Sarnia Asset Management

Investors always need to be on the lookout for any shortcomings in their fund managers that could negatively impact their investment performance.

Helpfully, a great missive was published on this whole topic by James Montier during his time at Dresdner Kleinwort Wasserstein back in 2005. You can read the full piece here, but we’ve also summarised it in this article for our readers.

Sin 1: Placing forecasting at the heart of the investment process (Pride)

Given investors are pretty hopeless at forecasting, they should not place much emphasis on it.

“An enormous amount of evidence suggests that we simply can’t forecast. The core root of this inability to forecast seems to lie in the fact that we all seem to be over-optimistic and over-confident. For instance, we’ve found that around 75% of fund managers think they are above average at their jobs! It doesn’t matter whether it is forecasting bonds, equities, earnings or pretty much anything else, we are simply far too sure about our ability to forecast the future.”

Sin 2: The illusion of knowledge (Gluttony)

The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

“All too often it seems that we thirst for more and more information. Investors appear to believe that they need to know more than everyone else in order to outperform. This belief actually stems from an efficient markets view of the world. If markets are efficient, then the only way they can be beaten is by knowing something that everyone else doesn’t know i.e. knowing more information or knowing the future. So it is all the more paradoxical to find fund managers regularly displaying such a belief.”

Sin 3: Meeting companies (Lust)

Most of the time these meetings are mutual love-ins and investors’ ability to spot deception is generally also very poor.

“There are at least five psychological hurdles that must be over-come if meeting companies is to add value to an investment process. Firstly, is the point just made above. More information isn’t better information, so why join the futile quest for an informational edge that probably doesn’t exist? Secondly, corporate managers are just like the rest of us. They tend to suffer from cognitive illusions, so their views are likely to be highly biased. Thirdly, we all tend to suffer from confirmatory bias – that is a habit of looking for information that agrees with us. So rather than asking lots of hard questions that test our base case, we tend to ask nice leading questions that generate the answers we want to hear. Fourthly, we have an innate tendency to obey figures of authority. Since company managers have generally reached the pinnacle of their profession, it is easy to envisage situations where analysts and fund managers find themselves effectively over-awed.”

Sin 4: Thinking you can out-smart everyone else (Envy)

The most common behavioural traits of over-optimism and over-confidence are what lead money managers to believe that they can out-smart everyone else which seems to be remarkably hubristic.

“The pressure to perform on a month-by-month basis is driving professional investors to prolong their exposure to a risky situation. As Keynes noted “It makes a vast difference to an investment market whether or not they predominate in their influence.” Because of this pressure to perform on all time horizons, they are being forced to rely on their ability to time this market to perfection. However, not everyone can get out at the top. Inevitably, some will be crushed under foot in the rush for the exit.”

Sin 5: Short time horizons and overtrading (Avarice)

Because so many investors end up confusing noise with news, and trying to out-smart each other, they end up with ridiculously short time horizons and overtrade as a consequence. This has nothing to do with investment, it is speculation, pure and simple.

“Short time horizon performance measurement leads to closet indexing. Fund managers are often rewarded with respect to assets under management. Hence they will try maximising those assets. Retention is usually therefore the end objective. The easiest way of losing funds under management is to underperform. The easiest way of avoiding underperformance is to track your benchmark.”

Sin 6: Believing everything you read (Sloth)

Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) story.

“We all love a story. Stock brokers spin stories which act like sirens drawing investors onto the rocks. More often than not these stories hold out the hope of growth, and investors find the allure of growth almost irresistible. The only snag is that all too often that growth fails to materialise.

Sadly, we appear to be hard-wired to accept stories at face value. In fact, evidence suggests that in order to understand something we have to believe it first. Then, if we are lucky, we might engage in an evaluative process. Even the most ridiculous of excuses/stories is enough to get results.”

Sin 7: Group-based decisions (Wrath)

Far from offsetting each other’s biases, groups usually end up amplifying them. Groups tend to reduce the variance of opinions, and lead members to have more confidence in their decisions after group discussions (without improving accuracy).

“Unfortunately, social psychologists have spent most of the last 30 years showing that groups’ decisions are amongst the worst decisions ever made. Far from offsetting each others biases, groups usually end up amplifying them! Groups tend to reduce the variance of opinions, and lead members to have more confidence in their decisions after group discussions (without improving accuracy). They also tend to be very bad at uncovering hidden information. Indeed, members of groups frequently enjoy enhanced competency and credibility in the eyes of their peers if they provide information that is consistent with the group view. So using groups as the basis of asset allocation or stock selection seems to be yet another self imposed handicap on performance.”

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.