Ignore the judgement of others – the only thing that matters is you
|Sep 18||Public post|| 1|
This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.
“Unto this thing pertaineth that not indiscreet saying of Socrates…, that virtue was nothing else but knowledge of things to be ensued and followed, and of things to be eschewed and fled.”
Erasmus of Rotterdam
Imagine you are sitting in a room with five other people and are asked to determine if the six colour fields shown below are blue or green. What is your opinion? Would you say the fields are blue? What if two people in your group insist that they are green?
Six colour fields
Source: Moscovici et al. (1969).
This is an experiment that French sociologist Serge Moscovici and his colleagues performed in 1969. To be clear, the colour fields are indeed blue and represent light at wavelength 483.5nm (Pantone calls this shade of blue Blooming Blue) but with different degrees of brightness.
If participants in the experiment were asked independently about the colour of these fields, only 0.25% of responses were for green. However, the responses changed dramatically once the experimenters planted two confederates amongst the participants. The job of these confederates was to insist that the colour of the fields was green. Note that these confederates were still in the minority because there were only two confederates in a group of six. Yet, Moscovici found that if the confederates consistently called the colour fields green, about one in five respondents changed their answer as well and publicly stated that the fields were green. If the confederates were not consistent in their opinion that the fields were green, the share of people who switched from blue to green dropped dramatically.
Minority influence in the colour field task
Source: Moscovici et al. (1969).
What this experiment showed fifty years ago was that a determined minority can influence a significant amount of people to change their opinion and publicly state something that they know is false. This was enough influence that in the experiments the majority opinion of the group judging the colour flipped from blue to green in more than half the cases. As long as the minority is consistent in its spread of falsehoods, its influence can easily change the overall behaviour of a larger group – something that has obvious implications for politics where determined minorities can lead entire countries astray.
However, this is not a post about politics but about investing and a similar effect can be observed in the investment world.
Take institutional investors like pension funds or endowments, for example. One of the common practices of institutional investors is to compare their performance to the average of their peer group. This is typically done to assess the performance of the investment portfolio relative to other institutional investors with seemingly similar characteristics. And if the performance of the institution is below the peer group for a couple of years, then obviously, something must be wrong, and the portfolio of the institution must be changed to be more in line with the peer group. The result of these peer group comparisons is that the portfolios of institutional investors look increasingly alike even if the individual circumstances differ.
This peer group pressure also leads to investment trends amongst institutions. About twenty years ago, most university endowments and pension funds had portfolios that were almost exclusively invested in stocks and bonds. Then a small group of elite universities like Harvard and Yale invested heavily into private equity, hedge funds, and other illiquid and alternative investments. Their success was tremendous, and they outperformed their peers by a wide margin. In response, more and more institutional investors compared their portfolios and their performance to the performance of these elite universities. Over time, this meant that they had to shift out of stocks and bonds into alternatives even though their individual situation was different from Yale or Harvard. Furthermore, many of these institutions didn’t have the expertise and skills to select high-performing alternative investments. So, investment consultants and banks were ready to help and offered advice in the selection of alternative asset managers.
Over time, the endowment model became the model for many institutional investors and an increasing number of wealthy individuals. But nobody ever seemed to stop and ask themselves if it made sense for them to emulate the Ivy League portfolios. Unsurprisingly, the results for many institutional investors were often disappointing since these investors did not have access to the best managers and came so late to the party that the alternative investment universe was already crowded and returns dropped. Markov Processes International tracks the performance of Ivy League Endowments and the chart below shows that over the last decade, the performance of these Ivy League portfolios lagged a simple 60/40 stock/bond portfolio.
Performance of Ivy League Endowments 2009 – 2018
By adopting the portfolios of a minority, many institutions have experienced lower returns than with their previous portfolios.
I don’t blame the elite endowments for this failure of asset management. They have simply done what’s best for them. But why did other institutions think they are like Yale or Harvard? And why did investment consultants think that other institutions could be like Yale and Harvard?
When it comes to achieving his or her investment goals, the virtuous investor must be aware that her portfolio has nothing to do with the portfolio of other investors or the overall market. Comparing your portfolio performance to the S&P 500 is stupid because the stock market does not care about your personal situation or your risk tolerance. It is like comparing the S&P 500 to the share price of Apple and then blaming the S&P 500 for not being able to keep up with the performance of Apple.
Similarly, the performance of other investors does not matter for your performance and the virtuous investor avoids comparisons of her portfolio with the portfolio of other investors or any generic benchmark. Instead, the virtuous investor measures the performance of her portfolio relative to her goals.
And here is how this can be done. Assume that the virtuous investor needs to achieve a performance of 5% above inflation in the long run. This is quite a high return target and requires a high ability to withstand losses, but let’s assume the virtuous investor has developed her portfolio with the help of a qualified financial planner and this return goal is adequate for her individual circumstances. Often, the expected development of the portfolio is presented with what I call the trumpet chart. It shows the expected outcome over time as well as a 95% confidence interval in which the value of the portfolio is expected to move.
The trumpet chart for a hypothetical investor
This chart is often shown at the beginning of the investment but for some reason forgotten afterwards. But this chart holds the key to measuring performance relative to the individual goals of the virtuous investor. Take a look at the performance of the portfolio seven years later.
Performance evaluation with the trumpet chart
In the first three to four years, the portfolio did extremely well, outperforming inflation by more than 5% per year. However, the chart also shows that despite this good run, the buffer of the portfolio relative to the expected outcome was small and given the long remaining time horizon, the investor would have clearly seen that it was no time to become euphoric about performance. Then, in year five, disaster struck, and the portfolio dropped by about a third in value.
The good thing about this chart is that it shows the virtuous investor that there is plenty of time to catch up lost performance and that the overall portfolio value is well within what could be expected. In other words, the chart helps the virtuous investor not to panic in the face of a short-term loss and focuses her on her individual long-term goals. And the chart never makes a reference to the performance of the stock market or other investors. So, if other investors say the sky is green, the virtuous investor still knows it is blue.