Avoiding ‘Chapter 11’ by starting with ‘Chapter 12’
Chapter 11 of the US Bankruptcy Code – even if you’re not American, you’re likely to have some sense of what it is. It’s a tool used by a company to protect itself when it’s teetering on the edge of solvency. We’ll no doubt be seeing a lot more of it over the next 12 months as the economic fallout of the pandemic bites.
‘Chapter 11’ is also a metaphor for when things have got challenging. Investment boards might avoid their own ‘Chapter 11’ moment, or strengthen an already positive position, through the wisdom of Chapter 12 of an entirely different publication – John Maynard Keynes’ General Theory of Employment, Interest and Money (1936).
Like Chapter 11, Keynes is on the periphery of most people’s knowledge. Best known as a brilliant and game-changing economist, he was also an accomplished investor. Whilst most of the ‘General Theory’ focuses on broader economic issues, Chapter 12 says some insightful things about investment decision-making, particularly its human elements. Some of the points that Keynes raises are directly relevant to the challenges and behavioural pressures facing investors right now.
Opportunities and risks
The dislocations that we are seeing in markets create both risks that need to be managed and opportunities that might be taken. In both cases, investors need to make choices in the face of considerable uncertainty.
Keynes nails three particular problems that are highly relevant today:
- Failure and being different from the crowd
- The short term vs. the long term
- Position sizing
Brilliant as Keynes was, however, he wasn’t that good at suggesting solutions. I’ve highlighted some insights from behavioural science and our experience of working with clients that should make life a little easier.
Failure and being different from the crowd
‘Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.’
Keynes managed his own money and for others including his alma mater, King’s College, Cambridge. Despite having an excellent long term track-record, as a contrarian/value investor, he presided over periods of significant underperformance. This made him acutely aware of the pain of doing things that others weren’t.
Evolution has hardwired us to seek the ‘safety of the pack’ and few of us have the level of self-confidence, gravitas and resilience to easily navigate those difficult periods when we are standing alone. Consciously or unconsciously, we are aware of this. Unless they are managed, these tendencies can seep into our choices.
Making life easier: As we have written about before, creating a culture of Psychological Safety is one of the best investments a board can make. It will negate some of the risks above and help you make confident and effective choices. However, this doesn’t happen overnight. If you are not there yet, what can you do?
First, get this issue on the table in an open and non-judgmental way. Many individuals and boards that I’ve worked with tend to think that this is a problem/weakness that relates specifically to them. It isn’t – it’s a hardwired evolutionary trait that’s built into all of us. Accepting this and having an honest conversation about it gives us a better chance of managing the situation.
Second, understand that the dominant emotion that is likely influencing us here will be regret, i.e. what if things go wrong? If we want to stop regret derailing our decisions there are some key things that we can do. If you’re an investment board, this includes ensuring that you get crystal clear justification for your choices. More background on regret and how to manage it is here.
The short term vs. the long term
‘Human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.’
None of us are going to argue with this. When we make an uncertain choice we’d like it to work in our favour straight away. We’d like to time the bottom of the market perfectly, or for a new risk-management strategy to pay dividends immediately. Of course, in most cases that’s an unrealistic expectation.
And whilst we want short-term gains, what drives our decision-making even more strongly is an aversion to short-term losses.
Making it easier: Again, a starting point of resolving many behavioural challenges is acceptance. Nature has built us to focus on the short-term and to avoid loss. We have to work and think differently to short-circuit these tendencies.
One of the easiest and most practical ways to do this is in the framing of the decision. For example, make it clear how the choice contributes to the overall performance of the portfolio. More on this in the next section.
Also be clear that whilst you will monitor the short-term performance of the choice, you will not judge it over a shorter time period. Explicitly setting a longer time frame will make it easier to commit to a hard choice.
Sometimes we can get caught-up in the complexity of certain risk management strategies. Reframing the argument as something that everyone understands and accepts can unlock challenging decisions. For example, most people wouldn’t feel bad about paying an insurance premium to cover their house, even if they don’t claim on it. Applying a similar mentality to key risk-management strategies, such as liability hedging, can make them easier to accept.
‘An investor who proposes to ignore near-term market fluctuations needs greater resources for safety.’
Keynes is, of course, right. And since these words were written, we now live in a world where risk budgets are more commonly used.
However, in the ‘fog of war’, investors can easily confuse what’s going on in the world/the nature of the investment choice with the sizing of the risk position.
For example, today may, or may not, be a good time to increase exposure to equity markets. Let’s consider two investors. The first investor’s only source of return is equities. For them the pressure to get things right is far higher than for an investor where it is one of many risks. This pressure can come from many sources, for example, the psychological pressure to make a good choice on timing. More prudence also needs to be taken when you are concentrating risks in a single area, e.g your estimates for loss may be insufficient.
A second investor has diverse sources of return (and risk). Here decisions should be easier as they are not ‘betting the farm’.
Also, at any time, but particularly in crisis, there can be a tendency to focus on and discuss what we understand and what we find interesting. For example, the nature of equity markets and how they broadly relate to what’s happening in the real economy makes them easier to understand than issues that might seem more esoteric, e.g. liability hedging.
In these difficult times, a crucial role of the risk budget is to direct our attention to what’s important. Clearly, this will be different for each investor. But for the ‘diversified’ investor above, if equity risk plays a very small element in future success, then it should not dominate discussions in a time-constrained environment. For most investors, the same is likely to be true for investment manager performance vs. asset allocation/risk management.
Making it easier for ourselves: First and foremost, investors should always have a clear risk budget that is clearly related to their objectives and their ability to tolerate bad outcomes. The risk budget, particularly now, should be a key input into where time and attention is focused.
When framing choices, we should always be clear about how the choice impacts the overall returns of the portfolio. For example, if we know and reinforce that we have a relatively small amount of risk riding on a choice, there is a better chance of it being taken even when outcomes are uncertain.
This equally holds true for timing of choices. If you wish to sell out of one asset into another, there can be a wide range of variables to consider, e.g. current prices in each market vs. expectations of future return and risk. For example, you might want to buy asset x, but there is some uncertainty about what might happen in the future, i.e. it might underperform. You want to finance this position by selling asset y, which has not met your expectations. Again, you have some concerns that once it has been sold, it might start performing.
In this kind of scenario, it is possible to get ‘frozen in the headlights’. We can easily get into an ‘either/or’ mindset. In reality, however, there is usually an ‘and’ option that can unlock decision-making. For example, you could simply split the investment between both assets as a starting point.
Summary – the ‘right thing’ is often the hard thing
In markets, the ‘right’ thing to do is rarely easy. Let’s be clear, these choices are hard for professionals and doubly so for individuals and investment boards.
We don’t need to have Keynes’ brilliance, reputation or resolve to make these choices easier. Simply ensuring that we focus on the most important issues and frame them well gives us a better chance of making more effective and timely decisions.
And when making these choices we should always remember a maxim that is often attributed* to Keynes:
‘It is better to be roughly right than precisely wrong.’
As always, both the science and practice of real-life decision-making is more complex than a blog post allows. If you’re a pension fund trustee or other institutional investor and would like more information, feel free to get in touch.
*Keynes probably didn’t say this, but never let a fact get in the way of a good finish (provided it is adequately footnoted!).