Many years ago, my landlord at the time said he was looking for a new financial adviser. To evaluate who to hire, he said he wanted to give three advisers some money to invest and then see how well they had done after three months.
He was a business owner, and from an entrepreneurial perspective, this approach may seem logical. Within three months it is possible to know whether many business decisions have been good, though other business decisions certainly take longer to evaluate.
From an investment management perspective, my landlord may have been better off throwing darts at a list of financial advisers or simply flipping a coin to make a choice. Investment management decisions often require a much longer period — five years, 10 years or more — to know if it was the best choice. Understanding the differences between these two skill sets can help you evaluate whether your adviser is the right fit for your situation.
Why is leading a business and managing a portfolio of publicly traded stocks and bonds so different? One reason, I believe, has to do with information disparity. Whether you are running a large or small business, you often have different information than your customers, employees and competitors. Different information can provide the opportunity to make more profitable business decisions.
In the publicly traded stock and bond markets around the world, however, thousands of people have nearly identical information. This means that, while it is possible, it is not likely that you can earn better investment returns than others by trying to time the market or pick the best handful of stocks and bonds to own.
This is known as efficient market hypothesis, and there is substantial evidence it is true. Instead, diversification and aligning your future objectives with appropriate investment risk is a more reliable way to harness the power of public investment markets to work for you.
Speed of feedback
Here is another reason business leadership and investment management are different — business decisions often provide quicker feedback. The concept of “fail fast” is often wisely applied in business decisions and is at the heart of design thinking. When a business is evaluating three different options, if it is reasonable to try all three and see what works best within a few months, then it can be very valuable to try. This process is used by many of the most innovative companies to improve the products you buy and the experiences you have.
Meanwhile, if you invest in two mutual funds, and in the next three months one goes up 20% and one goes down 20%, that will not tell you anything about expected results over a five- or 10-year timeframe. Instead, there are evidence-based factors, such as company size, relative price and profitability that can be utilized to improve long-term risk-adjusted returns, though it can take many years to experience the benefits of this approach.
Business skill and logical course corrections
There also is substantial evidence that skill can lead to better business results. In other words, a business leader can steer a company with well-placed course corrections. Perhaps you provide feedback to an employee that improves their performance or decide to spend more on a project than initially anticipated because you have confidence the outcome will be good, or you apply emotional IQ to intentionally develop a business culture.
Successful business leaders use information, but also their skills, to make business decisions. For example, Warren Buffett often buys entire companies and then relies on his managers to lead his various companies and make wise business decisions.
But when managing a portfolio of publicly traded investments, many short-term course corrections that may feel logical often lead to worse results. For example, I sometimes hear from very successful business leaders, “That investment went up, perhaps we should buy more of it.” This is logical thinking in many business decisions. But if we put our investment management hat on, it is often optimal to buy more of what went down and sell what went up.
In business, like in hunting, it makes sense to go where the opportunities are and change what isn’t working as well. In investment management, better long-term results often come from selling winners and then reinvesting more in what did not do as well.
For example, in March 2020, many types of bonds went up and most stocks went down. Better results came from selling what went up (bonds) and buying what went down (stocks). Given the headlines and the uncertainty that existed at the time, as logical as it may seem in hindsight, that decision was difficult for even many experienced professional investment managers.
If you can’t assess the performance of your adviser using well-known business leadership principles, what criteria should you use?
If you are considering hiring your next employee, it may be wise to consider the candidate who optimistically and confidently says, “I can do this better than others!” You can then evaluate their performance over a reasonable time frame, perhaps three months, six months, or a year or two to determine if someone is the right person for a role.
While a confident, hardworking employee may have a high probability to exceed your expectations, you will reasonably need longer to evaluate if you have the right investment manager. You can, however, evaluate a financial adviser in the short term based on other factors such as how well do they understand your values, your purpose, your goals and how proactive are they in addressing the details of your financial life so you can focus on what is important to you.
An effective adviser may not always use business leadership principles in making investment choices for you but should always carry out their fiduciary duty with your highest financial interests in mind.