Performance Chasing Bias
Humans are (unfortunately) hard-wired to attempt in keeping up with the "Joneses." This causes us to admire that new dress, lust after that new car, or drool over those seemingly perfect images from their recent dream vacation posted on social media. Not only is this bad for our emotional health, but it can be catastrophic for our financial wealth. We only see the surface and not what may be lurking underneath the pretty picture painted on the outside. In a similar fashion, we may be tempted to invest in securities (bonds, stocks, or funds) that have been on a recent tear. Worse yet, we may overhear our neighbors - Bobby and Bunny Jones - gushing over the killing they made investing in crypto at the end of summer neighborhood BBQ. This is just the situation that causes us to make an emotional decision with our stomach just when we need to make a rational decision with our brain. Performance chasing bias has been shown to detract x.xx% of investor returns when compared to a passive strategy over the years XXXX to YYYY according to research provided by Russell Investments.
Strategy Hopping Defined
Similar to the performance chasing bias exhibited when selecting individual securities, this bias also affects our decisions when we commit to overall investment strategies. One of our clients (let us call him Evan) recently called wondering why his portfolio had so significantly underperformed the "market" during the past year. What Evan did not recall is that he asked for his risk level to be drastically reduced just after the market swoon in early 2020. This risk level was then set for the lowest level of all our clients. Again, it is human nature to make the exact wrong decision at the exact right time. Evan is not your typical client - he has a PhD in engineering from a prominent university and decades of experience as an individual investor. Our conversation with Evan was not the only one that caused strategy changes in the first half of 2020. One other client (also with a doctoral degree) requested a similar downgrade in risk with understandably mediocre results. This strategy hopping is driven by the same emotions that rob us of our wealth building potential - fear and greed.
We Have Met The Enemy...
During the War of 1812, Commander Oliver Hazard Perry defeated Royal Navy forces at the Battle of Lake Erie. On September 10, 1813, he sent correspondence to Major General William Henry Harrison that "We have met the enemy, and they are ours..." It was one of the most famous notes in military history and the modern interpretation is that sometimes we are our own worst enemy. The best solution to some problems is to outsource potentially emotional decisions to a topical expert. With tongue in cheek, our goal here at JQR Capital is to be less completely wrong than most others over a long period of time. We also profess that (almost) any objective investment strategy will work well over an investing lifetime. The big struggle for us humans - of course - is to adhere to our investment strategy when results are much better than expected as well as when results are much worse than expected over the relatively short term.
The Yale Endowment
The CFA Society Hartford hosts an annual forecast dinner early each year to discuss market projections for the next year. There is always at least one investment strategist whisked in from Boston, New York, or Hong Kong. On one occasion - several years ago - the keynote speaker was Charles D. "Charlie" Ellis, CFA from the Yale Endowment. College (and religious) endowments have the luxury (or foresight) to be able to invest not just over years and decades, but over centuries. This perspective provides the patience needed to allow the ebb and flood of market cycles to run their course. The Yale Endowment used outside professional investment managers to help them deliver remarkable risk-adjusted returns for the Endowment Fund over a long period of time. During the question and answer part of the speech, Charlie was asked about how they handled underperforming managers in their investing process. His answer was something akin to the following. "[We obviously have a rigorous process of due diligence that we complete before allocating assets to a manager. If a manager underperforms after the 2 year mark, we simply double our allocation to them. If they underperform after the 3 year mark, we triple our allocation to them. If they are still underperforming after the 5 year mark, we start asking them questions about their process. By the time we reach the 10-year mark, they are either performing well beyond our benchmark for them - or we have replaced them with another manager.]"