By Robert G. Hagstrom, CFA
The Logic of Investment Failure
At the beginning of each new year, financial advisers and their clients step back and evaluate the performance of portfolio managers. Statements tally the percentage return of different strategies compared to relative benchmarks. Those that outperformed are ranked at the top, while those that underperformed sit at the bottom.
The science of evaluating portfolio managers and then determining who to keep and who to send packing is straightforward - or so you would think. But the evidence remains financial advisers and their clients continue to make the same decision mistakes over and over.
Generally speaking, we know those portfolio managers who post top-decile performance in one-year rarely repeat, while those at the bottom of the decile often rebound with better future results. However, there are instances when some poor-performing portfolio managers remain subpar, thus reminding us all that “polling does not replace thinking,” as Warren Buffett quipped.
Since performance results - outcomes - of top-performing portfolio managers vary from time to time, it is well understood that those in charge of selecting managers gain better insights by analyzing their process. If a portfolio manager continues to implement the same process that produced the results that attracted the decision maker in the first place, logic should dictate no changes are necessary. But, of course, in financial markets, logic does not always prevail.
Truth be told, decision-makers who are charged with selecting portfolio managers do care about outcomes, as they should. But far too often, decision-makers become obsessed in their quest for superior returns each and every year. In doing so, they place outcomes above processes, which inevitably leads to problems down the road.
Once decision-makers allow short-term outcomes to become paramount in how they think about managers, they inevitably place their portfolios in harm’s way. Becoming a performance chaser leads to buying a strategy only after it works and avoiding strategies that have lagged. In the investment world, buying only the short-term winners seldom works over the long term.
The slippery slope of only selecting portfolio managers with good short-term outcomes often means decision-makers lack a good understanding of the process that drove the results. We know there are instances when a bad process can lead to a good short-term outcome. But any thoughtful person would instantly recognize this was nothing but “dumb luck.” Conversely, we know there are occasions when a good process can lead to bad short-term results.
So, how should decision-makers ultimately position themselves to think about manager selection?
- Recognize investing is a probabilistic exercise. And with any probabilistic situation, success requires developing a disciplined process.
- Acknowledge that an excellent process will yield bad results some of the time.
- The best practitioners in all probabilistic fields not only focus on process but appreciate the role time has in delivering outcomes.
Robert Rubin, the former US Treasury Secretary, said it best:
“Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful. But, over time, more thoughtful decision-making will lead to better results, and more thoughtful decision-making can be encouraged by evaluating on how well they were made rather than an outcome.”
Evaluating good investment performance is not just tabulating outcomes but understanding how a portfolio manager‘s process ultimately delivers the long-term results clients seek.
By focusing exclusively on short-term outcomes, investors are ultimately led astray.
This, we believe, is one of the principal reasons why so many individuals are unsuccessful investors.
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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