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.

Financial pundits like to make predictions like “when XYZ happens, the stock market will go up 80% of the time.” Those predictions are particularly common around the start of a new year, when people are eager to know how the year could possibly unfold for them. Seeing so many predictions, I become curious about their validity. So, I did some digging into the historical patterns of stock markets. The following is what I found.

Studying human psychology, market history, and my own investment mistakes, I have increasingly come to believe that “Apparent Coherence” is a source of large investment mistakes. Stories that are so apparently coherent that they lead us to nod instinctively in agreement — that is often how large investment mistakes are born. It is not that coherent investment ideas are necessarily bad, but in fact, the logic goes the other way around. It appears to me that apparent coherence usually drives large investment mistakes. Below is a diagram I drew to illustrate what I mean.

In an environment where almost no active investment managers can outperform U.S. stock indexes, “risk management” as a serious subject has morphed into something different. Being able to tell a risk management story well does not mean being able to invest well. Unfortunately, for managers who cannot outperform stock indexes (almost all managers!), shifting investors’ focus away from investment performance and focusing instead on telling a risk management story has become business critical — managers need something to say in investor meetings. However, sensible investors should understand that excellent investment performance naturally lends itself to excellent risk management, but telling an excellent risk management story means almost nothing as to an investor’s ability to invest.