Have you ever wondered how it is possible that small investment teams, located in the middle of nowhere, can outperform multinational giants that have unlimited resources and a physical presence in all major financial centres around the world?
This conundrum has been lingering in the back of my mind since I joined the industry (at the very end of the last century). It took me quite some time to connect the dots and finally I think that I am beginning to understand how things are interconnected.
During discussions that followed presentations I gave at five European CFA societies, many in the audience admitted that they recognised their own organisations. Some even said that their senior management need to hear this.
One aspect of the explanation to this conundrum is in Knight’s definition of risk and uncertainty. Another can be found in our human nature and how we, as investors, should approach uncertainty.
Risk – when we do know the underlying process
We can define and quantify risk as random deviations from a known process. Knowing the process means that we can predict outcomes, estimate probabilities, manage risk and even optimise our solutions.
In my physics classes at university, we conducted experiments to measure standard acceleration caused by gravity. We also had to calculate the measurement error, which could be reduced by improving the measurement tools and techniques.
When you know the underlying process, economies of scale quickly pay off. By adding more resources and management we know that the output will improve, i.e. getting higher quality work at a lower unit cost.
Economies of scale apply to many activities within an investment firm, for example back- and middle-office, legal, compliance, branding, marketing, distribution and IT. Risk can be managed efficiently using Key Performance Indicators, Balance Score Cards and other traditional managerial tools.
Uncertainty – when we don’t know the underlying process
Things become more abstract when the underlying process is not known. We need to look for robust solutions that deliver satisfactory outcomes under a wide range of assumptions for how the world actually works.
As an undergrad studying social science, I faced this challenge: what will the consequences be of a change in tax law or a reform of the pension system? Faced with a new set of rules, people will respond differently from how they would have done previously as they will adapt to the new situation.
Not knowing the underlying process means that we can’t have a single model that will tell us how the world will react. It is pointless measuring statistical probabilities or to try to control the outcomes since they are all hinged on a specific model.
Investing is inherently about making decisions under uncertainty. Investors in financial markets interact and adapt their strategies, creating self-reinforcing feedback loops. To navigate uncertainty, we need to combine an adaptive mindset with diverse theoretical models and people.
Abandon all hope, ye who enter here
In Dante’s inferno, the inscription on the gates of hell read “abandon all hope, ye who enter here”. I would argue that organisations who believe that investing is about managing risk should have a similar inscription above their front door: “Abandon all hope of robust performance, ye who enter here”.
Many investment firms assume that the underlying process is known. This is understandable, since mainstream economics offers the comfort of a simple model that explains a multifaceted and complex world.
If we take this model as truth we can manage risk and have the feeling that we are in-control. With this false sense of security we can sleep like babies, until reality catches up with us. And then, in the middle of the night we will wake up screaming.
We operate in an eco-system where business and career risks create an appetite to manage risk. Large companies require complex hierarchical structures, standardised processes, house views on the market, model portfolios and so forth.
And then we have the bean counters – well they need beans to count even when there are none. The confluence of all these human factors makes it very difficult for firms to focus on uncertainty when taking investment decisions as most of their processes and structures are developed for managing risk.
Accept reality for what it is and be adaptive
Small firms in the middle of nowhere that are able to manage uncertainty have a better chance to deliver robust performance than large organisations dedicated to managing risk.
So what are the steps we need to take as institutional investors to manage uncertainty rather than risk?
- Try to see the world for what it is and stop using models and structures that are wrong. Richard Feynman captured this nicely: “It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with the experiment, it's wrong.”
- Understand the dynamics of the world better by embracing diversity in thinking – using tools such as Agent Based Modelling, Network Theory and Scenario Thinking –and be adaptive to an everchanging world.
- Acknowledge and accept our own human biases. Structurally apply tools such as devil’s advocate and pre-mortem, which will help us manage our biases and group-think when making investment decisions.
This general philosophy can be applied to all steps in the investment process: from understanding economics and setting investment mandates to constructing robust portfolios and selecting external managers.
This is not easy at first, but it is a skill that will improve through practice and learning. Eventually, we should be able to put up a sign at our front door that reads “Abandon all hope, and see the world for what it is”. This for some of the bean counters and process monkeys will make them think they are entering the gates of Dante’s inferno.