When conviction is just confirmation bias
Testing your belief in your portfolio holdings
Professional investors know that they need to develop conviction in the individual companies they own. Because understanding what you own is the key to holding on when the price declines. It’s the secret to buying when everyone else is selling. And it’s the element that gives you the confidence to allocate a big chunk of your portfolio to your best ideas.
As an individual investor outsourcing investment management, you can apply this same concept to your own portfolio—developing conviction in the managers you hire and the strategies they implement. The benefits of doing so are no less important.
But conviction can be a double-edged sword. While it’s a necessary ingredient to staying the course when everyone around you is panicking, it can also mean that you’re wrong and unwilling to accept any contrary information—firmly entrenching yourself in a losing position.
While you want your investment managers to have confidence in their research and methods, you also want them to exhibit a good degree of humility and to be able to admit when they are wrong. I’ve seen far too many portfolios die at the altar of a stubborn belief in rising inflation, interest rates, gold prices, or, worst of all, a strategy dependent on anticipating another market crash—another 1929, 1974, or 2000. If your portfolio’s success depends on events that take place only a few times each century, you are on the wrong path, playing a low-probability game.
A manager who has committed publicly to a strong opinion on a certain asset (for example, “oil is going to $200 a barrel” or “the US dollar will inevitably collapse”) is a huge red flag. Once you have publicly, and often very visibly, committed yourself to a certain viewpoint, it becomes far more difficult to disavow this position in the future without losing face1. You’ll find that money managers in this position will often stick to their public views far longer than they should, ignoring any contrary evidence, if only as part of refusing to admit they were wrong. Don’t let their ego take you along for the ride.
Conviction is not a one-time thing. Your conviction needs to be tested by constant enquiry and skepticism. Premeditatio malorum. Question. Debate. Discuss and think things through. If it’s instead driven by a religious fervor, causing you to dismiss contrary information out of hand, then it can be a dangerous thing. Now we’re heading into “blind faith” territory.
So I’m calling on you to make sure you have conviction in your manager, who in turn has conviction in their strategy. But I’m also asking you to beware of the impact of ego, and of having blind faith in a manager or strategy that may not have earned that confidence. Indeed, the more confident a manager appears in public, often, the more that confidence is masking tremendous insecurity and uncertainty. It’s a delicate balance. But being aware of it is an important part of the process.
So… how to develop conviction in your manager?
At this point you might be thinking, This is great, but how am I to gain conviction in a manager or strategy if I know very little about investing?
You can’t escape the need to have conviction, because without it you risk being shaken out of your investments at the worst possible time.
So, short of becoming a financial analyst in your spare time, what can you do?
First of all, immediately address any nagging doubts you have in your portfolio, the manager, or the strategy being employed. Because these minor doubts will be screaming at you in a downturn. Address them when markets are calm. Speak with your advisor or portfolio manager. Make sure you understand what they are trying to do, and the role that each investment plays in this objective. And if you’re not satisfied with what you’re hearing, the time to change strategies is now. Don’t wait for markets to find themselves in turmoil before you decide to act. You will almost certainly end up selling at the wrong time.
It’s also important to make sure that your expectations are reasonable. Chasing top-tier performance or insisting on outperformance in all market environments is the root of all investment failure. You will inevitably end up jumping on trends as they peak, and bailing on investments just before they come back into favor. I’m not saying you should tolerate sustained underperformance, but make sure to evaluate your managers over a long enough period of time, and don’t be afraid to stick with them if underperformance is driven by extenuating circumstances.
I’ve worked with clients in the past who have an idea in their heads that they can somehow optimize their portfolio. They’ve obviously sat through too many academic finance presentations. Outside of finance textbooks, there is no such thing as an optimized portfolio.
To be clear, there are many permutations of shitty portfolios, but much rarer are those that are built for what you are actually trying to accomplish.
Chasing perfection will be a constant source of unhappiness. If I considered leaving my wife each time I met someone who might be able to tolerate my taste in music or my crappy dishwasher-loading skills, I’d be eternally unhappy. Not to mention that I’d miss all of the things that attracted me to her in the first place.
You need to decide what’s important to you, and focus on that.
I gain conviction by acknowledging that I can’t optimize the portfolio; so, rather, I try to reduce the number of variables at play. If I can just own great companies that I purchased at decent prices and hold for the long term, that is how I gain my conviction.
Better—hire an advisor or portfolio manager who understands you, builds a portfolio that serves you, and helps you develop the conviction you need in your strategy.
When it comes to investment success, your ability to stick with a strategy can matter more than the strategy itself.
Conviction is the key.
This is one reason you won’t catch me making specific investment recommendations here. I want to stay nimble, and something that I love today I might dislike tomorrow, as the facts change.