The Sources of Underperformance

Better to fail conventionally, than succeed unconventionally

In our research department we have a letter that Warren wrote in 1965 that lists the reasons, that he believes, most money managers, institutional managers, underperform. We framed that letter and said to ourselves: ‘we should just try to avoid these five things’…

You know one was group decisions, that was number one. Number two was the desire to conform your portfolio and policies to what other large and regarded firms are doing. Three was the asymmetry of risk and reward, better to succeed conventionally than to succeed unconventionally. Four was over-diversification and five was inertia.

Chris Davis, The Investor’s Podcast

Putting aside the actual source of the quote (most Davis’ mutual fund products have had underwhelming returns over the last couple of decades - a little like the Sequoia fund, it seems Davis is still harvesting fruits from the performance of another age), the content has been something I have been thinking about deeply. We all need to reflect on this from time to time, as the positive action to manage one’s own money should come with certain expectations. While I’m assuming many of us (myself included) enjoy investing simply for its own sake, we are also confronted with a stark reality. Most of us will underperform widely accessible, low-cost index funds.

Despite the 30,000 word write-ups, the scuttlebutt, attending the BRK General Meeting, and the artisanal alpha (or levered beta), most of it will be for nothing. We adore the exceptions, and venerate their success. The deals won, the businesses that were turned around, and the seemingly flawless series of successes achieved by those who have come before lure in a new generation of investors. Every investing career, either amateur or professional, begins with the kernel of an idea that: ‘that could be me too’. Yet we are human, with limited time, connections, experience, and domain knowledge. So we resist entropy, to spite of ourselves.

The sources of failure (this doesn’t seem like the right word - if you have more than a few thousand dollars in savings you are already ahead of most Western adults) as Buffett identified all those years ago ring true. While we live in material abundance now, our evolutionary hardwiring still believes we suffer from the poverty of the pre-industrial age. Our worst instincts that once kept us alive on the Sub-Saharan plane, now they siphon money from our pocket books.

Group decision making enables so many in-built human biases. While it facilitates harmonious inter-group relations, it barely ever gets to the truth. At least six or seven elements of Munger’s Psychology of Human Misjudgement are activated in one go: social proof, contrast, commitment and consistency, reciprocity, authority, and envy and jealousy. What often starts as a clear and cogent thought brought by one member of a group decision making body, often becomes unrecognisable by the time it’s all over. Again, logic and reasoning go by the wayside.

I scratch my head trying to think up an example of a wildly successful investment outfit that has more than one decision maker. The idea of the ‘investment committee’ is itself a mechanism to enable risk aversion. Sequoia and Davis are clear examples of this. I can think up at least a dozen investors who succeeded unbelievably well while essentially working alone. My approach has been that idea generation is a group activity (leveraging smart people in your network is essential - I assure you at least 90% of my ideas are stolen!) but decision making is a solo sport.

The more sinister aspect of group decision making - along with the lemming-like behaviour emblematic of places like Twitter - is that it is also a mechanism for distorting or diffusing accountability. We have Taleb to thank for popularising the term skin in the game. Without accountability we become sloppy, more prone to compromise, and are generally less engaged in whatever we are doing. In this respect, investing is simply about being right. Those things which take us away from this simple, but difficult, task should be discarded.

This is easily adhered to by the individual investor, but it’s quite a different story for the professional. Again, there is unavoidably politics in any organisation with more than 3 people. Social proof is very powerful in this respect - and so you’ll never be fired by your investors if you fail conventionally. In extreme cases - like Dr Michael Burry during the GFC - you might even get fired for succeeding unconventionally!

Conforming to the crowd ensures reversion to the mean.

The question of diversification and risk versus reward are basically joined at the hip. Unless you posses the extraordinary ability of regularly extracting profits out of the market on a short term basis, your odds of outperformance are reduced with every additional position you take on. Concentration, as the saying goes, is the way to build wealth. Buffett distilled this point down with his usual pithy clarity:

We’re looking for situations where it’s safe not to diversify.

Risk is not tied proportionally to reward. Only in the sanitised world of academia can such a concept actually be believed. Most of us can think of situations where there was very muted downside, and tremendous upside at the same time. In fact, if nearly nothing can hurt you, then all the other outcomes are usually pretty good. Unfortunately, they only ever so rarely come along.

This is the kind of real world dynamic that forces concentration in those attempting to invest intelligently. However, concentration is also an excellent avenue for losing large sums of money. We walk a perilous rope as we attempt to invest intelligently, all the while trying to capture lightening in a bottle, without being destroyed by it.

Finally, inertia is of course our inability to be dynamic when needed. I find this one a little counter-intuitive, as there was a famous study conducted by Schwab that indicated that the best performing brokerage accounts were belonged to the dead, or the absent (owners who had forgotten about the account). Long stretches of inactivity punctuated by short periods of ‘pretty aggressive conduct’ (a Mungerism) is a tough balance to strike. I think the takeaway is that there is a time and place for action. Being successful in your investments is simply knowing when that is.

Larry.