-called uncorrelated assets are not uncorrelated at all and all that was different was the timing of valuations.

Why do funds believe that assets that are revalued less frequently are less volatile?

How volatile would your home be if it were valued daily?

If you believe that assets with appraisal values are less volatile, have I got a deal for you!

I can provide you with ASX200 returns for no fee with half the volatility of the ASX Just buy into a Macquarie True Index fund and revalue monthly!

Why do managers use the indices that they do?

Why would one use the UBSA All Maturities Composite Bond Index that contains credit and that the more debt that a company or the government issues, the more that it is represented in the index. Does that mean as a company is going under I should buy more debt issued by it?

Why are cap weighted equity indices (where highly priced growth companies are overly represented) a good measure?  No wonder value managers outperform these indices consistently.

Why are managers allowed to take lower quality, riskier, out-of-index bets and call any excess return ‘alpha’?

Isn’t it expected that a portfolio that includes small caps will outperform one without? So why do we applaud a manager that includes riskier, smaller cap assets and then pulls out his thumb and says “what a good boy am I?”

How come, managers rarely ask for a mandate to allow them to buy the less risky safer out-of-index assets?  I’ve never seen a small cap manager ask to be allowed to buy large caps or an EM manager ask to buy developed market stocks!

Doesn’t it therefore follow that fixed interest managers are likely to add credit (and risk) to a portfolio in an attempt to beat their index?

Doesn’t it also follow that we can look back at past performance, suggest that bond managers are ‘one-trick-ponies’ and be sceptical as to whether they exhibited any real skill?

Why do funds invest in bonds with low duration?

How are bonds (often with credit attached) with an average modified duration of 3.21 years) useful in protecting the portfolio of a member with 25+ years to go until retirement?

Why do funds which supposedly manage for the long-term pay so much attention to short-term performance?

My mum has never heard of Mercer or Intech so is not bothered about league tables.

She does however care about her after tax performance relative to CPI & cash.

If one was genuinely a long-term investor then one might hold a value portfolio like DFA for the very long term.

But please remember when taking long-term bets, whether leveraged or not, that as Keynes says “the market can stay irrational longer than you can stay solvent!”

Why don’t super funds manage to an after-tax benchmark?

If the goal was to make CPI +4% after tax then why not lock that when it’s possible.

Why don’t funds differentiate more between mark-to-market and genuine under-performance?

If one holds a duration matched portfolio of semi-government securities with a spread of 100 bps to CGS, then if one holds until maturity then the portfolio will outperform govs by 1%.

Who cares about the marking to market?

Why use a sector specialist model that is so clearly sub-optimal?

It creates artificial barriers that lead to absurdities.

For example, if the situation was such that adding preferred stock improved portfolio outcomes it is very difficult for a sector specialist portfolio construction to accommodate it. The bond guys don’t like it because it has delta and is out-of-index and the equity guys don’t like it because its beta is too low. Go figure!

Additionally it rewards managing against an index (no matter how stupid the index is) without regard to absolute returns or the opportunities in other asset classes.

My job is not to buy any bargains but to buy the best bargains!

I suggest only two asst classes, growth and defensive.

So, why aren’t equity managers keen to buy preferred stock and convertible notes when appropriate?

My guess is that it’s just a bit hard for them to deal with anything outside their very narrow irrelevant view of the world.

Why do people think that when the ASX200 is at 6800 with past low vol it is less risky than when it’s at 3400 with recent high vol?

I think that risk is neither vol nor Var but something more related to valuations.

Accordingly, when prices are lower and spreads are higher I am inclined to add to holdings.

Why listen to some asset consultants?

I do accept that they provide some level of protection. (CYA)

However, recent implemented consulting results do not inspire confidence.

Why pay managers win, lose or draw? Why offer performance fees which give managers a free option?

Is it any surprise that those on performance fees routinely add risk and those on flat fees routinely index hug and gather assets?

I guess we reap what we sow!

Why hire outperforming managers and terminate underperforming managers?

Surely mean reversion would suggest doing the opposite?

There have been numerous studies which show that the only type of performance that persists is really bad performance. Otherwise past performance is a poor guide to future performance.

Isn’t it interesting that on average recently terminated managers outperform the replacement managers?

Why pay fees based on FUM? Especially if the strategy is not capacity constrained.

Surely it takes the same work to manage or advise upon or provide custody for $100m as for $1 billion.

PS I do accept that there are some additional fees and risks associated with size but do not accept that they are as linear as service providers do.

Why do funds spend 80% of their time looking at manger selection and 20% looking at Strategy and Strategic Asset Allocation?

Surely this is the 80/20 rule completely arse about?

After all, managing beta is risky but is 400x* better than alpha as a tool for increasing portfolio outcomes.

*20 times cheaper and 20 times more important.

So, why not just go back to an old fashioned balanced fund where alpha and beta are both properly managed?

“The more things change, the more they stay the same” or “plus ça change, plus c’est la même chose”

Finally, I’d like to leave you with two thoughts.

  • If history revealed the path to riches, librarians would be in the Forbes 500 (Buffet); and
  • Flat is the new up.

Measuring Up – Effective Benchmarking for Individual Investors

Reading time:  9 minutes

What’s the best way for individual investors to benchmark their performance? I was recently asked this question by a fellow member of the Australian Shareholders Association.  I’m lucky to see how professional investors do this thanks to my day job as a portfolio manager. But most individual investors don’t have a post-graduate level education in quantitative methods. They’ve have never heard of GIPS, nor can they can afford to access a quantitative risk model.

The best way to answer this question and “keep it real” was to think about how I benchmark the performance of my personal portfolio. Obviously, the way that I analyse my performance has been shaped by my professional experience. I’d be foolish not to apply what I’ve learned from working with some of the best fund managers from around the world. That said, the pros don’t have it all their way. Yes, they may have knowledge, skills and resources that aren’t available to ordinary investors. But they are analysing performance not only to learn and improve their investment process but also to report to their clients.

Institutional investors demand as much information as they can get as often as they can get it. This is because they are usually part of a heavily regulated chain of principal and agent relationships (point 4). Each link in the chain has to account for its results to the next link in the chain and so on. This results in information overload. It also and increases the likelihood that results are dominated by short-term “noise”.

In contrast, individual investors only answer to themselves. They aren’t competing with anyone else and they aren’t trying to justify the fees that they charge. All that individual investors need to benchmark themselves are: an internet connection, a spreadsheet, a little effort and knowing what to look for.

Comparisons Matter

So how should individual investors benchmark themselves? They need to find a set of measurements that help them to improve their investing through deliberate practice. I’ve raised the idea of deliberate practice before in my earlier post on regret. In fact, it’s trying to manage the negative effects of regret that lead me to thinking deeply about how I should benchmark my own portfolio.

Readers of my post on regret will remember two key points:

  1. Regret is a comparative emotion. So, it’s really important that we make the right comparisons.
  2. It doesn’t have to be negative. Regret can be a positive if it motivates us to learn and improve.

It’s worth elaborating on what makes a bad, as opposed to a good, comparison. We can illustrate the difference with a few examples. Bad comparisons include:

  • Short time periods (less than 12 months)
  • Market benchmarks
  • Time-weighted returns
  • Comparisons that ignore real world costs and taxes

Bad Comparisons Don’t Teach

Short time periods reveal almost nothing about future performance and may even be harmful to our wealth for two reasons:

  1. “Noise” dominates over short time periods
  2. We are prone to over-reacting to noise due to our behavioural biases

See  my latest piece for i3 Insights (point 3) and last month’s column (point 7) for more details.

What’s wrong with using a market index? It’s not an investable strategy. It ignores dividends (unless you use a total return index). It ignores brokerage costs and it ignores taxes. But most importantly, it is completely backward-looking. It tells you almost nothing about what your future returns will be. That said, there is a “right” way to use market indices which we’ll consider later on.

Another reason why market benchmarks may be inappropriate is that an investor may have personal risk or return objectives that are quite different from the risk and return profile of the market.

Most of the published investment returns that we see are time-weighted. They make a key assumption: a constant or fixed investment amount for the entire period. Nobody invests this way. Our invested capital changes over time as we add or subtract funds from our portfolio or if we reinvest dividends.

Looking at time weighted returns ignores any asset allocation decisions that we make. This has a huge impact on the dollar performance that we earn. Remember we can only spend dollars, not returns, which is why looking at time-weighted returns isn’t that helpful. This is also another reason why using a market index (without making some adjustments to facilitate an “apples-to-apples” comparison) is a bad idea.

You can find more information on the differences between time-weighted and dollar weighted returns here.

Costs matter. We can illustrate why with the following analogy. Imagine that you had to measure a car’s power output, would you measure it at the engine or at the wheels? One measures the pure power output of the engine, while the other measures the power that’s available for the driver to use. Ultimately, what matters is the power that’s there when the rubber hits the road. In a similar way, it’s important to factor in the impact of brokerage, taxes and other frictional costs that detract from performance.

Good Comparisons Promote Learning

Good comparisons have the following attributes:

  • Long-term (minimum of 12 months, ideally much longer)
  • Take into account our objectives and goals
  • If market-based, they use a simple, low-cost, and investable strategy to create an “apples-to-apples” comparison.
  • Dollar-weighted returns
  • Create feedback
  • Consider real world frictions such as costs and taxes

We’ve already covered the reasons why it’s important to have a long-term horizon (see above).  Active investment strategies can have performance cycles lasting several years. Very few investors have that kind of patience. Still, it’s a good idea to periodically check and see how your portfolio is tracking relative to your expectations. This is particularly helpful if you’ve set your benchmarking up to create feedback to help you learn and improve.

It’s impossible to select an appropriate benchmark without clearly identifying your objectives first. You can find some helpful suggestions on how to do this here.

Here’s what I do instead of using a market index. My portfolio consists entirely of stocks listed in the United States. Most of them feature in the S&P 500 index. That’s why I have selected the SPDR® S&P 500® ETF (SPY) as my simple, cheap and investable benchmark. I create two portfolios using Google Finance (there are other websites that also calculate portfolio performance for you):

  1. My “actual” portfolio where I capture all of the trades and dividends in the stocks that I own.
  2. A “opportunity cost” portfolio, where I capture notional trades (equivalent to my actual trades) and dividends in the SPY.

Both portfolios factor in brokerage costs (assumed brokerage for the opportunity cost portfolio) and, in my case, currency conversion. This creates an “apples-to apples”, dollar-weighted comparison of two investable strategies (my portfolio and the SPY), net of costs.

This analysis helps me answer the question of opportunity cost: should I continue trying to pick stocks or would I be better off investing in an index ETF? But it’s purely backward-looking and it doesn’t provide any information to help me learn how to improve my investment process.

Winners Create Feedback

Imagine that you’re the coach of a football team. The season has just ended and now it’s time to begin preparing for the next year. How would you analyse your performance? Would you simply look at you win/loss percentage and call it a day? No, you would probably dig deeper in search of patterns. For example, you might examine how your results differ when playing at home or away. Or you might look at the percentage of games won when your team is in the lead at half-time.

You probably won’t stop there. You’ll keep digging. For example, you might review the performance of specific players, or examine how your team executes specific plays or manages possession of the ball  when attacking or defending.

What’s the point of this analogy? Winners create the feedback that they need to learn though deliberate practice. They break the overall result down into its component parts. Winners study each aspect of their performance and look for specific ways to improve. They create an action plan to improve and they make sure that they follow through.

Looking at your performance versus a benchmark or objective is important. But it won’t help you to identify the specific steps that you can take to become a better investor. For that to happen, you’ll need to create your own feedback.

Why Feedback Matters

Investment success requires sticking to an investment process that has an “edge”, that is a process that both facts and logic suggest will work on average over time. The corollary is that there will be frequent specific cases where it doesn’t work. I’ve observed that successful fund managers are often wrong between 40-60 percent of the time. They make a lot of money not because they avoid mistakes completely, but because their wins are much larger than their losses.

The only way we can improve as investors is if we track and hopefully improve our “edge” over time. This is impossible to do without detailed feedback. Historical performance isn’t enough because any strategy with a 40-60% error rate guarantees long stretches of underperformance. How can we identify an expected stretch of underperformance vs a strategy without an edge? Feedback!

The phrase “will work on average over time” is important. It implies that we’re concerned primarily with the quality of our decision making and not necessarily subsequent results. Why do we say this? Because results are a combination of luck and skill. Skill will eventually win out over luck if we make good decisions and we give our process enough time to bear fruit.

Constructing Feedback – An Example

What sort of feedback do we need? We need feedback that helps us measure and assess the quality of our investment decisions.

I create this feedback by breaking my performance down into decision “chunks”. These chunks will vary from investor to investor. That’s OK, the point is to find a categorization that makes sense to you and is appropriate for your investment strategy.  Here are the chunks that I group my investment decisions into:

  • Opportunity Cost
  • Efficiency
  • Selection
  • Portfolio Construction
  • Behaviour


Opportunity Cost relates to my objectives and whether or not the evidence suggests that I can reasonably achieve them. It also examines the question of whether or not I’d be better off investing with a different strategy. Efficiency is pretty straightforward.  Selection covers decisions such as searching for, evaluating and monitoring investment opportunities. Portfolio construction decisions include the sizing of positions, the timing of cash flows and how I manage the trade-off between concentration and diversification. Behavioural decisions refer to my actions once invested. For example, do I succumb to the disposition effect by selling my winners and letting my losers run?

Breaking my investment decisions down into levels of increasing granularity also helps me to learn faster. I run a concentrated (currently 6 stocks), low turnover portfolio. I might make only 3-4 buy or sell decisions in a year. I can learn from reviewing these decisions but it’s probably true that I could learn faster if I reviewed more investment decisions. That’s why I make sure to review both implicit as well as explicit investment decisions.

Buy and sell decisions are explicit. Every time I buy a stock, I am making an implicit decision not to buy the 3, 5, 10 or however many other stocks that I also considered purchasing. Each day that I hold a stock, I’m making an implicit decision not to sell it. Considering implicit decisions increases the feedback available to learn from.


We need to search for meaningful comparisons to help us learn and improve or investment process. This goes beyond simply benchmarking against a market index. It is possible for individual investors to do this by creating their own feedback. This involves thinking about your investment process, breaking it down into the decisions that determine your results and collecting and analysing as many examples of these decisions as possible. It’s important that the frequency of review aligns with the investment horizon of your strategy. Please don’t do this monthly unless you’re a trader!

I’ll use my own portfolio as an example of how to do this in a future post. In the meantime, I would really appreciate hearing from you, my readers, on how you benchmark your performance.


I hope you’ve found this post interesting and helpful. Please share it with your friends on Twitter or LinkedIn!



The Active vs Passive Debate Part II

Here is my latest column for i3 insights where I dig into the real reasons why active management so often fails to deliver on its promises.

For those that can’t be bothered reading on, here’s a spoiler: The problem lies with the business of active investing, not the activity. It is definitely possible to beat the market. But for that to happen, investors must avoid common mistakes, such as those featured in this post.

Part 1 of this series: Synthesizing the Active vs Passive debate

Please share it on Linkedin or Twitter if you like it!

Synthesising the Active vs Passive Debate

I’m a firm believer in the value of active investment management.

I also believe that 95 per cent of institutions should invest passively.

No, I’m not confused or delusional. My apparently contradictory viewpoint is the result of a deliberate effort to synthesise both sides of the active vs passive debate.

Most of the active versus passive debate focuses on the analysis supporting either the active or the passive side. In reality, the correct decision depends on the circumstances (see my earlier post).

This is why synthesising the arguments from both sides of the debate is vital. One of the best examples of the power of synthesis is the legendary Charlie Munger. Here’s a thought-provoking quote from Charlie courtesy of an interesting piece written by the Farnham Street Blog entitled The Work Required to Have an Opinion.

The ability to destroy your ideas rapidly instead of slowly when the occasion is right is one of the most valuable things. You have to work hard on it. Ask yourself what are the arguments on the other side. It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental discipline.

I’m going to take up Charlie’s challenge: an active investor presenting the case for indexing better than a passive investor. There’s a lot to cover, so I’ll tackle the subject in three parts:

Read more: Market Fox – Synthesising the Active vs Passive Debate

Click here for bonus material related to this post

Synthesising the Active vs Passive Debate – Bonus Material

Link to: i3 Insights: MarketFox – Synthesising the Active vs Passive Debate

Next week is marks the launch of my new column for i3 Insights, the Investment Innovation Institute’s (or i3) monthly online magazine. Institutional investors in Australia and Asia would be very familiar with the excellent work that Teik, Wouter and the team do in bringing thought leaders from around the world to exchange ideas. I’m honoured to be asked to present my ideas among such distinguished company.

We thought it might be interesting to get things started with a new take on a very old topic: the active vs passive debate.

I know what you’re thinking: is there anything left to write about? Turns out that there’s plenty to write about if you synthesise the two sides of the debate together. Synthesis is what’s largely been missing from the active vs. passive debate.

Synthesis is important because the answer to the active vs passive debate is this: it all depends on the circumstances (see my earlier post).

There’s a lot to cover so I’ve divided it up into three parts:

  1. Commonly offered reasons why active management so often underperforms, some of which are poor because they don’t really explain the poor performance of active fund managers.
  2.  More plausible reasons why active management usually delivers poor results.
  3. Strongest arguments in favour of indexing.

For part I, I came up with 13 arguments (see below) that are usually offered as “proof” that active management is a bad idea.  Most of these arguments are either weak or apply in some circumstances but not others. And yet they are the arguments that often get the most attention.

My i3 Insights features nine arguments, the remaining four arguments appear below. They are:

  1. Even if some managers do win, you can’t pick the winners in advance.
  2. There are now too many smart people investing in the market making it harder to beat.
  3. Some people do beat the market, but that’s because they take more risk.
  4. Warren Buffett says that Jack Bogle is his hero. I’d better do what Buffett says.

Even if some managers do win, you can’t pick the winners in advance

That’s true of most things in life. I think this is the logical equivalent of saying: “you don’t know where the fish are, so why go fishing? While its true that nobody knows where the fish are, we do know which species are commonly found in the area, their habits (e.g. deep sea) and what they like to eat.

Even though you aren’t guaranteed to catch a fish every time, it happens often enough to be a worthwhile activity. And who can deny that some people are genuinely skilled at fishing, even if they don’t always catch a fish?

In a similar way, we know many of the factors come together to create a successful investment strategy. Much more importantly, we know the factors that ruin our chances of success, such as:

  • High fees
  • High turnover
  • Benchmark hugging
  • Managing too much money

Trying to find the “best” fund manager is usually a waste of time. It’s just like trying to pick a winner in a horse race, the best horse winds up being the favourite, is heavily backed by most punters and consequently even if you’re right you end up making very little money.

Instead, look for weaker markets, and behavioural edges, invert, exclude the losers then pick the cheapest of what’s left. A better way to invest actively is to prioritise areas of the market where active management is more likely to work, for example a microcap strategy. Identify the behaviours that promote successful investing. Behaviours are far more persistent that performance, so it makes sense to base your search strategy on them.

The next step is to flip or invert the behaviours around and work out all of the wrong behaviours that investors need to avoid. I then screen the universe of fund managers for these bad behaviours and remove any managers that repeatedly engage in them. The final step is to then select the cheapest manager out of the remaining group of shortlisted managers.

The goal of this process is to maximise the expected value of active management for the investor, not the fund manager (see my earlier post).

Most people I share this approach with think I’m crazy. I can see from the expression on their face that they’re thinking it’s just wrong to not try and pick the best, or that I’m just settling for the cheapest fund manager (not true!).

The truth is that it’s hard for most people to accept that it might be easier to avoid a bad fund manager than it is to find a good one; especially when they are being paid a lot of money to find a good one. Then there are behavioural biases such as over-confidence that come into play.

This quote from Warren Buffett’s 2016 Berkshire Hathaway annual letter sums the problem up nicely.

That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.

Michael Mauboussin has observed that the simplest definition of whether or not the outcome of an activity is due to luck or skill is this: can you lose on purpose? If you can’t deliberately lose, then the outcome is dominated by luck.  So, if we can’t identify bad managers, we’re really just getting paid for random outcomes. Something to pause and reflect on.

There are now too many smart people investing in the market making it harder to beat

Yes, the market is really tough to beat and most people are probably better off not trying. But I think it’s debatable that this is due to the problem of too many smart people operating in the market for 3 reasons which I explained in detail an earlier post, they are:

  1. Markets may attract the wrong kind of people as investors
  2. Even the smartest people are still people
  3. Smart people may be looking out for their own interests

Some people do beat the market, but that’s because they take more risk

Academic studies show no clear relationship between market risk (beta) and return.

Several factors have been demonstrated to out-perform the market and most active managers either knowingly or unknowingly target these factors as part of their investment process. I cover this in my i3 Insights post.

Warren Buffett says that Jack Bogle is his hero. I’d better do what Buffett says

Don’t mistake Buffett’s comments about the business of investing for his views on the activity of investing. Buffett’s recommendation to invest passively isn’t because it’s impossible to beat the market (although he acknowledges that it’s become harder). Rather, he believes that the activity of investing can still be rewarding for those with the right temperament.

That said, the business of investing is riddled with principal and agent conflicts and high fees making active management unlikely to be a winning proposition for the client. Paying someone else to do it for you is more often than not going to result in the fund manager becoming wealthy (not you). For example, see my earlier post.

Here’s Buffett on the subject. This quote from Berkshire Hathaway’s 2016 annual letter.

Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions (sob!). Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees…

… The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Most people don’t have the right personality and/or circumstances. Buffett doesn’t advise people to invest passively because the market is efficient, or any of the other reasons we’ve considered.  He simply recognises that most people don’t have the time, knowledge or temperament to invest actively.

Temperament is the most important of these factors, as Buffett explains in the CNBC interview.

Buffett CNBC

Part 2 of my series on active vs passive management will appear on i3 Insights in May.

In the meantime, readers might enjoy previous posts dealing with the active vs passive debate.

Link to: i3 Insights: MarketFox – Synthesising the Active vs Passive Debate


13 weak arguments against active management

  1. Markets are efficient. Prices reflect all public information (semi-strong efficiency).
  2. Diversification is the only free lunch. The market-cap index is well-diversified.
  3. Between 60-90% of active fund managers under-perform each year
  4. There is little or no performance persistence from year to year.
  5. There are now too many smart people in the market making it harder to beat.
  6. Active management is simply factor investing at a higher cost.
  7. Regulation and technology have reduced many of the information asymmetries that made active management profitable.
  8. Some people do beat the market, but that’s because they take more risk.
  9. Get enough coin flipping orangutans tossing coins and at least one will come up with 10 heads in a row (luck).
  10. Positive Skew. The majority of the market’s return is due to a handful of stocks. You want to diversify and buy-and hold so that you capture these engines of growth.
  11. Warren Buffett is just a freak. We shouldn’t try to copy him.
  12. Warren Buffett says that Jack Bogle is his hero. Better do what Buffett says.
  13. Even if some managers do win, you can’t pick the winners in advance.

Are Markets Driven by Fear, Greed or Regret?

Reading time: 7 minutes

It is said that fear and greed drive markets. I would like to add regret to this list. Why regret? Because it’s often how fear and greed enter into our investment decision-making.

Consider two common investor acronyms: FOMO, fear of missing out and TINA – there is no alternative. Could there be any better example of regret inciting investors to greed than the fear of missing out? The phrase “there is no alternative” implies that a choice is made reluctantly. In other words, the alternatives would all lead to regret.

I have been struggling to deal with regret aversion and its effect on my decision-making for a while now. Like many investors, I’m a perfectionist by nature. This makes me especially vulnerable to regret aversion.

I try to review all of my investment decisions as part of my deliberate practice to become a better investor. This is how I discovered that regret aversion is a common theme underlying several of my mistakes.  Honest self-examination is an important part of deliberate practice.

What is deliberate practice? The Harvard Business Review article The Making of an Expert by Ericsson, Prietula and Cokely describes it this way…

Not all practice makes perfect. You need a particular kind of practice—deliberate practice—to develop expertise. When most people practice, they focus on the things they already know how to do. Deliberate practice is different. It entails considerable, specific, and sustained efforts to do something you can’t do well—or even at all. Research across domains shows that it is only by working at what you can’t do that you turn into the expert you want to become.

We’ll discuss why regret aversion has led me to make some poor decisions shortly. First, it’s helpful to elaborate on the nature of regret and why it’s a part of every investment decision that we make.

Deliberate practice wouldn’t be complete without also trying to figure out a way to manage the negative effects of regret. I will write about this in a future post.

Regret Explained

My reading on regret and its effects on decision-making revealed several important points:

Regret has a profound emotional impact. A study by Shimanoff (1984) found that regret was the second-most common emotion mentioned in conversation. Only love was more popular.

Regret is a comparative emotion. We feel regret when we compare what’s happened with what could have happened. We create the potential for regret every time we ask a “what if…“ question. I’ve learned that the key to managing regret is avoiding the “wrong” comparisons. We need to carefully select comparisons that will teach us the right lessons. This is the first clue to managing the impact of regret on investing.

Other comparative emotions include anger, frustration, disappointment, distrust, guilt, sadness and shame.

Regret requires a decision. It’s impossible to feel regret without making a decision. For example, you could feel disappointment if you go outside and it rains. But you would only feel regret if you decided not to bring your umbrella with you.

Regret feels worse for choices that were taken. Kahneman and Tversky (1982) found that feelings of regret are stronger when we’ve decided to act. In other words, we regret perceived errors of commission more than errors of omission.

Suppose you scan the 52-week-high list and notice that Nvidia (NVDA) is up 204.52% over the last 12 months (while the S&P 500 is up only 18.52%). You might think “I wish I’d heard about Nvidia twelve moths ago” and quickly move on without feeling much regret.

But what if you’d read a magazine article about Nvidia 12 months ago? What if that article explained that graphical processing units (GPU) were increasingly used for machine learning and that Nvidia was a leading manufacturer of GPUs? What if you also looked up the company’s fundamentals on Value Line? What if you’d also seen that the stock featured in the 13F reports of several prominent hedge funds?  Finally, what if you decided after only a cursory investigation that it looked expensive?

In the latter case, you would have experienced stronger feelings of regret because you chose not to act. I wish I could say that this his happened to a “friend” of mine but I can’t. Unfortunately it happened to me.

Regret can be a positive motivator. Not all regret is bad. If viewed appropriately, it can be a powerful motivator to learn, grow and consequently improve our performance. This is the second clue to learning how to manage regret.

The most disappointing thing about missing Nvidia wasn’t that I had missed out on a +200% gain. Every investor, even the very best, frequently miss opportunities. My regret is that I didn’t really have a disciplined process to ensure that I followed up on my ideas.

I’m now focused on building a systematic process to keep track of investment ideas. In other words, my regret has motivated me to improve my investment process through deliberate practice.

Regret is stronger for comparisons that are easily made. Our feelings of regret are more intense when we can easily and clearly measure the consequences of our choices.

Imagine that, after graduation, you decided to break up with your high-school sweetheart. As the years go by, you fall out of touch. Perhaps you moved to a different city and met someone new. You might occasionally think back to your youth and wonder what might have been if you’d stayed together. But you probably won’t feel regret.

Suppose instead that you decide to follow your high school sweetheart on Facebook (assume that it existed at the time). You find out on Facebook that they’re now successful and wealthy. Their profile is full of photos from exotic holiday destinations around the world. What’s more, they’re in a relationship with a personal trainer and they look fantastic. This might prompt feelings of regret.

Regret varies across individuals and circumstances. Let’s take our high school sweetheart analogy a step further. You may not find the Facebook comparison troubling if you’re happy and successful. But what if you’re life hasn’t turned out the way that you expected? In this case, your feelings of regret are likely to be stronger.

I’ve learned that we experience regret differently when we make decisions:

  • On behalf of other people
  • As part of a group
  • Without having any skin in the game
  • Knowing that our results will be judged by others and with the benefit of hindsight.

Regret influences our choices as we are making them. Regret isn’t just experienced after the fact. We actively anticipate regret and take it into account when making decisions. This is known as regret aversion.

Regret aversion is different from risk aversion or loss aversion. We sometimes take more risk to avoid feeling regret. For example, the gambler who accepts a “double or nothing” bet is taking an even bigger risk to avoid the regret that comes with facing up to a loss.

What does Regret Aversion Look Like?

Here are some of my worst mistakes. Each mistake was largely due to regret aversion:

  • “Company XYZ looks fairly-priced, but there’s a chance that it might fall in value. I don’t want to feel like an idiot if it drops 10% after I buy it. So, I’ll wait and buy it on the next pull-back.” The stock doubles.
  • “Stock ABC is up 10% since I bought it and the outlook for the company is improving. It’s still below my estimate of value. I should buy more. But what if I’m wrong? I’ll wait and see what happens.” ABC is up another 30% in less than 3 months.
  • “DEF is well positioned to take advantage of rising interest rates. I’ve done my homework on it, including reading the 10k from cover to cover. But Tom thinks I’d be nuts to buy US financials. He says you can’t trust the book value. Tom thinks the S&P 500 is way over-priced and that we’re due for a crash. What if he’s right? Maybe I should wait?” DEF is up almost 100% in 9 months.
  • “I really should sell RST, its down 10% since I bought it, but more importantly revenues are still falling and the fundamentals aren’t improving. But what if the new product they’re working on is a success? What if they use the billions that they have in cash to make an acquisition? The stock will rally and I’ll feel stupid for missing it. Maybe I should wait.” RST falls a further 15%.

Why does Regret Aversion Matter?

Simply because every investment decision that we face carries the risk that regret aversion will lead us astray.

Investing involves making decisions about the future and with incomplete information. It requires making decisions in the face of uncertainty. In many cases, there is no way of finding out if the decision was correct until several years into the future. If that doesn’t sound like a breeding ground for regret aversion then I don’t know what does.

Every decision requires us to ask “what if?” In other words, it forces us to make comparisons.

We all get to see our mistakes in high-definition; thanks to real-time market pricing, performance surveys and monthly returns.

Regret aversion is one of the main causes of the disposition effect – the tendency to sell winners while holding onto losers.

We can’t avoid regret aversion entirely, but we can learn to manage it if we:

  • Make the right comparisons to help us draw the right conclusions
  • Allow it to motivate us to engage in deliberate practice (instead feeding regret aversion)

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