Behavioral alpha: can you handle underperformance?

How you respond to periods of underperformance may have a lot to say about how successful you’ll be as an investor. For many, a year of underperformance isn’t likely to trigger big changes. But what about three years? Can you handle a period of that length? In the first of a series of articles on how human behavior can affect investment decisions, we look at the benefits of having a plan and sticking to it. 

For many consultants, three years is a key hire/fire period. It also roughly approximates the average holding period for retail mutual fund investors. But studies show that many successful strategies that go on to achieve superior long-term results are likely to suffer periods of underperformance of three years or more.¹ For the impatient, the tendency may be to fire that underperforming manager and cycle into a top performer (only to have them subsequently underperform!). Repeated often enough, it can lead to buying high and selling low, which is well documented in our industry and a leading cause of underperformance.

Why do we do it?

There are many theories for this behavior, but one that deserves consideration is that we’re applying the wrong mode of decision-making to the task at hand. You see, our primary mode of learning is through trial and error—because it leads to optimization. It’s why we learn quickly not to put our hand on a hot stove or roll in poison ivy more than once. We also apply this mode of decision-making to most everyday tasks, such as finding the fastest commuting route to work or the best time to avoid lines at the store.

The problem with trial and error decision-making is it doesn’t work with investing. Why? Because the investment domain is dominated by uncertainty and lacks two critical elements necessary for a trial and error approach to be effective—stable cues and stable outcomes. Back to the hot stove: A 400-degree cooktop will burn your hand—stable cue and stable outcome. With your commute, the traffic patterns may vary day to day, but most other factors remain constant.

The market, on the other hand, has varying cues and outcomes, especially over shorter periods, that often lack any discernable relationship between cause and effect. In this type of environment, a trial and error approach will constantly get fooled. In other words, there’s no learning curve—just the proverbial hamster wheel. To be successful, a probability-based approach to making investment decisions generally works best.

The solution: avoid “lane-switching” with an investment philosophy statement

A friend of mine is a CIO at an asset management company. Several years ago, he examined the performance of the company’s portfolio managers and noticed a common behavioral trait. During periods of underperformance in particular, they were much more likely to alter their process (lane- switching). In other words, they lacked the conviction necessary to stay the course.

This poses numerous problems, including the inability to repeat the decision-making process, which makes it near impossible to separate luck from skill, as well as improve over time. Advisors face the same challenges managing investor portfolios, with the added challenge of keeping the investor in their seat during these periods.

One way to build conviction to stay the course is by developing an investment philosophy statement (not to be confused with a policy statement) that conveys your strong beliefs in how capital markets operate and why your process makes sense. The exercise of developing one can build cohesion within the team and serve as a guiding principle when making decisions. It can also bring your process to life for clients and help them make more effective referrals in the moment.

A survey by Mercer found that establishing and effectively communicating investment beliefs to internal and external stakeholders was the number one area of focus for wealth management firms. According to Mercer, the findings indicated that strong communications with clients was often more important than investment results. Furthermore, maintaining a consistent investment philosophy—and articulating it clearly to clients—can help solidify the firm’s culture and performance.²

With its multimanager approach, John Hancock has a wealth of experience in developing and articulating investment processes. For more information on building your own investment philosophy statement, contact us today.


1
"Focusing Capital on the Long Term,” Harvard Business Review, 2/24/14. 2 “Key areas of Focus for Wealth Management Firms in 2018,” Mercer.