Investment professionals can add value in their investment decisions through good governance — not the good governance they preach to corporate executives of public companies but the governance of their own investment decision making.
At its core, good governance in investment decision making means subjecting your assumptions and behavior to tests based on data and then learning from your mistakes. This was the key message given to an attentive audience of investment professionals by Michael S. Falk, CFA, a partner in Focus Consulting Group, at the 68th CFA Institute Annual Conference in Frankfurt.
Process Trumps Analysis
Falk believes that what investment managers produce are investment decisions. These decisions cannot be solely judged on outcomes because the ex post financial performance depends not just on skill but also on luck. That’s why there ought to be a quality control system for investment decisions — “a checkup on your process and execution,” in Falk’s words. He quoted research that suggests that the process is six times more important than analysis and can make a difference of 100 bps per year in the performance of a portfolio.
In the context of investing in listed equities, Falk argues that an investment team needs to work on the governance of its investment philosophy, buy or sell decisions, as well as execution. What this means in practice is rigorously testing your assumptions and behavior with hard data and learning and adapting accordingly.
Although an investment team constructs a portfolio from a given set of stocks, there are many portfolios that can be put together from the same stocks. Falk suggests that to test its investment philosophy, an investment team should compare the construction and performance of its portfolio with portfolio opportunity distribution sets or randomly constructed portfolios that are subject to the same constraints.
Don’t Keep Your Losers and Sell Your Winners
Falk contends that not having a disciplined process for when to sell affects performance. Back-testing shows that a simple rule of thumb, such as “sell if a stock is down 15%,” performs better than case-by-case decisions. That’s because behavioral biases make investment teams prone to selling their winners and keeping their losers. If you do not feel comfortable with such a rule, then at least have one that forces you to call a meeting in which you must make a decision. You want to “sell your losers, and let your winners run,” but a lack of good investment decision governance may lead you to the opposite outcome.
Falk says that if you think you are adding value by overweighting certain stocks in your portfolio, compare its performance with an equal-weighted portfolio of the same stocks. This comparison could show you that the stocks with the largest weights in your portfolio may not be the best performers.
We Are Homer Simpson, Not Homo Economicus
Falk suggests that in our behavior, human beings are much closer to Homer Simpson than the Homo economicus of classical economics. Be aware of your frame of mind when making investment decisions and don’t let your ego make them for you, Falk says. Instead of reason and evidence, your decisions could be driven by biology — that is, by cortisol and testosterone. Honest debate is in short supply in general, says Falk, but when we are in a negative frame of mind, we are closed off to considerations of the merits and drawbacks of investment decisions. Before reaching a decision, we ought to ask ourselves if we are in the right frame of mind to make one.
Falk strongly favors keeping a journal of investment decisions, recording the rationale behind each of them, as suggested by Nobel Laureate Daniel Kahneman. This record lets us revisit the rationale behind our decision ex post and learn from it. He also advocates for performing a postmortem on investment decisions — that is, collecting data on how many of your calls proved to be right or wrong, comparing the performance of your portfolio with your watch list, and comparing the performance of your most- and least-confident trades. If the postmortem of your decisions tells you something is consistently problematic, “stop doing it,” Falk advises.
In a survey of one large team of investment analysts, Falk found that there was no shared understanding of value, with members split across nine different variations. When team members do not agree on such a basic notion as how to define value, it lowers the quality of debate and slows down the team’s decision making.
Easier Said Than Done?
Isn’t it easier for a consultant to preach good governance to clients because they’re the ones who have to bear the burden of practicing it? Falk was asked if he applies this wisdom to his own investments and how this has affected his performance. His response was that he does practice what he preaches. He says that any investor, himself included, who was holding broadly diversified portfolios in recent years would likely “look like an idiot” when their performance was compared to that of the S&P 500 Index. Regardless, Falk says he believes in mean reversion but does not know when it will take place. Rather than letting his behavioral instincts make his decisions, he is sticking to his investment discipline and says he “would rather be out of the market wishing to get in, rather than in the market, wishing to get out.”
Falk’s message is that governance of investment decision matters. It is a lot of work and a lot of effort and requires you to be tough on yourself and on your team. But it pays off. His suggestion to investment professionals: employ good governance practices in your investing and share this information with your clients and prospects to show them that you are committed to improving your investment decision making.
If you liked this post, consider subscribing to the CFA Institute Annual Conference blog.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo credit: W. Scott Mitchell