The comment in the headline, recently expressed by an adviser during a conversation about capital markets, does more to encapsulate the investment challenge than any number of text books or chart-filled PowerPoint presentations, as it reminds us that successful investing is not primarily about asset prices or economics, but rather about people and how they perceive the future.
The search for correct answers is deeply ingrained in us from a young age. Parents of teenagers engulfed by exams over the last few weeks will be especially familiar with the unrelenting search for the perfect ‘answer’ that inexorably draws the maximum marks from the examiner.
In contrast, we are uncomfortable with the unknown. Left unchecked this discomfort can lead us to accept false answers that appeal to our desire for certainty by presenting an overconfident view of a deterministic future.
As we over-invest our emotional and financial capital in this particular outcome, we make ourselves vulnerable to being surprised by events. Such surprises can trigger a fight, flight or freeze, which can derail an investor’s journey towards their goals.
To invest successfully, we must acknowledge the uncertainty of the future and accept there are no answers, only more and deeper questions. This is most obvious when meeting investment managers as part of the fund research process.
While a good question will usually provoke a thoughtful response from an experienced manager, it is only by continuing to dig deeper into that response through subsequent questions on the same topic that we can assess the quality of the original ‘answer’.
This process must be repeated across numerous topics, and often in repeated meeting time before a conclusion can be reached about the quality of the team running the strategy and the process they employ to do so.
This raises an obvious question: what is the difference between a conclusion and an ‘answer’? There are two key differences, both of which reflect the uncertainty of the future.
The first difference is that the conclusion reached by an investor when making a decision must always be probabilistic. Rather than focusing on a single outcome, an investor will have a central expectation that reflects their estimate of the highest probability outcome, but this expectation will be surrounded by a range of less probable outcomes that reflect the uncertainty that characterizes good forecasts.
By understanding that the actual future may be contained in this range (or even outside it in extreme circumstances), rather than at the point of highest probability, the investor is less likely to be surprised and consequently better equipped to respond to outcomes that are different from their ‘conclusion’.
It is for this reason that the Morningstar investment team estimates future asset class returns as a range of potential outcomes rather than a single estimate. These ranges typically overlap, reminding us that differences in estimated returns may simply reflect noise in the estimation rather than a genuine opportunity that can convey an advantage to the investor. In contrast an ‘answer’ ignores the range of outcomes implied by probability and encourages overconfidence in the investor.
Second, an investor will regularly update their conclusion as new information emerges and their analysis tools improve.
In a study made famous by the book Superforecasting, it was realised that the best forecasters are those that regularly adjust the probabilities linked to their forecast. This naturally requires the humility and curiosity to look beyond your first answer.
This carries through to the process of selecting a fund or portfolio for your client. When entrusting our clients’ savings to a professional investor, it is important to select a strategy that is not reliant on the manager knowing ‘the answer’.
Client portfolios should be sufficiently robust to withstand a wide range of market and economic outcomes while keeping the end-investor on track to reach their goals. This is especially important when considering past returns, as high-excess returns over short time periods may simply indicate the presence of a portfolio manager who was over-confident in the ‘answer’ he had selected and ignored other potential outcomes.
In an environment with a large number of portfolios on offer, it is very likely that a single manager using this approach will deliver high returns in a single period but that is unlikely to be predictive of high future returns.
While accepting simple answers may be detrimental to investing success, it is challenging to convey this idea to those who entrust us with their future. Therefore, it is essential that we help them to avoid seeking these simple answers. To do this, we need to move our clients’ focus away from the past that requires explanation and the present that demands simple answers to a future that has a goal we are working towards.
Answers become less important when the progress towards this goal is tangible, much like the exam papers of the last few months fade from memory as the next steps in our education become clearer.
