Many Unhappy Returns

Updated: May 17

Investment strategist James Montier now works with famed fund manager Jeremy Grantham at GMO, but in a past life wrote a fabulous paper titled The Seven Sins of Fund Management. The seven sins, he claimed, were: poor forecasting; being fooled by the illusion of knowledge; being mesmerised by company management; believing you can out-smart everyone else; short- time horizons and over-trading; believing everything you read; and group think.

"Perhaps the most sensible thing to do is to buy an index fund"

To varying degrees, these sins, Montier argued, were responsible for the poor decision-making that can often lead to unhappy returns. The performance of a fund, after all, or any investment portfolio for that matter, is the result of a series of buy and sell decisions.

The fact that the vast majority of actively managed funds do worse than a passive equivalent suggests that the average fund manager may actually be hardwired to make poor decisions.


Research supports this. Yale School of Management’s professor of Marketing, Shane Frederick, devised the Cognitive Reflection Test (CRT) – a set of three simple questions designed to assess the specific cognitive ability that relates to decision-making (answers at bottom of page):


(1) A bat and a ball cost £1.10 in total. The bat costs £1.00 more than the ball. How much does the ball cost?

(2) If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

(3) In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?


The test recognised that all individuals, when making decisions, use a combination of two brain processes, which he labelled system 1 and system 2. The former is the default option – a spontaneous response – while the latter is reflective, requiring a deliberate, conscious effort.


The CRT was designed to measure the extent to which people are able to interrupt their more instinctive system 1 response, and replace it with the slower, but more thoughtful, system 2 process, to produce the correct answer. Turns out, it is harder than you might think (see below).


Frederick carried out the test at 11 locations on more than 3,000 individuals – mostly students – and found that they averaged 1.24 correct questions each. His results, detailed in his 2005 paper Cognitive Reflection and Decision Making are instructive at several levels.

For example; those who incorrectly answered the first question thought that 92% of people would answer it correctly. Those that did answer it correctly thought that just 62% of respondents would get it right. The point here is that people whose system 1 is dominant – that is, the ones who answered instinctively, and therefore incorrectly – have an over-inflated sense of confidence.


Montier surveyed 300 fund managers and found that they did better than average, answering, on average, nearly two questions correctly. However, a third of them did worse than the average student.


This does not indict all fund managers, but it does mean that there are many who have a hard time distinguishing between decisions on the one hand that are based on information and patterns having been correctly interpreted, and those on the other that are based on an illusion of pattern.


This phenomenon was described in star pessimistic investor Nassim Nicholas Taleb’s 2004 book, Fooled by Randomness, a treatise on man’s capacity to mistake noise for pattern, luck for skill. A former proprietary trader, Taleb considers himself one of a “bunch of idiots who know nothing and are mistake prone but happen to be endowed with the rare privilege of knowing it”.


It is this sort of honest self- reflection that we would do well to look for in our fund managers. That is, of course, if one is not prepared to indulge in some honest reflection and conclude, perhaps, that the most sensible thing to do is to buy an index fund.


Published in What Investment




Answers to CRT: (1) 5p (2) 5 minutes (3) 47 days





The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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