Investing is about making correct and prudent decisions. The process and principles by which those decisions are made matter more than the decisions themselves. Similarly, understanding what drives outperformance matters more than the performance itself.
Confusing luck with skill is endemic in investing because the short term and the long term often diverge and investors tend to confuse frequency and severity. Short-term performance provides instant gratification and (false) validation, while underperformance, even for good reason (such as a manager being prudent), puts one on the defensive. Investors want to avoid pain at all cost, but successful investing often entails taking short-term pain for long-term gain.
The patient, contrarian investor prefers to lose the battle and win the war, while the short-term investor focuses on winning the battle even if it means losing the war.
Performance Evaluation Through a Different Lens
The stock market is my life. You’ve probably figured that out by now. People tell me that when I’m describing a stock I like or a company that has intrigued me, my eyes light up and I start talking faster. They mean it as a compliment—I think.
But I do realize that not everyone feels the same way. Not everyone thinks that digging up new market information that no one else has yet noticed is the greatest thrill in the world. They are quite happy putting their energy elsewhere and letting a professional make investment decisions for them. And that’s OK too.
Perhaps that describes you. If so, how do you know whether your fund manager is doing a good job? Or if you are at the stage of thinking about hiring one, how should you evaluate them and choose?
That is the heart of this chapter. Its mission is to give you perspective, through several lenses, on evaluating the performance of your money manager.
Statistics: What They Reveal Is Suggestive, But What They Conceal Is Vital1
In most areas of life, we tend to measure success statistically, whether it is a grade point average or gross revenues at the box office. So it seems logical to look at the past performance numbers of a money manager to assess how your investments are doing. In fact, historical performance remains the most important determinant of asset-allocation or manager-selection decisions. However, that would be no different than driving by looking in the rearview mirror instead of at the road ahead.
If you heard about an athlete who had won every major competition in a certain sport for several years in a row, you would conclude that he (or she) was a high performer with great skill. But several years later, if you learned that he had been taking steroids to boost his performance, you would have a vastly different view of his prowess. The same is true in money management: it is critical to understand not just the performance outcomes, but the performance drivers. Why is once again more important than what. In the fullness of time, more facts will emerge that put earlier facts in wider context, and you may end up forming a different conclusion.
“In money management: it is critical to understand not just the performance outcomes, but the performance drivers.”
Sometimes an athlete might perform well simply because of rookie luck or a home-court advantage. He may not be able to repeat that performance at different times or in different environments. The same is true of money managers. Were they smart, or just lucky? To answer that, you have to analyze multiple data points over many years in varying conditions. You also have to consider the planning and preparation that drove the outcome. In investing, skill is best assessed not just by looking at a performance track record, but by understanding the philosophy and process that underpin that performance. You also need to take into account the headwinds and tailwinds that might help or hurt over various time periods. Differently put, performance must be judged in context and over an extended period, not in isolation or in short intervals.
Luck or Skill: A Bad Manager Having a Good Time, or a Good Manager Having a Bad Time?
In the early to mid-2000s, buying real estate in America was widely considered a surefire way to make money. Cocktail party conversation inevitably turned to home renovations. HGTV became one of the most popular TV channels. Sprucing up your house, or buying a vacation home, became the national pastime. The fast money went a step further: not only owning real estate but flipping it. Before long, the average person on the street thought they could moonlight as real estate investors and strike it rich. In fact, you felt like a sap if you did not get on the bandwagon.
Between 2001 and 2007, anyone who owned real estate looked smart, and those who did not (such as me) looked dumb. We know how that turned out. People who sat out the bubble were ultimately proven smart as they picked up bargains when home prices fell precipitously.
My decision not to own real estate stocks from 2001 to 2007 would eventually prove smart, but at the time I looked very foolish. To make matters worse, I got unlucky. I happened to own reinsurance stocks when a “1 in 150 years” event unexpectedly occurred in 2005—a record-breaking hurricane season, including notable storms such as Dennis, Elma, Wilma, Katrina, and Rita. In addition to the tragic loss of life, the hurricanes caused catastrophic and costly damage (the highest on record at the time), resulting in many billions of dollars’ worth of insurance claims on Swiss Re and Munich Re, whose stocks I owned.
These two unrelated investment decisions—being underweight in real estate and overweight in reinsurers—conspired to make my short-term performance look unbelievably bad. Eventually my performance did turn around, but it took several years. In the intervening period, I was pegged as unskilled, even though I was just unlucky.
On the other hand, many of my competitors owned both real estate and refinery stocks in their portfolios and did very well, not because they had the foresight to know that the hurricanes would cause many refineries along the Gulf of Mexico to shut down and create temporary shortages, but because they happened to be in the right place at the right time. As those stocks went up, they looked skilled, even though they were just lucky. An untimely confluence of unpredictable disasters and uncorrelated developments meant that my performance record took a big hit.
In investing, unexpected stuff happens—the proverbial unknown unknowns. No amount of fundamental research could have uncovered those outcomes. But what happened next was in my opinion a function of skill, not luck.
My research told me that after every catastrophic natural disaster, the reinsurers would initially suffer but eventually benefit, because they would be able to raise prices substantially in the next renewal season. I doubled up on my reinsurance stocks as they fell and enjoyed the gains that followed a few years later when their stocks rose. My other decision—to not own real estate—also paid off several years later when the housing boom turned into a bust. Both these non-consensus calls eventually contributed to my better performance numbers, when measured against the benchmark and my peers, but in the meantime my record suffered.
In the short run, luck can hurt or help a manager’s performance. In the long run, skill tends to drives performance. This can be true for markets as well—in the short run they can be lucky or unlucky due to noise, newsflow or need, but in the long run, fundamentals are likely to prevail. For example, during 2013, Mexican stocks suffered collateral damage from a financial and political crisis in Brazil and declined by almost 20 percent, which is bear-market territory. Emerging-market managers sold Mexican stocks simply because of their need to raise cash to meet redemptions; it was Mexico’s bad luck to be in the wrong place at the wrong time. This correction represented volatility, not risk, because the price action was driven by flows not fundamentals. Recall from chapter 3 that volatility can be an opportunity instead of a threat. Mexican stocks were providing potential investment bargains to contrarians who could stomach the temporary sell-off.
However, buying when everyone else is selling is painful because a falling stock hurts a manager’s performance in the short run. You look dumb even though you are being smart. On the other hand, buying into a rising market makes you look smart for a while, even though you are being dumb. Looking smart or dumb versus being smart or dumb makes a world of a difference in investing. And the same goes for looking at annual versus annualized performance, which is the topic of the next section.
Lose the Battle to Win the War: Consistent Returns Come at the Expense of High Returns
We saw in chapter 6 that severity (order of magnitude) matters more than frequency (which is just another word for consistency). A money manager can underperform more than half the time and still deliver superior performance over time. Yet, investors continue to mistakenly focus on batting averages, which are a measure of frequency, not severity. In investing, you can lose many battles and still win the war. In fact, you often need to.
“In investing, you can lose many battles and still win the war. In fact, you often need to.”
Let’s revisit the the performance table of the hypothetical risk aware active manager in chapter 6. Even though the hypothetical portfolio underperformed in six out of ten calendar years, its cumulative performance over the decade still beat the benchmark by a wide margin, with annualized returns of 8 percent versus 4 percent. A few things to note here: First, the risk-aware actively managed portfolio does not deliver outperformance every year (annually), just over time (annualized). Second, it is important to look at performance data in terms of “growth of a $100” investment, which reflects absolute returns over time in addition to relative returns annually; Third, by itself, underperformance in any given period is meaningless. The money manager may be avoiding popular but expensive stocks and owning unpopular stocks with more compelling values. Understanding why your manager is underperforming is more important than the frequency or degree of underperformance.
In investing, you can lose many battles and yet win the war. The key is to understand the difference between annualized and annual returns: Expecting high returns or outperformance every single year is wishful thinking and dooms you to disappointment. This is because persistent alpha (risk-adjusted returns relative to a benchmark) is rarely consistent (year in and year out), and consistent alpha is rarely persistent. In fact, as far as I know, only one money manager even pretended to deliver this fairy tale, a fellow named Bernie Madoff. And you know what happened to him—he went to prison for defrauding investors. This anecdote should make clear how impossible it is to constantly deliver both superior annual and annualized performance—one often comes at the expense of the other.
Consider another example. In the long run, small-cap stocks have delivered higher returns than large caps, but they rarely do that consistently (aka annually). In fact, in many years, large caps will outperform small caps. That does not mean small caps cannot deliver higher annualized returns over time; they simply may not do so annually.
This is true of most performance numbers; short-term and long-term outcomes may diverge a lot. In fact, it is fairly typical for the vast majority of top-performing managers over a ten-year period to have three straight years of underperformance. My own experience corresponds to this. Even Warren Buffett, the best money manager of all time, has underperformed from time to time. As he puts it, “We are happy to sacrifice a smooth 12 percent for a lumpy 15 percent.” Compounding of capital is a long-term game. Lumpy but higher is better than linear but lower.
Astute money managers know that consistent returns can come at the expense of high returns. You should realize it too. In fact, I would go as far as to say that if your portfolio manager is not underperforming with some frequency, you might want to question whether such performance is sustainable.
Think of investing as a marathon, not a sprint. If you try to win every lap, you are likely to lose. Unfortunately, most investors think investing is a sprint, a test of speed instead of stamina. So they measure the wrong thing: how their manager is performing every quarter or calendar year, rather than in the fullness of time. This creates pressure on their money manager to not lose out in the short run. The cheapest trick in the book to achieve good short-term performance is by chasing momentum, owning whatever is in vogue at the moment, a subterfuge that enables a money manager to show consistency even if it is at the expense of persistency.
But chasing momentum is nothing other than following the herd. By the time you discover that your money manager’s investment process was no more than a case of the blind leading the blind—which is what herd investing is—you have lost both your money and your mojo. Better not to put yourself in such an awkward position in the first place. Stop measuring and incentivizing short-term performance results. It results in unintended and perverse consequences, where consistency is prioritized over longevity and returns are prioritized over risk.
Investing is an Endurance Test, Not an Endearment Test
It was December 1995. I had just joined the multi-billion-dollar money manager Oppenheimer Capital in New York as an Asian-equities analyst and portfolio manager. Back then, Asian stocks were all the rage. Global investors were enamored with the region and clamored to have more exposure in their portfolios. It was the classic crowded trade filled with confirmation bias: nobody looked for what could go wrong; everyone focused on what could go right. And their unbridled optimism had plenty of company. Experts from the International Monetary Fund, the central banks, and the credit rating agencies were falling over each other to compliment the local governments and regulatory bodies for their success while simultaneously and self-servingly taking credit for it, as if their economic and monetary policies had led to the spectacular growth rates and market performance. The media fed this frenzy of good news, and everyone was palpably cheerful and confident. Nobody dared to question let alone look for evidence that contradicted those expert assertions, which were passing off as truth. The worst part was, even though investors were clueless and unprepared for the brewing storm, they felt as if they were “in the know” because they were engulfed by glowing headlines in newspapers and ebullient predictions on TV by experts who were telling them all was well.
Amid all this, I stood out like a sore thumb because I saw things very differently. My due diligence suggested that the heady growth rates were the result not of sound economic policies but of unsound lending practices. I foresaw that a debt-fueled binge would unravel badly and cause a lot of losses in its wake. Where others saw an Asian miracle, I saw an Asian mirage. My research led me to be prudent and own utilities while my peers chose to be profligate and owned banks. I paid the price for this non-consensus positioning by underperforming.
While I was looking out for my clients’ long-term best interests, they thought I was hurting their pocketbook. Even in internal investment-committee meetings, my colleagues and fellow portfolio managers were getting frustrated with me. Not only was I not giving them ideas to buy in Asia, I kept hammering home reasons to sell. Out there in the real world, they were hearing an entirely different story, and it was hard for them to support me, let alone sympathize.
As days turned into weeks and months into quarters and then years, I felt tormented. Even though I knew I was doing the right thing, if I was not proven right soon, I could lose my job. And that would mean losing my ability to stay in the United States because I was on a work visa. I sometimes wondered which would crash first: my dream to prove myself on Wall Street or Asian stocks. It would have been convenient to fold, especially when I had a lot on the line—not just unemployment, but deportation.
I knew Asian stocks (and banks in particular) were risky and overvalued, so I did not invest in them. But while those stocks were going up, my colleagues and clients felt I was letting them down. I found myself in a quandary of “failing” them or “cheating” them. I chose to “fail”. My performance stank because I prioritized risk management over return management. I had no doubt it was the right thing, but I paid a steep price.
Recall from chapter 6 that the cost of risk management is incurred in the present, but the benefits are secured in the future. The result is that many money managers sacrifice risk management at the altar of return management. This risk-taking behavior is often unknowingly and unwittingly blessed and incentivized by the very clients whom it ultimately hurts. This is what played out during the Asian bull market. The money managers who chased momentum and stock-market favorites looked like geniuses, even though they were taking remarkably high risk, while managers who were prudently sitting out the fads underperformed and underwhelmed.
Naturally, I was ostracized while my peers were feted. They received accolades and assets while I struggled to secure credibility, let alone clients.
Finally, on July 2, 1997, the tables turned. The Thai baht halved against the dollar, crashing from ฿26 to ฿54 in a matter of months, setting off a firestorm of currency devaluations around the region. Surprise turned to shock and then full-blown panic. Investors who had vied to get in now rushed to get out. Asian markets and currencies fell like dominoes. Governments were toppled. Crony capitalism and corrupt practices were exposed. Widespread defaults and layoffs occurred. Suddenly and sadly, the region that could do no wrong became the region that could do no right.
The rest is history. I went from being zero to hero inside my firm. Not only was I not fired, I was promoted. Clients and money soon followed.
“What Matters May Not Be Measured and What Is Measured May Not Matter.” (Albert Einstein)
If you measured a five-star chef on speed of service instead of quality of food, he would probably flunk. Likewise, if you tasted gourmet food before it was ready, it would taste awful, even if the finest-quality ingredients were used. Measuring the wrong thing or over the wrong time frame risks yielding an erroneous conclusion. Despite this, human beings feel obliged to measure progress and performance along preset timelines.
In investing, the danger here is twofold. Managers know their clients require performance reports at preset periods, such as quarterly or yearly, so they oblige by delivering what is undeniably short-term information. What is worse, they make decisions specifically designed to give good results in that time frame. In other words, they manage to those preset periods, knowing they will be measured on them. This reinforces the bad habit of measuring what does not matter (short-term data) and not measuring what does (process and prowess). If you meticulously monitor your portfolio’s performance at short intervals, you run the risk of losing sight of the endgame, which is to compound capital in the long run.
Worse still, frequent measurement of performance is not only futile, it actually proves counterproductive. This is because investors tend to feel losses more intensely than gains of the same magnitude. The more often they look at performance numbers, the greater the emotional cost over time, and the more likely they are to act on those emotions rather than resist them. The result is that investors experience worse returns than the market averages because they make buy/sell or hire/fire decisions based on recent—and misleading—performance.
Manage Expectations: No Pain, No Gain
The ideal scenario is a money manager who has built an investor base with a common investment philosophy, time horizon, resolve, and tolerance for underperformance. Only then can a manager maintain the stable capital base required to see his contrarian philosophy through to a successful conclusion. Unfortunately, many investors want instant (and constant) gratification, so their financial adviser may feel compelled to serve up the fast-food equivalent instead of offering the choice of fine dining. We know that fast food is comfort food; it feels very satisfying when you are hungry. But indulging in short-term quick fixes to ease your hunger comes at a very steep cost: it jeopardizes your long-term health. Also, you miss out on a wonderful experience and the satisfaction that comes from enjoying a gourmet meal. In life, you have learned the importance of good eating choices. The same principle applies to investing choices. Superior short-term numbers may be easy to serve up and comforting to digest but will likely prove injurious to your long-term wealth.
This is about managing expectations rather than managing money. Most people know it takes far more time to prepare a gourmet meal than fast food, so they are willing to wait patiently for their meal with positive anticipation. However, if the fine dining restaurantdid not tell them at the outset that the meal would take time, they would soon complain, and perhaps rush to a fast-food restaurant that would quell their hunger (but not satisfy their appetite).
No one would insist that a chef prepare a sixty-minute dish in thirty minutes. It’s equally foolish to insist that a money manager deliver good results in a short time frame. In my view, managing expectations about performance is better than managing performance on a short leash.
Balanced Scorecard: Assess Prudence and Prowess Instead of Performance
Often, the challenge for individual investors or their fiduciaries is the inability to assess whether a good money manager is experiencing a bad time, or a bad money manager is experiencing a good time. If you are not supposed to judge prematurely, how do you conduct evaluations in the intervening periods? After all, the long term is a series of short terms.
The correct approach to evaluating performance is in a multifaceted way, using a balanced scorecard. Here is a framework to consider:
1. Look at performance over a long time frame, such as a full market cycle that comprises both bull and bear markets. Short-term performance numbers contain a lot of noise and therefore have limited power to predict a manager’s skill. In his book Active Portfolio Management, published in 1995, Ronald Kahn demonstrated through a series of equations that it takes sixteen years’ worth of performance data to prove skill over luck with a high degree (95 percent) of statistical confidence. To evaluate a strategy or manager, it is important to look at long-term performance data spanning not just years but several cycles of bull and bear markets.2
2. Look at performance in absolute dollar terms as growth of a $100 investment (as shown in table 6.1), not just relative returns every calendar year.
3. Understand the context of the performance data, not just the content. Were there tailwinds or headwinds that helped or hurt performance? Did elements of good or bad luck play a role? Luck equals things that could not have been foreseen; skill equals predictable performance outcomes under certain conditions.
4. Why a strategy is performing is more important than knowing what its performance is. Look at performance attribution data (this is an analytical report that deconstructs the drivers of performance), not just raw performance numbers. Your goal is to analyze what contributed to or detracted from the performance. Was it driven by factors within the manager’s control, such as his/her stock theses playing out, or did some unexpected externality influence results?
5. Evaluate whether the performance attribution is broad based, with many small things contributing, or whether it came from one big call. My preference is for performance to be driven by multiple, independent theses working out over time, not a single stock or theme driving the numbers, as that tends to be less repeatable.
6. Do not simply analyze the returns; analyze the risks taken to achieve them. In particular, check if leverage has been deployed to juice up returns. Sometimes higher returns may be a function of higher risks assumed. This reflects aggression, not skill. You may recall from chapter 6 that a significant portion of the returns of private equity came from loading portfolio holdings with debt, which is a risky way to generate them. Look at risk-adjusted returns, not returns alone.
7. Look at performance metrics such as Jensen’s alpha, appraisal ratio, and upside and downside capture ratio.3 Many independent, third party databases provide such data. Looking at a multitude of metrics and ratios helps provide a more holistic understanding of the drivers of performance.
To assess process, make a concerted effort to understand why the manager’s investment approach should work in long run. Ask the following questions:
• What market inefficiency is the strategy trying to exploit (understand the investment philosophy and approach)?
• What skill is being brought to bear to uncover and arbitrage this inefficiency (consider the training and experience of the practitioners)?
• How long will it work? This is about repeatability: will it stand the test of time, or is it a fluke?
• How much will it work? This is about scalability: will it deliver the same results at higher levels of investment, or is it capped by size?
• Where will it work? Is it limited by factors of geography, certain sectors, etc.?
Finally, I would not ignore the soft skills. Investing is as much about stomach as it is about smarts. I prefer money managers who have a track record of staring temptation, fear, and contempt in the eye and not capitulating for short-term gain. I would also seek managers who have been baptized in the school of hard knocks and not given in or given up. It takes character and fortitude, not just caliber and intellect, to succeed in this profession.
I think it is clear from the above discussion that there is no shortcut to assessing performance—it is a multidimensional exercise that requires looking at a lot of numbers but also the narrative behind those numbers. Look at the hard facts but don’t ignore the soft factors.
Understand Potential for Future Returns; Do Not Invest Based on Past Performance
In chapter 4, we learned how to distinguish a genuine investment management strategy from a gimmicky asset-gathering strategy. Often, strategies appear compelling because they are easy to explain and understand, not because they are sound or effective in practice. When launching a new product, it has become easy to impress investors with back-testing statistics that predict high performance potential. That kind of statistical evidence can seem very convincing but be careful. It may be none other than fanciful data mining that fails in practice because implementation costs are too high, or the targeted inefficiency is so small that it is unlikely to produce any meaningful returns. Evaluating skills and capability has predictive power; looking at historical performance does not. Sadly, data, however misleading, wields more power because it is tangible to look at, while skill is hard to figure out. But easy does not equal right.
In the 1990s, hedge funds reported spectacular returns, and many people piled in, seduced by the compelling performance data. Few tried to understand why these funds were performing so well. It turns out that most were leveraged long-only funds: their investment portfolios were augmented with borrowed money to lever up their assets and returns. Leverage turbocharges performance in a bull market but decimates it in a bear market. Instead of figuring out whether those managers had good skills in shorting, which would enable them to perform in bear and bull markets, investors simply looked at performance data to make their decisions.
“Often, strategies appear compelling because they are easy to explain and understand, not because they are sound or effective in practice.”
A decade later, the hitherto terrific performance had turned terrible, and investors realized they were paying high fees for less than stellar skill. Since the issue of skill had never been evaluated (but assumed based on performance data), the only thing left to do was to bail at the first sign of trouble. This is neither smart nor responsible. It is easier to blame the hedge fund managers than to take responsibility for failure to ask the right questions. It is your responsibility to evaluate performance drivers using the framework provided earlier.
Sadly, instead of learning from their mistakes of the past, many investors are making new ones in the present. Their asset-allocation decisions are driven by their need for and assumption of a certain level of actuarial returns based on past performance, rather than the potential for achieving those returns, especially net of costs and fees.
In my view, the recent trend toward allocating to private equity, junk bonds, and passive are glaring examples of this. These three decisions are risky and also highly correlated, although few view them through that lens. Here are the common denominators from my vantage point:
1. They show classic signs of being crowded trades, but investors looking at their high historical performance find it easy to justify their allocation decisions (even though it is common knowledge that past performance is no guarantee of future results).
2. They have benefited from low interest rates and quantitative easing (QE: loose monetary policy by central banks, which boosts the appetite for and price of risky assets) and are likely to suffer when QE is unwound. Private equity has used low-cost loans to lever up their portfolio companies. Junk bonds have benefited from investor appetite for high yield which in turn has reduced the margin of safety with respect to future default risk. Passive has turned into an “all night long” momentum party where nobody questions whether what it owns is overvalued or undervalued, so long as it is delivering high absolute returns.
3. Their sales pitch tends to focus on a single metric to the exclusion of other equally important considerations. Private equity talks up its lack of correlation to other asset classes. Junk bonds flatteringly rechristen themselves as “high yield.” Passive draws attention to its low costs.
4. They have large and growing risks (as described in earlier chapters), but since they have not materialized, they get a free pass (Recall from chapter 6 that investors overlook risk exposure and overly anchor on risk experience).
5. They are likely to have disappointing future returns compared to their past, given their high valuations. (This is my research opinion—I could be wrong).
Recall from chapter 9 that we humans are reductionists by nature. We want to simplify things to the point of zeroing on one thing at the expense of everything else. Such blind spots introduce risks. In forming any assessments, one should be balanced and weigh the positives and negatives, the upside as well as the downside. I am not arguing these asset classes may be wrong investment choices for you or forever, I am simply saying you should make well-informed decisions and consider their risks as much as their returns.
The one question that should be asked before making any asset-allocation decision is this: Based on available value spreads, what are future returns likely to be? Future returns are predominantly determined by whether the asset class is under or overvalued. Unfortunately, despite the SEC’s familiar and very clear warning, “past performance is no guarantee of future returns,” most investors still extrapolate past high returns and believe they can reliably generate them in the future. This is a risky assumption to make; there are no guarantees in investing. Assuming a high return in theory does not mean it will be generated in practice. In fact, the opposite is more likely. After a prolonged period of high returns, typically low returns set in. Bull markets tend to become both crowded (everyone wants to get in on the action) and overvalued. To restore efficiency, markets undergo corrections to wipe out such overvaluation. Unfortunately, markets can overshoot, and the sell-off can be larger and longer than warranted, to the point of correcting so much that stocks become undervalued instead of fairly valued. This pendulum swing from overvalued to undervalued and from crowded trade to lonely trade presents advantageous opportunities for the contrarian investor.
However, exactly when the opportunity to make money is highest, investor interest is lowest. An out-of-favor asset class, sector, geography, or stock offers rich pickings for those who are willing to be contrarian. But contrarians tend to be in short supply (read the next chapter to understand why). Instead of availing themselves of contrarian opportunities and stepping away from the herd, investors gravitate toward it, and the vicious cycle of prioritizing consistency over longevity, returns over risk, and short-term over long-term continues. Your investment portfolio should try to take advantage of such greed/fear pendulum swings by allocating countercyclically instead of procyclically. One leading indicator of excess is when a lot of new products or funds are being launched in a given category or sector. They are usually asset-gathering strategies pandering to investor appetite, instead of investment strategies with genuine return potential. I covered this in more detail in chapter 4.
Optimize, Do Not Maximize: Practice Prudence Over Profligacy
Some investors want to pounce and go all in at the lows and all out at the highs. This may sound like a great idea in theory, but it is impossible to execute consistently. After all, we only know the highs and lows of a stock in hindsight, making such market timing a fool’s errand. The art of building a position and gaining exposure to your desired investment ideas and subsequently exiting them when your theses have worked out (referred to as portfolio construction) is about optimizing, not maximizing. The goal is not to bottom tick or top tick a stock. The idea is to capture the “meat of the trade” by generally buying closer to the lows than the highs. To ensure the juice is worth the squeeze, your investment idea must possess a large difference between where you accumulate and where you pare back, to have both a reasonable margin of safety and a decent margin of upside. In other words, there must be a large value spread to exploit between your view and what is priced in by the consensus.
The principle of optimizing instead of maximizing also applies to portfolio construction, where you must own neither too many stocks nor too few. Owning too many stocks results in an active manager turning passive, mimicking the benchmark instead of differentiating from it. Owning too few stocks makes a portfolio quite risky as it does not possess adequate diversification.
So how do you both concentrate and diversify your portfolio? This may sound like an oxymoron, but it is not. The key is knowing that what you leave out of your portfolio is as important as what you put in. Active investing is not about owning everything in the benchmark (that is passive’s prerogative and obligation), but about knowing what not to own.
It is also about doing your homework and being very discerning. If you can only send twelve men to the moon, you will be incredibly careful about which twelve you choose. Likewise, in investing you can choose from thousands of stocks around the world, but you must choose only the very few that will do better than the rest. This scarcity/abundance paradox—you can choose from a lot, but you must only choose a few—is key to successful active management and portfolio construction. For this, we need to apply the lessons learned in chapter 6: rejecting low-quality businesses is as important as selecting high-quality ones, because it is the weakest links that break the chain. Also, to reduce concentration risk, individual investment ideas and theses should be uncorrelated as far as possible.
Do Not Judge a Book by Its Cover
When an athlete takes shortcuts by consuming steroids, this can pay off temporarily but proves costly and risky eventually, not just to the athlete but to the sport itself, as spectators and sponsors lose trust. In investing as in sports, winning at any cost or through any means is in my opinion a form of fraud, not a feat. In investing, it is better to choose a money manager who looks foolish but is being smart, who prefers to “fail” rather than to “cheat”, and who may disappoint you in the short run but will impress you in the long run, rather than the other way around.
Finally, for investment success, it is not just your manager’s discipline that matters. Your discipline matters too. Both parties need to:
a. Practice patience (endure short-term pain for long-term gain).
b. Possess perspective (recognize that a lumpy 15 percent is better than a smooth 12 percent).
c. Exercise prudence (not sacrifice risk management on the altar of return management).
Last but not least, humans are programmed for survival and gut reactions, not soul-searching or delayed gratification. Our mind and body prioritize the short term over the long term because if one is dead, the long term does not matter. However, most investment decisions are not about survival or life or death, and our instinctive fight-or-flight response proves counterproductive. With practice and persistence, these factory settings can be reset, and practitioners like me have spent a lifetime doing this. However, if this is not your forte or desire, you can still enjoy the fruits of patience and prudence. Simply outsource your investing needs to the right professionals who have mastered this discipline, and go about your business.
Top Takeaways
1. Do not confuse performance with prowess. It may simply be a function of being in the right place at the right time. In the short run, it is hard to distinguish skill from luck or aggression.
2. Premature judgment is likely to be erroneous judgment. Wrong behaviors are incentivized, and right behaviors are disincentivized.
3. What matters may not be measured and what is measured may not matter.
4. A money manager can have a poor batting average (annual outperformance) yet outperform on an annualized basis over a full market cycle. It is not uncommon for even top performing managers, to have three straight years of underperformance over a ten year period.
5. High returns and consistent returns are typically mutually exclusive. Lose the battle of chasing consistent returns in the short term and win the war of generating higher returns in the long term.