I have written frequently on the topic that most active investment managers are unable to outperform the general stock market. To explain the collective underperformance of active managers, some answers have been found and discussed, such as the increasing level of efficiency on the market level (blame the market) or the increasing level of concentration to a few large stocks on the index level (blame the benchmark). In this article, I want to expand on this topic by laying out two factors that represent, on a more fundamental level, I think, the source of investment manager underperformance.

Diversification and Its Downsides

In many people’s mind, diversification is the orthodox way to go about investing. In school, investors are taught by their professors to build a “well-diversified portfolio.” At work, investors are asked by their client investors to build a “well-diversified portfolio.” On paper, diversification can be proven elegantly as probably the only “free lunch” in investing: same return, lower volatility. To be frank, I used to think that way as well. However, the longer I practice investing, the more obvious it has come to me that diversification can have huge downsides.

The other day, I came across another investor’s portfolio. Let me generalize that portfolio for the sake of simplicity: That investor has six stocks in his portfolio; four of them worked out well and two didn’t work out. Impressive results, at first glance, for most onlookers. But when I saw the portfolio’s overall investment return, it was not as impressive as I thought it would be. If a person makes six bets and four out of six turn out to be good, why was the final investment result underwhelming?

Think about it. In a non-investing world, intuitively, “four out of six” is a great batting average. In investing, however, we have to think about what “four out of six” actually does to an investment portfolio: 1) the two losing bets lose money; 2) the losses from the two losing bets — let me generalize it here and assume all six bets are sized equally — “cancel out” the gains from two of the four winning bets; 3) so, four bets (two losing bets, two winning bets) are essentially a wash; 4) therefore, only two remaining winning bets are “at work” for the portfolio. Think about it. Only two out of the six bets are net contributors. With 66% (=4/6) of the portfolio busy canceling itself from within, the investment manager is only investing 33% (=2/6) of the portfolio! Unless the two net winning bets outperform the general stock market by a factor of three, there is no hope that such a portfolio can outperform as a whole.

But wait a second, isn’t “winning four out of six times” a great record? It is. However, in investing, this kind of “intuitive reasoning” leads to underperformance, as I just laid out above. Making it even worse, most active managers’ batting average is nowhere close to “four out of six.” Most managers’ records probably hover around 45% to 55%. Therefore, the end result of their investment portfolios would only be worse than the example that I gave above.

That is probably why George Soros does not shy away from making super-sized bets. That is probably also why Warren Buffett keeps a huge pile of cash. I don’t think either one of them seriously believes in the “free lunch” of diversification. Remember what Yogi Berra said before, “In theory there is no difference between theory and practice; in practice there is.”

Diversification can have huge downsides. Sadly, most investment managers feel they must diversify, because they were taught to do so (in school), and they were asked to do so (by clients). Isn’t it ironic?

Manage “Investments” versus Manage “Investors’ Expectations”

This idea is something that I have come to see more and more clearly as I gain more investment experience. Let me put it this way. When an investor is only investing for himself, he is managing investments. Clear and simple. When that same investor starts to have external clients, his mental space will be increasingly occupied by various considerations, such as business development and client relationships. He wakes up thinking about whether his clients are happy about his investment performance or not. He goes to sleep thinking about whether his performance numbers still look good enough to retain existing clients and to attract new clients. During the day, his mind could not focus for an extended period of time on investment research without being distracted by similar thoughts about his client investors’ expectations and how to manage these expectations.

You see what I am saying here? Without external client investors, an investment manager is “managing investments.” With external client investors, the same investment manager shifts some of his or her focus toward “managing client investors’ expectations.” The more external clients, the more severe this dynamic can become.

Imagine this: A race car driver stops focusing on the race. He is now in the business of selling seats in his car and keeping these paying passengers content and comfortable. He thinks he is still in the race. His passengers think so as well. But is this race car driver still in the race?

Are you managing investments? Or are you managing client investors’ expectations? The former is about doing an investor’s job. The latter is about something else. How could one expect an investment manager in the latter camp to deliver superior investment results?

That’s why I constantly remind myself of this above-mentioned distinction.

We are all staring at this simple fact: Most investment managers are unable to outperform, year after year, decade after decade. Perhaps, instead of blaming others (blame the market! blame the benchmark!), investment managers should reflect back on themselves — to look for reasons from within. And I hope this article at least can serve as a starting point for that reflection.

(END)