I was interviewed by HedgeNews Africa for their First Quarter 2020 edition. The title of the article was, “Deal With The Noise To Unlock Opportunity”.

Markets have been particularly noisy of late. What can you offer a fund manager who is struggling in the current climate? 

This has been a period of acute noise and it’s been a severe test for many fund managers. But for a few managers this is a time of extraordinary opportunity. In my view, what differentiates the few from the many is the ability to recognise, manage and exploit noise.

The conventional definition of noise is that it is a mild irritant, something inconsequential that should be ignored. I think this is a dangerous fiction that is starkly revealed in times like these. Noise, as I define it, is the set of acute disruptions and chronic disturbances that undermines the ability of the professional investor to function at an optimal level. Noise should not be ignored, it should be actively managed.

How does noise affect a fund manager’s decision-making?

One way to describe it is that noise affects how you perceive the world, how you process what you have perceived, and what you decide to do with what you have processed. If your perceptions are distorted and your processing is distorted, it’s highly probable that you will make errors of judgement.

When your noise levels are elevated, you experience two types of perceptual distortion.  The first is spatial distortion, a kind of tunnel vision that results in you missing peripheral data, information that is not in the centre of your perceptual field. The second is temporal distortion, a perceptual foreshortening of time, and this myopia results in you not seeing possibilities beyond the immediate first-order consequences of the situation that you face. This means that elevated noise makes you see a mere subset of the available data, you see only the obvious and the immediate, which is data that’s already priced in. Noise crowds out potentially valuable information, it undermines the quality of the inputs into your analysis.

Noise also drains away precious processing power, lures you into taking mental shortcuts and makes you more prone to cognitive biases. Acute noise, if it’s not properly managed, causes discontinuities in your cognitive processing, it interrupts the smooth running of clean sequential logic. That’s not good. The equation is simple: perceptual distortions + processing distortions = decision error. 

Can you give an example of how this plays out in the markets, in a way that is applicable to the situation we’re in now?

At the end of the Global Financial Crisis the massive decline in prices was accompanied by the perception of elevated risk levels, when in fact risk was ebbing away precisely because prices had over-reacted to reality. There is no denying how scary things were for a while and there was no shortage of credible scenarios indicating that everything would end in a smoking heap, but the scariness had outpaced the reality on the ground. This meant that the risk/reward relationship had become attractive but it was very difficult to see at the time because the acute noise interfered with clear thinking. Extreme price action had triggered heuristics and biases that were very difficult to overcome for those who were less able to manage noise. Two cognitive biases that come into play when prices fall dramatically are loss aversion, which happens as price declines extend and accelerate, and irrational extrapolation, which happens as panic sets in and weak hands capitulate.

Those who were best able to manage this noise, which meant not being suckered into equating falling/fallen prices with rising/elevated risk levels, were the ones who were able to see the opportunities more clearly. They were able to take advantage of generalised noise and turn it into significant alpha. Very few fund managers participated in the extraordinary opportunities that existed, most had experienced severe amygdala hijack and had begun to fear that everything was going to zero. It’s very hard to stand apart from the crowd when noise levels are elevated, but the more skilled you are at actively managing noise, the greater your ability to think clearly and act constructively in difficult circumstances. The skill of active noise management turns a problem into an opportunity.

What can fund managers do in the current climate to help them stay on course and achieve their goals? And on the flipside, what should they not do?

Managing your emotions is obviously important, especially during times like these. But fund managers generally do a poor job of this because it’s part of orthodox investment mythology that emotions are the arch-corrupter of pure rationality. Emotions seem to be the enemy, to be defeated at all costs. This myth logically calls for the vanquishing of troublesome emotions, for suppressing them out of existence.  

As a fund manager you quite rightly do not want to be overwhelmed by emotions because every time you pull the trigger when you are in this state you are virtually guaranteed to destroy alpha, unless you are profoundly lucky. However, the attempted suppression of emotions has unintended consequences, one of which is that you will inadvertently amplify and prolong the very emotion you’re trying to suppress. 

There is a way between the two extremes of allowing yourself to be overwhelmed and attempting to suppress troublesome emotion. Much like you might manage the exposures in a fixed-income hedge-fund in response to market turbulence, you can manage your exposure to troublesome emotion by doing two simple things. One, remind yourself that the emotion is fractional, it’s only one part of your total experience, and in this way you deleverage the emotion. Two, remind yourself that the emotion is transient, it’s not a permanent state, and when you do this you shorten the duration of the emotion. When you reduce your exposure to a troublesome emotion in this way, you’re in a position to re-engage in clear-headed analysis and constructive action faster and better than your competitors.  

Is the management of noise then really about improving fund managers’ investment discipline, the ability to stick to their investment process under difficult circumstances?

Investment discipline is very important, of course, but it can’t be the whole story. If you’ve got great discipline but a poorly designed process, then you will be disciplined about destroying alpha. That’s not good. So, in the investment domain, discipline and design must go hand-in-hand. But there is another domain that also needs to be considered, the people domain, your relationships with the various stakeholders in your process.

Conventional wisdom has it that if you’ve already designed a decent investment process then you should be laser-focused on following that process, and ignore everything else. But even if you have the mental toughness to not abandon your process during a rough patch, you must also pay attention to the quality of your conversations with your clients, or they might abandon you. If they can’t stick it out during a difficult period, then neither can you, no matter how great your investment discipline. That’s a lot for a fund manager to do, and none of it is easy.

What advice can you give on communicating with investors when things are going wrong?

Many fund managers half-consciously equate their worth as a human being with their investment results. For a number of reasons this is a very risky existential proposition. A bad performance print is painful beyond belief, and it’s often accompanied by troublesome emotions like embarrassment and shame. The instinct will be to hide and hope under these circumstances, but giving in to that instinct will just compound the problem.

Fund managers need to communicate as quickly and directly as they can with their clients if they’ve had a bad month. Letting your clients hear bad news from anyone other than yourself is going to embarrass them, on top of their feelings of shock or anger. You don’t want to do that. It should be the chief trigger-puller that makes a personal call, even though there are a hundred other important things to do. In the call the fund manager must, clearly and simply, lay out the facts of the situation and the plan to repair the damage. The manager needs to be able to properly hear and accept the client’s emotional reaction in all its awkwardness and messiness. This will be hard because it is seldom the fund manager’s natural game. And, if the client has been deeply enough heard, the fund manager might explore possible courses of action with their client and perhaps make a direct request for what they need, such as a temporary stay of execution while they fix what has gone wrong.

As if that’s not enough to contend with, fund managers also need to remember that their own views and opinions can become too rigidly held, especially when these views are forcefully and frequently expressed as might be the case when you make multiple client calls after a bad performance print. Then you can find that you’ve unknowingly crossed the threshold that separates your need to be right from your desire to repair the damage, and these two things are by no means identical.  

What about communication within investment teams during times of crisis?

Most fund managers have excellent hard skills, the ability to do all the difficult work of security selection and portfolio construction, but many have not fully developed the soft skills of personal regulation and relationship management. These soft skills are generally ignored or disdained, but they are vital for your professional survival during times of crisis. They also represent an opportunity to develop a sustainable competitive advantage.

The cerebral and numerate people who are drawn to investment management find this soft stuff really hard. High quality communication within your investment team is essential for success, but it’s seldom achieved because the underlying personal dynamics within the team are not easily understood and managed. That’s a serious problem at the best of times, let alone in times of crisis.

I have developed a framework that transforms stuff that seems vague and hand-wavy into something intelligible and actionable. It takes account of something that is obvious but often forgotten, especially in difficult circumstances, that not every person in your team is wired the way you are. Different members of your team will show up differently under conditions of low noise and high noise, sometimes radically so. If this is not properly grasped, your team is going to be a source of considerable noise, rather than consistent support. My framework allows you to map the way in which the members of your team, and the team as a whole, are likely to function under different conditions. This enables you to identify and manage otherwise hidden dynamics in your team, which serves to protect against team dysfunction and disintegration. It enables you to bring about deeper trust, higher quality debate, and sharper decision-making.