Illusion of Control
“Being on a hot streak is one of the most dangerous things that can happen to a professional or individual investor”: these counterintuitive words are a key takeaway from a recent Wall Street Journal piece on the illusion of control and the importance of staying grounded in the face of investment success. We agree, and coming off one of our best quarters in terms of performance we are mindful to the potential for these types of behavioral biases.
The illusion of control can be intoxicating and cloud the judgement of even the most rational person. Research cited in the WSJ article shows how individuals could be made to believe they can ‘control’ coin flips simply by being told they guessed correctly on eight of their first ten tosses. Separating luck from skill is one of asset management’s oldest problems, but appreciation of the ‘hidden’ role of chance is highly cyclical, only peaking after a major episode challenging ‘consensus’ views. As Warren Buffett liked to point out, “only when the tide goes out do you discover who’s been swimming naked.”
It is a complicating feature of manager selection that strong market performance, or ‘beta’, acts to float all boats, regardless of the correctness of underlying investment theses. After the heavy bull run in risk assets seen since the lows of March 2009, managers may be tempted to attribute too much of their performance to investing skill, suffering from their own illusions of control. One of our key tasks as fiduciaries is to find managers aware of, and avoiding, such biases.
We, too, must remain vigilant and self-aware. One of our founding investment philosophies is that it is critical to stay humble in building investment portfolios. Getting it right in the short and medium term is simply not enough – it is just as important to scrutinize a strong quarter as a poor one, to investigate an excellent manager as it is to cut an underperformer. Assumptions must be challenged if we are to keep one step ahead of Taleb’s “Black Swans”, Rumsfeld’s “Unknown Unknowns”, or McCulleys “Minsky Moments.” In many ways, the best asset to have as an investor is humility.