In a former life I used to look over hundreds of private equity fund pitches every year for investment opportunities. A few things stood out in the similarities of these funds:

Every single one of them claimed to be top quartile — either through past returns or the promise of future returns.

90-95% of funds marketed target IRRs in the neighborhood of 15-20% per year, maybe 12% on the low end. It didn’t matter where we were in the market, credit or economic cycle. Huge returns were being offered up regardless.

They all talked about their differentiated process.

There was rarely, if ever, talk about the risks involved to earn those returns (assuming they were even possible).

There’s no way that all these funds could be in the top quartile, let-alone earn the type of returns they were presenting. It’s all a charade, but one that both sides are willing to keep up, as Charline Munger reminds us:

I know one guy, he’s extremely smart and a very capable investor. I asked him, ‘What returns do you tell your institutional clients you will earn for them?’ He said, ‘20%.’ I couldn’t believe it, because he knows that’s impossible. But he said, ‘Charlie, if I gave them a lower number, they wouldn’t give me any money to invest!’ The investment-management business is insane.

The blame for this line of thinking should probably be shared equally among investors — who set unreasonable expectations — and portfolio managers — who pretend that they can meet those lofty expectations.

Delusions of grandeur can cause investors to believe that they can earn double digit returns no matter what is going on around them while taking as little risk as possible. Risk is pretty much guaranteed. However, the returns are not always what we would like them to be when we need them.

Most individuals and institutions seem to have an idea of the range of returns they want or need (not always the same thing). Many assume that doing whatever it takes to achieve those returns is warranted without first considering the implications.

When you manage exclusively for returns you tend to forget about risk, which is really the most important part of the equation. Corey Hoffstein at Newfound Research had an excellent piece this week on on this topic. He discussed how alpha is not a risk management technique:

We think it is fair to make the sweeping generalization that investors are obsessed with outperforming the market. Why? Because of an even greater generalization: people are greedy.

Greed can make people myopically focus on potential rewards and neglect any added risk. In the finance industry, we’ve gone so far as to distill this entire notion down to a single statistic: alpha.

The problem with a sole focus on alpha is the unintended consequences that can arise. Investors assume that as long as they outperform that everything will work out. It’s a loaded assumption. Hoffstein continued:

Investors focused on only maximizing the return side of the equation may not always be aware of the extra risks they are taking on in chasing that return. In an industry where benefit is distilled down to a single number – alpha – it is important to remember the return and risk require separate analysis.

The problem most investors run into in the elusive quest for alpha is that they end up taking on unnecessary risks that they don’t understand. Not only that but they open themselves up to taking on risk that is perfectly avoidable.

Every asset allocation study I’ve ever seen has used various market indexes as the inputs for risk and returns. But when the portfolio is allocated those in search of alpha fill every single asset class with different active money managers. Right away there’s a mismatch between stated risk and return goals and actual risk and return characteristics.

I’m not saying everyone needs to use all index funds at all times, but I’m not sure investors spend enough time thinking about the extra risks they’re taking by deviating from those indexes. Far too many investors are looking to bail themselves out by outperforming, but don’t really have a contingency plan for if and when that doesn’t happen. Outperformance should be pretty far down the list in terms of investment planning needs because it’s so hard to pull off consistently.

You can manage expected returns by how you allocate your portfolio, but no one is good enough to be able to manage their portfolio to hit actual return numbers. You can’t optimize the real world like you can in a simulation.

Naive investors manage their portfolio in hopes of hitting a specified return target over a short period of time.

Successful investors look to control risk, first and foremost, with the understanding that the returns will come eventually.

Sources:

Alpha is Not a Risk Management Technique (Newfound)

A Fireside Chat With Charlie Munger (WSJ)

Further Reading:

The Bedrock of Portfolio Management