You will produce above-average investment returns if you’ve had the good sense to figure out your competitive advantages, and if you’ve designed your investment process around those advantages.
But even then you won’t produce above-average returns all of the time. Two things will conspire against you.
- Bad Luck. No process produces alpha under all conditions. Stuff happens.
- Poor Discipline. You’ll be tempted to abandon your process when stuff happens.
No matter how much of an edge you have, and no matter how well designed your investment process, inevitably there will be periods when you underperform.
The structure of the investment industry changes, the structure of securities markets changes, the structure of your team changes. These and other changes mean that an unchanging investment process must be out of sync for some of the time. The way to adapt to these changes is to make periodic assessments of your competitive advantages and to make adjustments to your investment process if necessary.
The more interesting part, perhaps, is what happens between those periodic assessments and adjustments, the ongoing part that falls under the heading of investment discipline. This is the degree to which you are able to stick to the investment process that you have designed. It always matters, and it matters most when stuff happens.
If your process has been designed around real competitive advantages, then abandoning that process means that you have allowed yourself to be pushed into areas where, at best, you probably have no competitive advantages. At worst, you may be the patsy. That is a recipe for the destruction of alpha.
The difference between your actual activities and your intended activities is the measure of ill-discipline. If you are suckered into giving attention to something that lies outside your process, then your attention has been captured by noise, which means that you are in no position to capture alpha.
Noise, in any of its many forms, forces you to stray from the path that you have plotted. When there is little noise, you’ll mostly find yourself roughly on track. But when the noise levels pick up you will find yourself doing things that you had not intended to do, or not doing things that you had.
Elevated levels of noise put you at risk of getting seriously lost and losing serious money. The folks who will be taking that money are usually the ones with better discipline.
- How would you rate your investment discipline?
- How is that rating affected when your noise levels are elevated?
- What might you do to inoculate yourself against the effects of noise?