Are you resulting?
Decision making under certainty means that good decisions lead to good outcomes and bad decisions to bad outcomes. On the contrary, decision making under uncertainty means that both good and bad outcomes follow good decisions.
We all have a tendency to mix the quality of the outcome with the quality of the decision. When people are asked what their best and worst decisions were during the last 12 months, almost invariantly people will think of the best/worst outcomes.
In professional poker there is even a word for the phenomenon of mixing up the outcome with the decision, ‘resulting’. It refers to the mistake of changing strategy because a few hands do not turn out well in the short run.
Sounds familiar? In our business, resulting rear its ugly head through short term performance chasing, or mixing up luck with skill. There is a strong tendency by institutional investors to fire managers (or sell their funds) once they have underperformed the market over the last two to three years and replace them with funds or managers that recently outperformed. Whereas many of the best managers may well continue to win, as illustrated in the chart below, using three year performance as a criteria is simply a very bad decision rule. It is akin to say it is better to run red than green traffic lights because it worked so well for the last three crossings! Why waste the time waiting for the light to turn green?
Obviously this does not mean results do not matter. Performance can be a relevant yardstick to measure the quality of the investment decisions. However, it is imperative that it is used within its limitations.
Take the example of value investing. Let’s assume that we turn the clock back to December 2009. We want to invest with one of the best value managers in the world, Cheapskate Asset Management. The manager’s track record during the last 60 years is stellar, beating the S&P 500 index by 5.6% per year. Not only is the long term performance exceptional, with the exception of the dot-com bubble in 1990s, every decade was solid. Furthermore, we take particular comfort from the fact the noughties was the best of decade of them all. His strategy seems to work better than ever.
We felt really good about investing in the strategy. Not only was the long-term performance good, the manager was really at the top of his game having recently logged his best decade ever.
The chart below shows our experience since our investment. Cheapskate has delivered cumulative negative excess returns of nearly 20% since we invested more than eight years ago.
Does eight years of underperformance mean that Cheapskate has lost its mojo? Trouble is, the performance tells us little. A cumulative under performance of nearly 20% amounts to -2.2% per annum. As illustrated in the chart below (blue star), such performance is inside of what we should expect for the strategy. Investors using historical performance to determine the efficacy of the strategy would require negative excess returns of more than 15% to conclude something is wrong if their lookback period is only 12 months. With a 36 month evaluation period, negative annual excess return must be worse than 8.9% p.a. before it becomes a meaningful indicator that something is amiss.
This is the problem with using performance as a gauge of strategy efficacy, it takes long observation windows or extreme performance before it tells anything.
What can the capital owner do?
Two things:
Measuring/evaluating investment decisions / investment process. I.e. focus on what can be controlled by the investment manager, and what can be controlled by the capital owner. Be extreme careful with the hazard of resulting (buy high – sell low)
Diversify among multiple managers to make the risk easier to bear. Even the best managers have some difficult 5-year periods. As illustrated by the chart below from consultants Willis Towers Watson, even their top rated global managers can underperform the market by 6% per annum over five years. However, a portfolio of eight top rated managers provides the capital owner with sleep at night (note that top rated do not mean top performance, but a solid investment strategy and process)
Takeaway. Select managers that are using investment criteria you believe could work over time and are implemented in a process that ensures that the information inherent in the decision criteria are effectively captured in the portfolio. Hold between 6 and 8 active managers and rebalance them periodically to capture the diversification benefit. Don’t be a slave to short term performance.