There is no getting around it. We are pattern-seeking generalists. The focus of the image to the right is a standard cinnamon roll, but we easily (eagerly!) see something more, perhaps Mother Teresa. We like to think that we perceive things “as they really are,” but (uh-hem), in reality our perception is highly ambiguous. We often see what we expect to see, want to see, are primed to see or are conditioned to see. This general problem is also a function of our tendency to seek excessive detail within complex systems.
My favorite example in this regard is perhaps the famous Virgin Mary grilled cheese sandwich (see below left). Its story is improved dramatically for me in that it was sold via E-Bay for $28,000 back in 2004 to a casino in order to be displayed in Las Vegas and elsewhere. That alone is a remarkable commentary on modern American culture, but I digress. If you aren’t predisposed to see the Virgin, you might think it’s the late actress Jane Russell (right).
These pattern-seeking perceptual difficulties are especially common to investing. The investment management business is full of people who are convinced that they have discovered some new secret sauce that cuts through the complexities of investing successfully and provides a sure-fire winner. However, in the words of the great Benjamin Graham, an “investor’s chief problem – and even his worst enemy – is likely to be himself.” We misperceive investment reality or even “see” what isn’t really there.
While I try desperately not to be an investment ideologue — to focus on and believe in only what actually can be shown to work — most of these secret sauce managers, if they have success at all, have success right up until they don’t anymore.
Sometimes the fall-off is on account of overcrowding. In investing, when people see something that works they pile on. As a consequence, it is axiomatic that as a strategy, approach or asset class becomes more popular, it suffers from both falling expected returns as well as rising correlations and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns.
But often the fall-off is because the manager saw a pattern or alleged pattern that didn’t really mean what s/he thought it did (if it was even there at all — like the Virgin Mary grilled cheese). Despite ga-zillions of investment systems and approaches, only a few (such as value, size, momentum and low beta) can be shown to persist over time.
Caveat emptor applies here with a vengeance. I’m open to the idea that some new secret sauce might be discovered and that it may be a temporary success (subject to crowding) or even persistent. But because we so readily see what isn’t there and since so few investment approaches evidence persistent success despite constant attempts to conjure it up across many decades, it makes very good sense to be highly skeptical about any manager — even an apparently successful manager — if and when it isn’t clear how and on what basis the success was and is achieved.
At the extremes, a lack of skepticism can lead to being defrauded (think Bernie Madoff). In the more likely scenario, a manager will look pretty good from a performance standpoint, money will flow in and the performance will go away, perhaps spectacularly.
Sometimes the problem lies with the approach — what seemed like a useful pattern wasn’t. And sometimes the problem lies with the extra money — smaller is more nimble and less susceptible to overcrowding. Either way, it’s easy for illusion and delusion to beset any of us. A healthy dose of skepticism is rarely (if ever) a bad thing.