Hard and soft factors in investing

At a high level, investing for institutions consists of hard and soft factors. The hard factor is related to finance – how to set an asset allocation and select securities in a portfolio. The soft factor is related to behaviour – how to understand the personal characteristics of board or investment committee members and engage them in the investing process. To ask which factor is more important is difficult to say, since they are – or at least should be – closely related. Yet the question is important and we will try to answer it.

Rocket scientist or social worker?

As a thought experiment, let’s contrast two extreme cases – investing done by a rocket scientist or a social worker. The rocket scientist is technically brilliant at finance but not very good at dealing with people, while the social worker is remarkably skilled in understanding human relationships but doesn’t know much about finance. Our rocket scientist has designed an algorithm that she believes can generate a 16% annualized return while greatly limiting losses. Our social worker, recognizing he doesn’t know that much about finance, has selected a handful of index funds, which he understands could generate a 6% annualized return, even though he’s not sure of that. Who’s likely to generate a better return for a charitable institution over the next 10 years?

Rocket science gone wrong

Clearly, there will be cases when a rocket-science system can produce remarkable results, if the underlying process is sound and has enough time to bear fruit. Yet there will also be cases when the rocket-science system has violent swings, looks very different from a regular portfolio and, most important of all, scares the living daylights out of a committee who took the whole system on trust and never really understood it in the first place. The risk of the rocket scientist under-performing the social worker comes from the committee changing or abandoning the strategy during this period of stress. In comparison, if the social worker uses all his skill to explain the investment process to committee members and engage them in the ownership of the investing process, there is a reasonable chance they will stay the course and actually capture the benefits of the social worker’s admittedly more modest-looking investment system.

What would Warren do?

Most institutions should not have to choose between an investment professional who is good with numbers or good with people. But imagine if we did have to choose, so that we could only get the benefits of one approach by losing some of the benefits of the other approach. This means we could either 1) retain a brilliant investment system but lose some of the social worker’s skill in dealing with people or 2) retain a remarkable ability to understand human relationships but lose some of the rocket scientist’s skill in designing an investment system. When put this way, I suspect that many institutions would realize that the second option is the better choice. The choice serves to illustrate the point made by Warren Buffett: “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing”. This applies all the more when working as part of a team to invest for the benefit of others.