(Bloomberg Opinion) -- We all suffer from cognitive biases. Paul Marshall says he’s prone to optimism bias — he’s “too easily romanced by new stories and new opportunities.” He says his financial partner, Ian Wace, succumbs to the gambler’s fallacy, expecting market dislocations to disappear rapidly as prices revert to their mean. But neither trait has prevented them from building Marshall Wace LLP into one of the world’s biggest hedge funds, overseeing more than $44 billion and making billions for themselves in the process.
After more than three decades in finance, Marshall has just published a book, “10 ½ Lessons From Experience: Perspectives on Fund Management.” His overall prognosis for the industry is optimistic, in that opportunities to make money will continue to arise, and there’ll still be humans around to take advantage of those moments. But he caps it all off with a cautionary tale for his peers — the half-lesson that makes the final chapter.
Financial markets are inefficient, prices have memories whereby today’s values influence tomorrow’s rates, and reflexivity creates feedback loops, Marshall writes. Moreover, nothing trades in a vacuum. Diamonds are relatively useless compared with water, yet the former are vastly more valuable — until you find yourself dying of thirst in a desert:
Markets are an exemplar of what cannot be contained within axiomatic thought. They are highly complex non-linear systems created by a myriad of half-informed or uninformed decisions made by fallible (human) agents with multiple cognitive biases.
Not only do those humans suffer from predetermined inclinations that are tough if not impossible to shake; they are also dumb. “You can’t model stupidity,” Marshall says. “It does not conform to any predictable rules.” But that fallibility helps to create the market inefficiencies that a good hedge fund manager can profit from. And a good trader has to be right only 52% or 53% of the time; a “truly great” manager can still be wrong 45% of the time, he says.
Marshall Wace splits its equity investment strategies about equally between fundamental stock picking managed by humans and systematic mathematical trading run by computers. Marshall reckons the former will continue to be important, albeit with more reliance on the latter. “Machines have not won yet,” he writes. “Machines typically do not fare well in a crisis. They are not good at responding to a new paradigm until the rules of the new paradigm are plugged into them by a human.”
The human traders, better suited to making “the leap of imagination to understand the implications” of a tectonic shift in the investment landscape, performed better than the machines in the aftermath of both the 2016 U.S. presidential election and the U.K.’s Brexit referendum — in which Marshall backed the decision to leave the European Union, with Wace in the remain camp.
In the future, Marshall says people will become increasingly reliant on alternative data sets “to provide extra conviction to the mosaic they are building around a stock,” adopting a hybrid strategy between fundamental and systematic trading that’s been dubbed quantamental analysis. By harnessing a broader range of numbers than the traditional financial metrics, traders will gain an edge over the robots — even as competitors catch on to the usefulness of social media, credit-card spending and weather patterns to predict market moves.
The title of the finale to Marshall’s musings on his industry is a zinger. “Most Fund Management Careers End in Failure” is a riff on Enoch Powell’s verdict on the fate of politicians. With many of the world’s most storied firms run by single individuals, hubris and arrogance can set in, he warns. Wealth becomes confused with worth, and a hedge fund star can become “impatient of advice, blind to your own limitations, weary of democratic decision-making.”
Marshall doesn’t say it, but his 21-year partnership with Wace seems to have avoided that pitfall: “Extremely lonely” is how the latter characterized the years between 2005 and 2008, when Marshall stepped down as chief investment officer to concentrate on political and charitable work.
The biggest threats Marshall has identified to a successful hedge fund manager are personal crises that are all but unavoidable. What he calls “the reddest flags” to future underperformance are “the three Ds of death, divorce and disease.” That's Marshall's sobering reminder that whether you worship religion, science or something else, there but for the grace of our Gods go we all.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."
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