(In)efficient markets

Pretty much anyone who has been involved in financial markets for any length of time and has some success knows that these markets are not efficient. And thank goodness. Well sort of. Thank goodness from the point of view of an investor, because this creates the ability to generate excess returns. But most investors don’t, most because quite frankly – although rarely admitting it – they’re not even trying.

There are many reasons why markets are not efficient, most with roots in the fact that markets are by definition complex adaptive systems which have constantly changing dynamics and local equilibria. But one of the key drivers contributing to the dynamics of this system is the psychological biases that have been effectively embedded in the DNA of the modern “industrial” asset allocation paradigm. The natural and instinctive herding mechanism that is built into the way humans think.

For most people, there is no way to switch this off; the best one can hope to do is have high self-awareness and try to compensate for this bias. Interestingly, some people are physiologically missing these mental pathways. As an example, think of people afflicted by Asperger’s Syndrome. I’m not a doctor but some of the most (consistently) successful traders who I have had the privilege to meet or work with over the past couple decades certainly seem to have personality and behaviour traits that line up with (at least mild) versions of the Wikipedia definition of this conditions. I’m pretty sure this is not coincidence.[1]

But generally, most people (and thus the institutions they represent) make (investment) decisions locked inside a Keynesian Beauty Contest – trying to guess what everyone else thinks is pretty, not searching for intrinsic prettiness. And this is often a reasonable strategy, ie they are not behaving irrationally. Although it will never produce consistently strong returns – certainly not on an absolute basis, it will for long periods avoid consistently poor relative returns and even if absolute returns are poor (or even catastrophic) there is significant and very real safety in having fallen (jumped?) off the cliff in a herd. People like covering their ass. Wrong together rather than successful alone. Loss aversion. It’s a rational survival strategy.

And this behavioural framework applies through the whole asset allocation food chain – LPs to Funds to Companies – which means a couple things:

• the big tend to get bigger (buy IBM)
• there is an extremely high energy barrier to new entrants (at every level of the food chain)
• an actor’s ability to raise capital is the most important factor in their ability to raise capital (recursive)
• and for asset managers their core business becomes gathering (not investing) capital (tail wags dog)[2]

Which creates a big opportunity/risk pair[3] (or set of fractal pairs):

• (for individual actors) an opportunity: for those that can break away from this cognitive and behaviour framework to make outsized excess returns if their convictions are fundamentally sound
• (for society) a risk: that intrinsically value creating investments (funds, companies) are starved of capital, while many mediocre “me-too” investments are overcapitalised

In my opinion there is no precise, fundamentally “right” optimal balance in this pair, or certainly not one that is consistent in all environments but I suspect that our current state is quite far from a potentially optimal range. It’s great for a (very small) number of actors that may have the skills and good fortune to take advantage. But collectively poor for our societies and economies. Systemically brittle. From this societal point of view, I think it is important to at least try to redress this balance. I don’t have a magic solution for doing so, but as suggested above, self-awareness can be quite effective in helping to mitigate (at least a good portion) of our systemic biases. It won’t eliminate the Keynesian Beauty Contest paradigm, but it will at least dampen it.

Lest you think I’m exaggerating the extent of this herding behaviour baked into the world’s capital allocation system, let me share some of my first-hand experience of this. For almost a decade I was a syndicate manager. For those of you not familiar with investment banking jargon, my job was to manage the process of raising capital (in an industrialised, repeatable process.) While my focus was fixed income (bonds) (meaning that each year I was involved in managing hundreds of deals – ie my data set give me a decent sample size), the capital raising process – whether you are raising a seed capital round from angels, doing an IPO or selling a bond issue – is fundamentally the same. And if I were to draw a graph of the first questions investors asked during the marketing of a new issue of securities, it would have looked something like this:

(Yes, sadly Virginia this is how too many of the traditional managers of your savings frame their decisions…)

But, for the smartest investors (defined by those who consistently delivered better returns, who – during my tenure as a syndicate manager – were mostly a small number of hedge funds) this graph was inversed. It’s not that they didn’t care at all how big the book was or who else was investing, but that these were structurally second-order, tactical questions for them. First they made up their mind whether or not they thought the investment was compelling and only then did they factor in the deal dynamics in their bidding tactics.

I was reminded of this and inspired to write this post (in the hope of contributing to increasing the systemic self-awareness alluded to above) by a couple posts that I stumbled across in my bedtime reading last night that highlighted the biases (failings?) of investors in the venture capital food chain (LPs and VCs.)

In “How to Convince Investors”, Paul Graham highlights the behaviour I’ve described above:

If you can make as good a case as Microsoft could have, will you convince investors? Not always. A lot of VCs would have rejected Microsoft. Certainly some rejected Google. And getting rejected will put you in a slightly awkward position, because as you’ll see when you start fundraising, the most common question you’ll get from investors will be “who else is investing?” What do you say if you’ve been fundraising for a while and no one has committed yet?

While Eghosa Omoigui of EchoVC talks about the risk/opportunity pair that arises from the “Trough of Conviction” that LPs and VCs are prone to get stuck in:

Conventional wisdom has always been incredibly seductive. Particularly as it requires little to no intellectual effort. I am slowly forming a hypothesis that pattern matching in VC is showing similar characteristics, oddly enough.

Today’s VCs are falling prey to the minefield of so-called axioms masquerading as truisms. So sticking to the ‘x for y’ or ‘a for b’ pitches is simple, believable and thus fundable. I have no issues with this framework. It helps entrepreneurs to tell a story and VCs love to fund storytellers. But it implodes when faced by disruptive innovation, which I have seen recurrently present itself as an undiscovered versus unmet need.

…So all this boils down to the apparent calcification of pattern recognition (formulaic VC?), and the departure from the two-sided risk-taking marketplace (entrepreneur AND venture capitalist) that was always a key part of early stage venture. A fulltime dependency on pattern-matching when unaccompanied by thesis formation means that you will miss the big winners. As the venerable Tom Perkins declared, ‘If there’s no risk, you’ve already missed the boat.’

And he goes on to quote Elon Musk:

“I think it’s important to reason from first principles rather than by analogy…The normal way we conduct our lives is we reason by analogy…

We are doing this because it’s like something else that was done..or it is like what other people are doing…slight iterations on a theme…

“First principles” is a physics way of looking at the world…what that really means is that you boil things down to the most fundamental truths…and then reason up from there…that takes a lot more mental energy…

Someone could –and people do — say battery packs are really expensive and that’s just the way they will always be because that’s the way they have been in the past…”

Now perhaps by endorsing this view I myself am suffering from confirmation bias, after all, the DNA of Anthemis Group is entirely thesis-driven (both in the businesses we support with capital and in how we’ve organised Anthemis and our approach.) Although it is too early for me to definitively say our thesis is proven. That said (self-awareness!), this framework is the same one that informed my biggest previous (investment) successes – Betfair, Markit, Weatherbill, Zoopla – that have vastly outweighed the ones that didn’t work out. (Interestingly, one example of a poor investment I’ve made was in a company called GnuTrade. And although GnuTrade didn’t succeed, a company formed at almost the same time with the same vision called eToro[4] has succeeded spectacularly. Thesis confirmed, backed the wrong horse.)

So my “call to action” is that anyone reading this who has responsibility for making investment and capital allocation decisions fights harder against their biases to simply follow the path of least resistance – the crowd – and to develop and embrace real conviction, arising from a robust cognitive framework, and to act on this. Even if only at the margins. Let’s move the needle. We owe it to our children to try.