Humans prefer to do something rather than nothing. We like office environments that are a “hive of activity” and commend “men of action.” When stuck in a traffic jam, we will take an alternate route just to keep moving, even if it prolongs the journey. We tend, though, to conflate activity with productivity, mistaking the people whom we see doing the most with those who are the most valuable.
We see this bias in many domains. Our political leaders tend to respond to a crisis with ill-considered policies that capture attention but often do little good and may even do harm. It would be unacceptable for them to stand by and simply do nothing. While serving as both vice chairman of Harding Loevner and as chairman of a professional soccer club that competes in the English Football League (EFL), I have been struck by the parallels between investing and sports when it comes to the biases that damage effective decision-making. Studies have looked at penalty kicks in soccer. When a penalty is awarded, the ball is placed 12 yards from the center of the goal and a kicker gets the opportunity to score with only the goalkeeper standing in the way. It turns out that because of the goalkeeper’s bias for action, the optimal place to kick the ball is directly at the center of the goal. A goalkeeper will almost always dive one way or another in anticipation. If he dives the wrong way, he’s forgiven as having simply guessed wrong, or as being sent the wrong way by the kicker’s supposed feint. If he dives the right way, he has a chance to stop the ball entering the goal. If he merely stands in the middle, however, he is the subject of much abuse for doing nothing.
Investors fall victim to similar pressures and impulses. The immediate costs of transacting are low, and the propensity to transact is high. The result is that investors transact too much, and their returns suffer. They tend to transact at the wrong time, buying after prices have risen, and selling after prices have fallen.
Underlying these behaviors is a general misunderstanding of the roles of luck and skill. In sports and in investing, short-term results are the outcome of a combination of the two. Yet, we tend both to attribute the outcome more to skill than to luck and to extrapolate a series of outcomes (good or bad) into the future. This tendency stems from our deep-seated need for explanation, and a need to feel we are in control even when we are not. This occurs particularly in those sports, like soccer, that are generally low-scoring affairs. Unlike in basketball, for example, where there will be more than a hundred points in a game, the average number of goals in a professional soccer game is roughly three. The result of a single game will largely be driven by luck—one bobble of the ball, the inches between hitting a goalpost and scoring, a poor refereeing decision. Yet the narrative in post-match interviews is seldom “we got lucky.” At least, it’s seldom the case that “we got lucky” when the interviewee’s team wins. When the team loses, the loss is the result of bad luck! How similar this is to investment narratives, where there seems to be only two kinds of investment managers: the talented, and the unlucky.
At my own club, last season, we had a pair of games scheduled close together. In the first, we gave up a 1-0 lead late on and ended up with a tied game. In the second, we scored a late goal from an unexpected source to win 1-0. The narrative of the first was that “we didn’t know how to hold a lead,” and of the second that “we were gutsy and played to the end.” Same team, same players, both close games, but different outcomes drove radical differences in explanation.
As in investing, in sports a series of poor results needs a narrative to explain it, and action to reverse it. Often that action is to replace the coach. Acting to replace him when results go the wrong way attributes far too much causality to the coach. George Steinbrenner famously hired Billy Martin five times as coach of the New York Yankees. Between the Premier League and the three levels of the EFL, more than half of the 92 clubs replaced their manager this season alone. Replacing a manager tends to come at considerable cost—he (it’s always he) will have his own preferences for players and staff, and perhaps may even want to change the style of play completely—with little evidence that the players who actually kick the ball around improve their own performances as a result. Because luck occurs randomly while skill is reasonably constant, after teams are unlucky for a stretch their luck will tend to mean revert. The “manager bounce” is a well-established phenomenon whereby short-term results usually improve after a manager is replaced. It is a statistical phenomenon, though, that has little to do with on-the-pitch performance.
For asset owners, there is a similar temptation to replace a manager after a period when returns have disappointed, but, alas, unlike the fans of a soccer club, the clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them.
For asset owners, there is a similar temptation to replace an investment manager after a period when returns have disappointed. But, alas, unlike the loyal fans of a soccer club, the former clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them. There is plenty of evidence that investors’ urge to act is damaging to their long-term returns. In mutual funds, on average, dollar-weighted returns that shareholders receive from their funds lag the time-weighted returns that the funds generate. This “behavior gap” is directly the result of poorly timed action on the part of shareholders.
Incentives and market structures only make the bias toward action greater. One reason that English soccer coaches get changed is that, once the season starts, players may not be traded outside the month of January. A result is that during the January transfer window it’s almost non-stop activity. The period has become its own media event, with fans, players’ agents, and media pundits all calling for teams to make their moves. This, even though only a few such moves ever have significant impact on a team’s results, and despite evidence that prices paid for players tend to be higher than between seasons.
The investing industry has many incentives to transact; indeed, the revenue models of many participants depend on transactions taking place. When I started in investment management, in London in the late 1970s, our fees were not based on assets managed as is the case today. We were paid when we made a transaction in our clients’ discretionary portfolios. Why is the portfolio turnover of the average equity mutual fund so high, when doing nothing and allowing returns to compound over prolonged periods of time is often a superior way to generate market-beating returns? It’s because the investment industry exploits clients’ bias in favor of action. Managers’ actions are described in emotional terms. We read of “conviction,” of “exciting opportunities” and “story stocks.” The reality is more mundane. Successful investing is about resisting the urge and the calls to action, knowing when to sit on your hands and do absolutely zilch. ∎