Simon Evan-Cook: When the maths does not add up

Rational logic is generally a good thing, but you can have too much of it. And we may have too much of it today - sometimes what seems logical from one perspective looks bonkers from another.

Mathematics is the home of the rationalist. But, in the real world, mathematical logic can come a cropper and it is useful for investors to be able to spot such episodes when they arise.

Rory Sutherland, in his book Alchemy: The Surprising Power of Ideas That Don't Make Sense, provides plenty of examples. One that stood out was his contention that 1x10 does not equal 10x1.

He gives the example of recruitment. You might think one person hiring ten people is the same as ten people hiring one person each, but it is not. Even if we do see a difference, we might assume the latter would lead to greater diversity of recruits than the former. Again we would be wrong.

When one person makes one hire, they will tend not to take a risk. For most people, not taking risks means hiring someone like themselves. But one person hiring ten people? They may hire one or two clones, but they will be more likely to take a chance on some radically different hires for their other picks.

This reminded me of a fund selection conundrum. In portfolios where we had a high Japanese weighting, we used four funds - all completely different to each other and to the market itself. But for other mandates, which had much smaller Japanese exposure, we felt we could only justify one fund pick. For that pick, we were not prepared to risk picking a single ‘satellite' fund, so we went with a ‘core' fund we thought was good, but looked and acted much more like its market.

The results are in the graph below. The combination of our four specialist picks beat the core fund. And we think it will continue doing that too, hence why we have long since gone with multiple selections across all of our mandates.

Over the last 18 months, this four-way specialist combo has dragged its feet, while the market and the core fund has played catch-up. I think this illustrates the overly ‘rational' phenomenon I am talking about.

The prevailing logic in investment committees is the average investor cannot beat the market, so do not bother trying. This is true, but the logic has been stretched to mean that, because the ‘average' investor cannot beat the market, ‘every' investor is unable to. That patently is not true. Regardless, investors are increasingly not trying anymore, and this growing ‘rationalism' is driving more and more fund pickers to buy either a market tracker or a core fund that acts like the market.

This flow of assets affects real-world stock prices, and therefore has the self-fulfilling impact of making those rational ‘core' funds perform well at the expense of peripheral selections. But those flows have no impact on the real-world profits of the underlying stocks. This means you are generally getting more and more for your money by buying the neglected peripheral stuff, and less and less for the increasingly popular core. 

Eventually the dispersion between the poor value of the popular core and attractive value of the neglected periphery will become too high to miss, so money will start flowing back the other way. This is exactly what happened at the end of the nineties. Then the elastic snapped back sharply after 2000 and for several years the ‘irrational' outperformed while the ‘rational' sold off. Twenty years on, history looks set to repeat itself.

Simon Evan-Cook is senior investment manager at Premier Multi-Asset Funds

This article appeared in the December issue of Professional Adviser's sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please do register your interest here

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