What you are about to read is a rare occurrence in my industry. It will rub some of my peers the wrong way. Much like a magician who gives away how the elaborate guillotine illusion works, I won’t make friends with this article by uncovering the mystique of the investment illusion my industry relies on to sell you, the client. Regardless, it is a missive that should have been communicated from the industry long ago.
I’m a Portfolio Manager and have been for the majority of my working life. I’ve worked with thousands of clients, hundreds of financial planners and investment advisors. I have helped planners and advisors build investment solutions for their own business. I work to educate industry participants regarding the basic rules of portfolio construction and how to evaluate client circumstances to achieve fitting, appropriate, and regulatory suitable solutions.
As many critics have pointed out, the financial services industry has long been castigated for the way in which it markets and positions its services, extols the virtues of its expertise, and creates a perception among clients that its special brand of highly nuanced investment philosophy is obligatory and integral to the success of client investment goals. The arrogance of that statement stings – but it’s truly how many advisors within the industry try to convince clients to bring them their money.
Like everyone in my industry, we have to start somewhere. In many cases the genesis is a boardroom filled with other analysts, investment managers, portfolio managers sharing insights on companies and industries, or listening to others provide their conclusions on the merits of potential and current stocks and bonds. In contrast to this standard route to portfolio management, I started off facing clients across the table, trying to address their needs. Later, I transitioned to more of the heavy analysis, portfolio management, and money management role that I still pursue today.
As an aside, I think every analyst, portfolio manager, and investment manager could stand to learn a lot by starting out in front of clients – before they touch one spreadsheet, make one investment model, or pick one stock. They’d see first-hand how they’d have to answer to a client for lagging portfolio performance or a backfiring investment thesis. And they’d understand very quickly how this affects the trust built up in a client/advisor relationship – something that’s impossible to learn fiddling with algorithms while locked away in a room full of blinking screens.
I digress. In my case, I would sit there in these rarefied investment committee meetings, intently trying to hone my craft and gain perspective on how to analyze the next company or how I could approach profiling and validating an economic theme that would provide insight on how my clients should be invested. Essentially, the analytics is one part math and one part art when it comes to trying to interpret and extrapolate the data. Torture the data enough and frame it in a semi-logical story, and anyone could have heads around the table nodding in agreement that indeed one had singular insight.
Common phrases that you’d hear in these types of meetings include: “My presumption, based on the presentation was…” or “I interpreted management’s response as…” or “My hunch, after meeting with management was…” or “I consolidated these inferences and extrapolated….” These represent only a few examples, but their permutations are numerous. All are fraught with subjectivity, few could be tested in real time, and all take advantage of our innate human nature to trust those that can tell elaborate stories. Believe it or not, we’re prone to ascribe a higher level of expertise to people who communicate their rules-of-thumb decision making process in a complex, elaborate, nuanced way, no matter how subjective. Surprisingly, we do so even without evidence to support how successful that process is.
The influence of behavioural psychology
I point to Professor Alex Bavelas, a psychologist at MIT, who ran an experiment decades ago where two participants were shown pictures of healthy and sick cells. They were asked to identify those cells by learning through feedback given as they took the test.
Here’s the twist, one participant “A” was given correct feedback each time he guessed. As suspected, he got better and better at identifying those cells that were healthy and those that were sick – almost 80%. Subject “B” was given erroneous feedback based on subject “A’s” guesses. Needless to say there was no improvement in his being able to identify healthy or sick cells – which led to dismal success rate.
When both were asked for their heuristic models (their identified rules-of-thumb), participant “A” had simple rules, concrete and straight to the point. Participant “B” on the other hand had complex nuanced rules for identifying healthy and sick cells. Here’s the kicker, when the participants shared their rules with each other, participant “A” marveled at the genius of “B’s” complexity. In fact, participant “A” was so taken by “B’s” “brilliance” that the next time they took the test, participant “A” tried adopting the other’s heuristics for cell identification and did worse!
Participant “A” actually felt that his rules were naïve and simplistic. I encourage you to read more about Professor Alex Bavelas and his various studies regarding how we are influenced by the complexity of how information is relayed.
Why am I sharing this with you? It’s because my industry has caused you to buy into the concept that you have to send your money to grizzled old analysts and portfolio managers who have great stories about identifying stocks and investments, with elaborate models and subjective insight. We know now, however, in many instances this isn’t true.
Yes, but can they beat the index?
I can hear the collective deafening scoffs of portfolio managers and analysts across the country as they give retorts along the lines of: “What does he know? I’ve been doing this for decades…Look at this manager or that manager who prove otherwise. Investing is complex, and it’s nothing to be trifled with. You must know how the information is presented and model for those nuances.”
So friends, the next time you sit across from one of my learned analyst and portfolio manger brethren and they pooh-pooh the opinion I’ve shared with you, simply ask, “So how come the majority of you can’t beat an index?” Then wait and see if their answer is highly nuanced, complex, where outcomes are steeped in esoteric rules-of-thumb. If it is, you know where you stand.
Next time: Why simple, systematic, rules-based-investing makes sense and works. In future articles, I’m also going to dispel some of the stories (myths) my industry tells you in order to get you to believe what they are selling. Does this still leave room for detailed analysis? Absolutely. And I’ll explore when it works and when it is necessary.
Courtesy Fundata Canada Inc. © 2016. Mark Taucar, CFA, manages discretionary client assets through Bespoke Discretionary Service for Accilent Capital Management Inc. Securities mentioned are not guaranteed and carry risk of loss. This article is not intended as personalized investment advice.