Failing in Order to Succeed

It is hard to imagine that anyone would willingly entrust their savings to a failure. Indeed, few professional services will ever concede to having a guaranteed failure rate. But that is exactly what an active investment manager is going to deliver their clients. Guaranteed failure is part and parcel of being a truly active investment manager.

From an early age it gets drummed into us that true success is scoring 100%, or as close to it as possible, in a test or exam. We are required to demonstrate at school that we understand a topic by scoring high in tests. We have to try as hard as we can to get all the answers correct. The higher your average score as you progress through school, the more choices you have when it comes to choosing a university course, if you decide to pursue tertiary education. For example, you only gain entrance to medical school if you score near to 100% in all your exams. You just do not get those types of scores if you are having to guess at answers, you have to know the material inside out.

If you are fortunate enough to progress and have a professional career, such as a doctor or architect, failure does not suddenly become an acceptable option. A general practitioner that has one in ten patients dying while under their care is unlikely to stay a doctor for very long. (Harold Shipman did kill over 200 of his patients over the course of his career from 1975-1998 as a general practitioner but you’d like to think he is the exception that proves the rule). Meanwhile if you engaged an architect to design your dream home that was otherwise perfect but for the fact that the garage falls over in the first strong wind, you would doubtless sue the architect.

So why is it to be expected that a truly active investment manager will experience failure? It is because share market outcomes largely depend on events in the future, which creates problems for the active investment manager because the future is unknown and uncertain. A doctor largely deals with a set of patient symptoms that can generally be allotted into factual compartments that lead to a diagnosis and then a treatment for that diagnosis. A great deal is known as fact before a treatment begins. The architect is generally given a specific brief and then sets about melding design and engineering to draw up the plans for their clients. People may feel that a particular building is ugly (and let’s face it the Beehive is an ugly lump of a building), but if it’s functional and it will still be standing in a 100 years, the architect will rightly feel they succeeded in their task.

When an active equity investment manager is assessing a listed company with a view to potentially buying shares in that company, there are a great deal of known facts available about what has happened in the past. The past is very useful for telling you why a company has seen its share price rise or fall over time. The past, though, has very little bearing on what a company will earn in the future which is the key determinant of future share price movements. If earnings double the share price will also likely double, if not more, while if earnings half the share price will generally half, if not more. But those events are in the future and an investor can never have certainty about the future.

Another factor to be aware of is that investment managers have typically gained their position by scoring high in tests. As mentioned, failures typically do not advance your career to the point where you get to manage people’s money. Two issues start to develop at this point. One issue is that when you manage an investment portfolio, particularly an equity portfolio, failures are very easily quantified. You purchased shares in company A at a $5 and now it is trading at $2. That is a clear and evident example of failing in your job. A second issue is that investment managers are not used to failing, having up to now always having scored highly in tests. The interaction of those two issues creates unfortunate behavioural biases.

The first unfortunate bias is that in future the investment manager becomes very reluctant to become the only manager in New Zealand to own company A, regardless of the validity of the investment case. It is bad enough to fail the test but to be the only one is unthinkable. This bias moves the investment manager closer to the general market and away from being an active investment manager. Even though nine times out of ten owning company A was a great decision that would have made clients a great deal of money but on this occasion, luck was against the active investment manager.

The second unfortunate bias is that the investment manager experiencing failure for perhaps the first time in their career also decides that the failure was not their fault. They find some reason beyond their control to blame the failure on. So, they don’t learn from the experience and so don’t become incrementally better at their jobs.

The good news is that all of this creates opportunities for active investment managers that are prepared to fail. By expecting and accepting failures you can build portfolios that are resilient to individual failures and perform better in the long run. 

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