Why Sustainable Active Investing Fails

October 09, 2015

Like Poker: Pick The Right Table

Behavioral finance outlines a framework for being a successful active investor:

  1. Identify market situations where behavioral bias is driving prices from fundamentals (e.g., identify market opportunity)
  2. Identify the actions/incentives of the smartest market participants (e.g., identify market competition and what they are doing or not doing)
  3. Find situations where mispricing is high and competition is low

In the context of poker, a similar strategy is critical for success:

  1. Know the fish at a given table (opportunity is high)
  2. Know the sharks at a given table (competition is low)
  3. Find a table with a lot of fish and few sharks

In Figure 2 below, the graphic outlines the questions we must ask as an active investor in the marketplace.

  1. Who is the worst poker player at the table?
  2. Who is the best poker player at the table?

To be successful over the long haul, an active investor needs to be good at identifying market opportunities created by poor investors, but also skilled at identifying situations where savvy market participants are unable or unwilling to act.

Figure 2: Identifying Opportunity In The Market

Understanding The Best Poker Players

In our orange arbitrage example above, transport costs impeded the arbitrage opportunity. In the stock market, there are similar direct cost frictions such as short selling, commissions and so forth. However, these costs are unimportant compared with perhaps the biggest market friction imposed on most of the smart poker players in the stock market: agency costs created by short-horizon performance expectations.

Consider the pressures produced by “tracking error,” or the tendency of returns to deviate from a benchmark. Say you are the smartest investor in the world and your job is to invest the pensions of 100,000 firefighters. You have a choice of investment strategies. You can invest in either A or B (summarized in Table 1):

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