As I was taking my morning walk along the shores of Lake Wakatipu a series of ideas washed around in my head...
It culminated in a simple, 3-dimensional, framework for active investing that outlines the major ways to get things wrong when it comes to active investment management.
The 3 dimensions of active investing:
If you get any or all of them wrong it can have dramatic adverse implications on your risk and return experience, and these 3 dimensions apply whether you are a hedge fund wizard, a sovereign wealth fund, an individual investor, a novice, or a Warren Buffett. They also apply to a greater or lesser extent regardless of what you invest in.
This article will talk through how to get each of them wrong… and by doing so also add some insight on how to do it right. Now, you might think that you should be more focused on ‘doing it right’, but the first rule of investing is: don’t stuff it up. So let's see the major areas where you can get it wrong.
This is your major thesis or concept behind *why* you are allocating risk budget, putting scarce capital to work, or punting your retirement nest egg or whatever term you want to use. This is about the conceptual foundation of why you think the investment will either preserve capital or produce returns. The concept and detail will be different depending on whether you’re picking stocks, direct investments, or looking across asset classes.
It might be very simple and it may not be overly rigorous and you may not even have it explicitly written out… it could even be (as you might find it is in many cases) something like a belief or intuition that e.g. “real estate always goes up”.
At first glance it seems simple, but there can be many facets to the conceptual backing of an investment idea that range from big top down macro factors such as the path of the global economy and interest rates down to micro or idiosyncratic factors such as assumptions about market share or the sensitivity of earnings to changes in pricing.
There are also many different approaches and schools of thought too even within the same type of investment.
But the essence is: you have an idea that supports your belief that a particular investment will produce a certain outcome. And you develop sufficient conviction in that idea/belief to take action.
Clearly if you get the underlying concept wrong then not much else can help…
(or can it?)
This is about *when* you invest… or really it’s about the price you pay. You can nail the concept, you can say “yes, internet companies are going to change EVERYTHING”, and be completely right, and envision all the ways things will change, calculate expected revenues, foresee the disruption, and so on. But if you pay too high a price or buy at the top of the market then guess what? You got it wrong.
So, can you get your concept wrong and timing right? Yes, it’s often called luck, and sometimes called being right for the wrong reasons. Or it might even be called having a solid process for timing that uses reliable signals and takes some of the heavy lifting over from the conceptual side. For example, you might have a view that the stock market is going to crash because another financial crisis is coming, but you wait to act on that view until a certain timing signal lights up… as a result you stay fully invested in the market as it goes up another 20-30% and no crisis comes - you basically got the concept wrong, but the timing right.
To be clear, whether your concept is right or wrong, timing matters.
If your conceptual backing is superb and your implementation is smart you can probably alleviate some of the potential pitfalls in getting timing wrong. But whether you like it or not, whether you acknowledge it or not, timing matters and timing is easy to get wrong, especially if you don’t have any process or tools to help.
This is *how* you obtain exposure once you have built conviction on the concept and timing. The dimensions of implementation are broader than you might think, to name a few: direct vs indirect, synthetic vs real, actively vs passively managed, diversified vs concentrated, leveraged vs cash, liquid vs illiquid, and it could have a variety of different indexes and reference prices, varying transaction costs and slippage, varying fee structures, and so-on.
At this point it should be clear that there are a lot of moving parts and the more moving parts you have the more scope you are given to either bungle it or blow it away.
It’s important to note - you can absolutely nail it on concept and timing and get it completely wrong on implementation. By the same token, if you have a poorly thought out concept and clumsy timing you could still do ok if something on implementation saved you e.g. diversification, liquidity, leverage, a really good outsourced active manager, etc.
The key point is regardless of the efficacy or otherwise of your concept and timing, implementation matters.
What matters most?
It depends. For some investors, it might be implementation (e.g. for private equity managers where a hands on approach is often taken), for others it might be the concept (e.g. venture capitalists who are trying to find the next big thing), or it may be a combination of concept and timing (e.g. active asset allocators or macro funds who make calls on big trends and turning points).
As an exercise, it might be worth looking at your own approach to investing and go through these 3 dimensions and explicitly identify the ways you can get it wrong. Because remember, the first rule of investing is ‘don’t stuff it up’. If you lose 50% you need a 100% return to get back to where you started. It’s all very well to get aggressive and try to generate the best possible returns, but start strong on defense because sometimes the biggest key to success is just showing up – and you can’t show up if you get fired or lose all your money.