Portfolio > Asset Managers

Needed: Investors With Delusions

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I recently discovered that I am delusional. But just for the record—so are you.

In survey after survey, over 80% of those questioned consider themselves above average in driving skills, self-awareness and general knowledge—really almost anything. I still recall the frustrating comments of an elementary school principal as he wearily told me that over 90% of his parent body believed that their children were geniuses. Yet a growing number of experts say that self-delusion in modest doses is actually desirable, a sign of a healthy and normal personality; one that can help an individual persevere in the face of repeated failure.

This persistent over-estimation of our own specialness may help explain our fascination with stories of truly unique and iconoclastic individuals, who risked everything to challenge the conventional wisdom of their day in the service of advancing knowledge or wisdom: Abraham, Socrates, Jesus, Copernicus, Galileo and Darwin are among the hundreds, perhaps thousands, of well-known examples of individuals who looked out at the world and saw it in a fresh new way.

Today we are the grateful beneficiaries of their combined efforts. And yet we wonder what set of perverted incentives caused the apparently ignorant, superstitious or foolish people to feel so threatened by the new information that they needed to act, in some cases violently (Galileo was put under house-arrest by the Catholic Church; Socrates was sentenced to death).

It would be reassuring to know that today we are much more enlightened and things are different; that we are more open to change and that, after all, proof is proof. Perhaps we are enlightened, but if so it isn’t by much. Progress still needs individuals who are willing to suffer, sometimes greatly, in order to successfully confront conventional wisdom—that is still the operative rule.

Medical Cases

Consider Barry Marshall, an unknown M.D. from a small town in Western Australia. After a few years of investigation he found a direct link between ulcers and the presence of H. Pylori bacteria, ultimately demonstrating his point dramatically by ingesting the bacteria himself and giving himself an ulcer. But the world medical establishment had no interest in data that contradicted what they believed to be true, and certainly not from some nobody from nowhere.

Marshall discovered that despite overwhelming clinical evidence—despite the science—other doctors simply refused to believe it. In an interview with Discover magazine, he recalled his experience: “To gastroenterologists, the concept of a germ causing ulcers was like saying that the Earth is flat. After that I realized my paper was going to have difficulty being accepted.” Marshall persisted, and received the Nobel Prize in 2005.

Starting in the 1960s Michael Merzenich was one of the early observers of plasticity in the brain—its ability to modify and repair itself. Along with a number of other scientists he was able to show that the brain had the ability to establish new pathways and even redirect functions to different parts of the brain, contradicting the previous understanding that such flexibility was impossible after early childhood. It took more than 20 years before plasticity became fully accepted, but not before the scientists who identified and recorded it were treated to years of professional and personal derision and attack.

Despite the science, even the most rational of us are human beings, and human beings are influenced by social incentives that have stood in the way of progress in the past and are likely to do so in the future. Ironically, these are not perverted incentives. These incentives are important, even critical to our lives. They are responsible for our desire to create a civil society: to behave generally within socially acceptable limits, keeping us connected to our families, our friends—even to strangers. And being connected is a sign of a normal and healthy life. But these otherwise positive attributes in different contexts can and will push us into behaviors that don’t serve us well, either individually or collectively, as we have seen above.

Lord Keynes famously summarized this dilemma: “Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally.” Keynes made this brilliant observation 80 years ago, and it is quite a wonder how successful we have been in collectively ignoring the implications of his insight.

In his book, “The Wisdom of Crowds,” James Surowiecki illustrates how Keynes’ observation has played out in the investment world. In referencing a well-known study of herding by David Scharfstein and Jeremy Stein, he writes: “What Scharfstein and Stein recognized, though, was that mutual fund managers actually have to do two things: they have to invest wisely, and they have to convince people that they’re investing wisely, too.” The problem, Surowiecki notes, is that for the most part investors don’t know how to differentiate between a wise investment and an ill-advised one. But investors can know if a manager’s style, process and strategy are similar to those of other managers (i.e., in the mainstream)—and if so, they will conclude that the manager is making rational decisions.

This kind of thinking has led investors of all levels of sophistication to consider that someone whose investment approach is noticeably different in style or outlook from the mainstream is odd, irrational or even dangerous; hardly the place to invest serious money. This lays the foundation for the bizarre environment we find ourselves in today, as Surowiecki concludes: “It’s much safer for a manager to follow the strategy that seems rational than the strategy that is rational.”

Psychoanalyst* David Tuckett reinforces Surowiecki’s conclusion in a study he featured in his book “Minding the Markets.” Among the dozens of money managers he interviewed, Tuckett could only find a handful who were willing to execute the long term strategies they knew would be successful. For the rest, the pressure not to stray unacceptably far from their benchmarks was just too intense. In order to keep their jobs they knowingly sacrificed their skill.

Fund Dilemma

In Joseph Heller’s iconic book “Catch-22,” the lead character, Yossarian, tries to get out of flying combat missions by claiming he is crazy. But he’s stopped in his tracks by the company psychiatrist who invokes “Catch-22”—which says that only someone who’s crazy would want to fly combat missions and therefore doesn’t have to, but if someone doesn’t want to fly combat missions, he’s obviously sane and has to.

If fund managers did what they were trained to do, at some point their strategy (like all strategies) would seriously underperform the market averages, investors would liquidate their shares, and the managers would lose their jobs. So fund managers fudged in order to satisfy the investing public (by not straying too far from their benchmark) and therefore kept their jobs—and it worked for decades. Now investors finally see through the masquerade and are liquidating their shares; the managers are losing their jobs, the fund industry’s reputation is in tatters and investors are increasingly throwing in the towel and indexing.

I have an alternative solution. Let’s find some (modestly) delusional, unique and iconoclastic investors who are willing to go up against the conventional wisdom of today; who are prepared to be denigrated, discounted, demonized and peripheralized—but believe enough in themselves and their chosen path to persist in the face of repeated failure. One day our great-grandchildren might read books about a few of them.

I could be wrong about this—but history is on my side.

* – Editor’s note, 2/4/15: This article’s original reference to David Tuckett as a “psychologist” has been changed to “psycholanalyst” based on subsequent discussion with Tuckett.

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