Sometimes it is easy to think we live an investment world driven purely by profits and losses.  That idealized notion that investors are all risk/return maximizers. Even a cursory glance at the behavioral finance literature will disabuse you of that notion.  All manner of (mis)behavior in the financial markets is driven not by an attempt to generate economic returns but is rather an attempt to build or maintain an already existing business.

In a comment to my post on bubbles and the risk of underperformance David Merkel wrote:

Real value investors don’t care about underperformance.  That’s a fact of life for value investors, where their time horizon is significantly longer than that of average market participants.

As for bubbles, value investors have long horizons, and see what can’t be sustained.  They see the bubbles.  But most don’t short, because they know that the market can be insane longer than they can be solvent.

My response would be that very few “real value investors” actually exist.  Professional investors, value or not, live in a world where underperformance of either a sufficient magnitude or duration will cost them their clients and/or their business.  Therefore the risk they face isn’t necessarily underperformance, but the risk that their performance causes their clients to desert in droves.

Eric Falkenstein at Falkenblog addresses this issue in regards to the momentum effect.  Despite the long history of the momentum effect its implementation is still a risky endeavor.  He writes:

At any point in time your strategy is susceptible to a draw down that could cost you your client base. You can’t just say ‘hey, that’s risk!’ Investors see it as a failure, not a bad draw from the urn of chance..If you are in the bottom 10% at any time for any reason, your portfolio probably has hit an ‘absorbing barrier.’

Once you begin to look at the investment world through this lens things begin to make a lot more sense.  It makes sense that ETF manufacturers throw strategies up against the wall to see what sticks.  You see why asset gatherers try to make their offerings as sticky as possible so that when that inevitable underperformance does come along leaving that firm is as painful as possible.

The question for investors is whether they should be playing the outperformance game in the first place.  Underperformance is a fact of life in investing and if you don’t have a good grasp on it you are likely to carom from one strategy to the next.  As Scott Bell at I Heart Wall Street writes maybe investors need to take “a hard look in the mirror” before blaming Wall Street for their investing woes.

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