Preparedness and Patience
"The future is uncertain. Correlations can change. The analysis is thinking about scenarios and risks and not getting false confidence from the past." – Simon Pilcher
Whilst the act of making an investment is much celebrated in investment management, two qualities emerge in the conversations with CIOs, to help improve the precision and effectiveness of action - preparedness and patience.
Information is no longer scarce. The constant flurry of updates on slow moving situations arrives hourly, and market prices show strength or weakness by the millisecond and the talking heads provide binary commentary all day long. One of the key skills of today’s Investment Management is to filter out low-quality content and generating high-quality signals.
With investment horizons often measured in the years of decades, short term forecasting is not where institutional investors choose to focus.
Prepping
I recently listened to a podcast on “prepping”. Prepping is readying your home for unusual situations like power cuts, floods or war. It involves flashlights, gas hobs, drinking water and tinned food. Investing is similar. Whilst you cannot predict a once in a lifetime event, you can try and make sure that when you construct your portfolio it avoids placing too much risk on one factor/scenario.
Rather than preparedness being forecasting it increases ability to act i.e. increases optionality. It is not free – it involves allocating today’s resources for uncertain future benefit.
Broad preparedness includes
thinking through different states of the world
understanding what you can allocate from (which requires liquidity planning)
what you would allocate into, including things that seem really far off today
This is easy in theory, but in practice, it requires aligning other stakeholders. Having agreed IMAs with managers that are not set up, having considered multiple scenarios with committee members and what action you can and expect to take. For preparation to be effective, governance needs to be pre-agreed or have the delegated authorities to allow action to take place. All of this requires foresight, communication and trust which takes time to build.
Simon Pilcher described USS as building portfolios that could thrive in many futures and survive practically all of them. That is preparedness in action.
Guillermo Donadini of Lloyds approached the same challenge through risk tolerance. Stress tests helped paint a picture of what might happen, but so did whether decision-makers could "stomach that risk" during a drawdown. Many strategies that look good on paper, do not survive contact with the reality of a stressed market.
Andy Chorlton made an important point about preparation from an asset management perspective. If you understand your style and process well, you should have a sense for which market scenarios will lead to outperformance and underperformance. That honesty and clarity upfront will help keep the relationship on track during stressed markets.
Is patience just inaction?
Patience at first sight seems passive, almost the epitome of not acting. I think that misses the mark. Waiting when great action is available is not valuable but resisting sub-optimal action when action is available has great value.
Patience comes in many forms. It is the ability to fend off nervous nellies keen to do something. It is following but not feeling compelled to “play” in an investment thesis which is developing. It is being able to focus on valuable signal from a noisy world and making sure that action occurs when there is enough (not 100%) of the signal available.
Long-term investment requires patience. David Thompson described forecasting the next black swan as "a bit of a fool's game". The implication was not that investors should stop thinking about scenarios. Rather, portfolios should not rely upon our ability to predict precisely when the next disruption will arrive but knowing that they will.
Similarly, Simon Pilcher spoke about considering different futures and avoiding false confidence from historical relationships alone. That is often lost when people rely on back-tests and modelling which considers too narrow a range of possibilities.
The dreaded framework
Without patience or preparedness, we are at the whim of the market and become a Reactive investor. The Aggressive investor has a process for everything but act hastily when things are to be done.
The Passive investor appears patient but has not done the groundwork so ends up missing opportunities. Liquidity has not been arranged. Governance has not been tested. Stakeholders have not been aligned.
The Deliberate investor combines both. Chetan Ghosh often returned to the point about portfolio construction. It was not about whether a portfolio looked acceptable on paper. It was whether the institution could live with the outcome and retain enough optionality to act when circumstances changed.
The A+ preparedness feature
The most interesting form of preparedness for me is stakeholder management. Coming back to Guillermo Donadini’s observation about "stomaching the risk", it is the people element that needs to be considered.
An all-weather portfolio with an unprepared Investment Committee will not capture the key opportunities that arise in stressed markets. The role of a CIO is to make sure that conversations are being had about tomorrow not just today.
What does that preparation take? Probably deep relationships, establishing trust and credibility and going through the future scenarios so many times that it is part of the institution’s DNA.
So what?
Preparedness and patience are the two qualities that distinguish effective long-term investors from merely active ones. It builds optionality so that when opportunities or crises emerge, the institution is capable of acting.
You cannot predict the precise shock, but you can ensure your portfolio, liquidity and governance are resilient enough to respond. True preparedness requires pre-agreed governance, delegated authorities, stakeholder alignment and trusted relationships.
Risk tolerance is behavioural as much as analytical. A strategy that looks attractive in a stress test is useless if decision-makers cannot stomach the drawdown when it arrives. the highest form of prepping is with stakeholder management.
Patience is the discipline to resist available action until sufficient signal emerges from a noisy environment.
The framework creates four investor archetypes: Reactive (low preparedness, low patience), Aggressive (high preparedness, low patience), Passive (low preparedness, high patience) and Deliberate (high preparedness, high patience).
Next week's blog will be "Intuition revisited". As always get the blog delivered directly to your inbox on Home | Deciders | for mental fitness | change your mind.
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