Behavioural OversightRujuta Tamhankar
Anand Sridharan reminds investors that it is unfair to blame a fund manager for something that he/she doesn’t control (i.e. timing & quantum of flows in & out of fund). However, behaviour gap is real and hurts the average equity investor quite badly. Poor returns to the average investor are rooted in the following:
- Every investing strategy experiences (cleverly hidden) cycles
- Size is enemy of returns
- Substantial money tends to pile into a fund/strategy late in an upcycle
- Human nature and institutional (mis) behaviour exacerbate the above
Investing strategies witness headwinds & tailwinds –Odds are that valuation will be a headwind over next 15 years. As a corollary, future returns will be worse than past. Only question is by how much. Without experiencing an inevitable downcycle for my approach, I cannot eliminate the possibility that I’m just a lucky idiot with a hot hand. Headwinds and tailwinds are often cleverly hidden and can only be deciphered with hindsight after an entire cycle. This is why the #1 criterion for judging an investor is longevity, not quantum, of outperformance. Decades, not years, are required to separate skill from luck.
Size is gravity for returns– Investing strategies don’t scale well, especially when inflows lead to step jumps in fund-size. Factors such as ability to build positions, liquidity, inefficiency or impact cost are very different at $ 1 billion AUM than at $100 million. The only peer-group at that size (pension & sovereign-wealth funds) has delivered single-digit long-term returns. Headlined time-weighted returns usually mix up big returns with small money followed by small returns with big money.
We’re suckers for extrapolating recency– Predictions of asset or commodity prices are severely biased by recent movements. Naturally, those selling funds for a commission pile onto this ride as it’s easier to palm off whatever’s hot. Everyone, fund managers included, starts believing in permanence of recent success. Topical nonsense (e.g. valuation doesn’t matter, this time is different) is extrapolated as timeless wisdom. Between misplaced expectations, inherent mean-reversion of any hot-hand strategy and size-effect, majority of inflows are set up for disappointment.
System doesn’t help investors’ cause one bit– Self-delusional fund managers on premature victory laps. Intermediaries’ mis-selling products with ridiculous return promises. Investors not learning from history. Media cheerleading instead of cautioning. Disregard for fundamentals/valuations being rationalized as new normal. What a fund manager does when one’s strategy stops working is the acid test of investing.
Anand Sridharan concludes that aforementioned factors aren’t independent and feed on each other in unknown ways. What can a retail investor in institutionally managed funds do? Ideally, stick to systematic investment in passive index funds.
Source: Buggy humans in a messy world by Anand Shridharan
Asset Multiplier comments:
- It is difficult to distinguish the exact role of luck in successful trades or decisions, especially in the near term. As a result, performance of a stock or fund should be assessed over a longer period of time rather than the quantum of performance.
- Humans are hardwired to place huge importance on recent occurrences than on earlier events. Just because a fund has a track record of outperformance does not guarantee that it will continue to outperform in the future.
- When it comes to active funds, the only thing that can support an average investor is a suspicious, buyer-beware attitude.
- One of the most significant impacts in stock markets is the behaviour gap, which is the difference between the rates of return that investments create when an investor makes rational choices and the rates of return that investors actually get when they make emotional judgments.
Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”