Noise - Chapter 6
Sources Of Noise: Performance
Briefly: Performance
Self-Perception. Your performance, whether good or poor, changes your perception of yourself.
Others’ Perception. Your performance, whether good or poor, changes others’ perceptions of you.
Noise. Both sets of perceptions change your relationship with the markets, often to the detriment of future performance.
Each performance print contains two items of information:
The Number. The number indicates a change in the value of your clients’ investment with you. The number gives rise to stories, yours and others’.
The Story. The story is the meaning that you and others assign to the number. These stories give rise to actions, which determine the next number. The story has greater power than the number.
Your investment returns are a source of noise because your story of your returns changes your perception of yourself; others’ stories of your returns change their perception of you; and both of these change your treatment of your portfolios.
Good (or bad) performance can make you believe that you are better (or worse) than you are, make your clients increase (or decrease) their investment in your funds, make your firm give you (or take away) rewards and privileges, which contributes to your inflating (or deflating) confidence, which increases (or decreases) your appetite for risk, which impacts on your performance.
Good performance can sow the seeds of bad performance, and bad performance can beget further bad performance. Whether you get locked into a performance death-spiral depends on how you deal with the noise that arises from your investment returns. What you do depends on the stories you choose to tell and on the stories you choose to believe.
Stories that you tell
There are two types of story that you tell about your investment returns:
Public Stories. These are stories that you tell to others about the observable facts. The public stories are a necessary part of your role, these are the stories that you tell your clients about the facts of what happened, where you attribute your performance to a set of factors. Such a story might go: “We generated 40 bps of alpha last month, mainly due to an overweight position in Microsoft, which had a 10% pop.”
Private Stories. These are updates of your personal belief system. These stories are more powerful than your public stories. They are subject to distortion and escalation.
Distortion
Your experiences shape your beliefs. You tell yourself private stories to make sense of your experiences, and these stories get embedded in your personal belief system. This system consists of a multitude of assumptions and conclusions of varying degrees of validity and reliability. Your private stories get distorted so that they fit with your existing belief system.
You need a relatively stable sense of self in order to function in the world. This means that the coherence of your personal belief system is more important than the truth of any one story. The stories that get embedded into the system need to fit, and if they don’t, they are either rejected or they are made to fit. So you will distort some of the stories that you tell yourself so that they are congruent with your personal belief system. What the system gains in coherence it loses in accuracy, and these inaccuracies give rise to noise. The distortions that are embedded in your personal belief system erode your capacity for clear perception, rational analysis, and constructive action.
An accurate story of the previous month’s performance might be: “Due to a combination of luck and skill and input from my analysts, we generated 40 bps of alpha last month, which puts us in the lower second-quartile of our peer group over the past three years.” This is a dull story. A more compelling private story is: “Man, I am good,” which is a selective interpretation of the performance number, a subtle distortion of the mundane facts. You have concluded something about yourself, something beyond what is offered by the data. Because this distorted story is more compelling it has a greater chance of becoming embedded in your belief system. The component of the system where this distorted story is going to find a home is in your sense of confidence, which will inflate to overconfidence.
When you are overconfident it affects your relationship with:
Your Portfolios. You will be tempted to abandon your investment process and take inappropriate risk. This is a function of your distorted story rather than an accurate assessment of the opportunity set.
Other People. You will be tempted to believe that you are better than you are and that you are better than others. Your behaviour will alienate the people on your team who contributed to the performance, and will undermine your ability to repeat that performance.
Conversely, if the overweight position in Microsoft had taken a 10% hit and wiped out 40 bps of alpha, your private story and its consequences would look different. A distorted story that goes “What an idiot” is also a cognitive error, a story based on selective abstraction. Your distorted story about your questionable intellectual abilities will deflate your sense of confidence. Your underconfidence will paralyse your decision-making or tempt you to defer to those with less insight, neither of which is good.
Escalation
Your beliefs shape your experiences. The way that you engage with the world is a function of your personal belief system. This system gives rise to your preferences and inclinations, which in turn gives rise to your actions and experiences. Some of your beliefs get escalated outside of your conscious awareness, and these affect the way that you function.
Your personal belief system is an ongoing work-in-progress. Existing beliefs are updated and adapted, often automatically and without your conscious permission or approval. The process makes available cognitive resources for other tasks, but this carries a hidden cost.
You once told yourself a private story that went: “I want my performance to be top quartile.” This story got encoded in your operating system as a belief: “To be top quartile, I must be right a lot of the time.” Later this belief was escalated outside of your conscious awareness to: “If I am wrong, then I am worthless.”
The original story was perfectly acceptable: you are consciously committed to generating alpha by following your investment process. The escalated version gives rise to a competing commitment: you are unconsciously committed to being right. Being right and generating alpha are not the same thing, and the conflict between the two can cause havoc. When you are under pressure your commitment to being right will prevail to the detriment of both your investment performance and your professional relationships.
Your unconscious commitment to being right makes you prone to cognitive biases, for example:
Confirmation bias. The more determined you are to prove that you are right, the more you will ignore contradictory data and the more you will seek evidence that confirms your position.
Loss aversion. The greater your losses, the more reluctant you will be to cut problem positions.
Your unconscious commitment exerts great power over you precisely because you don’t know it exists. Your behaviour will perplex you until you bring this concealed commitment to the surface. Then it will become abundantly clear that your behaviour was logically consistent with the now-revealed commitment. Your behaviour will also seem irrational to those who have heard your public commitments, and they will incorporate that dissonance into their story of you.
Stories that others tell
Two things happen when you incorporate others’ stories into your personal belief system:
Confirmation. You unconsciously confirm the truth and accuracy of their stories. You forget that their stories emanate from their own imperfect belief systems, which contain inaccuracies and contradictions. You interpret the actions that accompany these stories as evidence of their truth.
Amplification. Their stories amplify the distortions of your private stories. They tell their stories in the most compelling way at precisely the time when you are most susceptible to the effects of distorted stories. Their stories will be more believable at these times, but not more true.
The most toxic stories say something about your character, which is stable over time, rather than your investment performance, which is transient. When a period of poor returns is storied as a character deficiency, it will contaminate your ability to see, think and act in a constructive way. If you leave this contamination unchecked you run the risk of being caught in a vicious cycle, where poor returns beget toxic stories, which contaminate your perception and action, which undermine your future performance.
The confirmation and amplification effects of others’ stories also apply when your performance is good, but also with negative consequences. After a run of good performance their flattering stories will confirm and amplify your private story about your skill as a fund manager and your worth as a person. Your growing confidence quite quickly inflates into overconfidence, which opens the door to a host of problems.
The story that others tell depends upon your investment performance. The most important storytelling groups are:
Management. The firm’s management, especially your boss.
Team. The members of your investment team.
Clients. Your firm’s existing and prospective clients.
Management
Free will is located in the space between stimulus and reaction. The greater the space, the greater your ability to function at an optimal level. A skillful boss will be acutely aware that her job is to help you manage that space in good times and in bad. Sadly though, the person whose job is to get the best out of you is likely to create conditions that are bad for you by shrinking the space when it is already contracting.
When your performance is going through a rough patch, the pressure on you will intensify and the space between stimulus and reaction will tighten up. You’d like your boss to absorb some of that pressure so that you can concentrate on generating alpha, but an unskilled boss will add to your pressure by expressing dissatisfaction with your performance and making threats about your career prospects.
The story that she is telling herself is that if she exerts more pressure it will magically get you to turn things around. You will need to divert scarce resources to reassure your boss that you have things in hand when you really need her to be reassuring you that she has your back. Her unskillful storytelling changes your orientation from alpha generation to career survival. This change in orientation has consequences for your decision-making and future returns.
When your returns are good and your boss is pleased, she will tell a story about how you are gifted and valuable and she will give you special treatment and greater leeway. Your idiosyncrasies are tolerated and your ego gets inflated because you are special. This greater freedom is your new normal, it’s your right as the investment genius you know yourself to be. This story is a more subtle way in which your boss shrinks the space between stimulus and reaction. The space must shrink to accommodate your inflating ego, which means that your ability to see, think and act constructively is shrinking too.
Team
The members of your team, your ambitious fellow fund managers and analysts, are highly attuned to shifts in your boss’s approval. When your boss’s story is that she is unhappy with your performance, your colleagues will smell blood and they will begin to circle for your position. You will need to apply energy to survive this political battle at the same time as you divert resources to reassure your boss.
After a period of good returns your colleagues will begin to defer to your apparently greater wisdom, which inflates your ego. You begin to treat your teammates as second-class citizens and your growing arrogance begins to alienate the very people upon whom you rely to help you deliver alpha. When your performance inevitably deteriorates and you really need others’ input, you’ll find yourself isolated and weakened.
Clients
When your clients are unhappy with the returns you have delivered, you will need to invest more time and energy to soothe their concerns and to change their story. You will divert resources away from generating alpha at the very time that the opposite is required.
To soothe your clients you will need to tell a persuasive story by showing conviction about your portfolio positioning, which traps you into being more deeply wedded to your positions at a time when you need to be most flexible and fluid in your thinking. You will be tempted to depart from your clients’ investment mandate and/or your investment process to make up for lost ground, which is likely to compound the problem.
When your returns have been good you gain the attention of prospective clients who want to hear you confirm their story of you. You spend more time being interviewed by those who want to feel a piece of the magic, which diverts your attention from generating alpha in your portfolios to gathering assets for the business. The more you tell the story, the more compelling it becomes, which reduces the flexibility of your thinking.
References
Frankl, V.E. (1985) Man’s search for meaning. New York: Washington Square Press.