Conviction Is The Enemy Of Performance

In the initial phase of my career, I worked as a sell-side corporate bond trader. Trading ultimately proved not to be my true calling, but I generated consistent profits with a simple method: Buy on the bid side, sell on the offered side. Under the tutelage of experienced traders, I learned to spot market imperfections that sometimes enabled me to improve on the basic formula by buying below the bid side or selling above the offered side.

There were other voices, though, lecturing me on the vital necessity of “having conviction.” Translation: You are morally obligated to decide which way the market is heading in the short run and load up your inventory accordingly, i.e., with either long or short positions.

The individuals most insistent on this point were a few interdealer brokers. These intermediaries, most of whom were on a spectrum from harmless to genuinely helpful, earned one-eighth-of-a-point commissions by facilitating—or if they were more skilled, inducing—trades between dealer firms. The more transactions they brokered, the higher their earnings.

By urging me to have conviction, the more problematic interdealer brokers hoped to generate trades that otherwise would not happen. They sought to persuade me to buy bonds on the offered side, if I was bullish, with the expectation of selling them at higher prices as the market rallied. This was a surefire way to lose money, I quickly figured out. As far as I could tell, no one was capable of consistently guessing correctly on short-run market direction. Nothing in the subsequent 45 years has changed my mind about that.

The best I can say for the interdealer brokers who exhorted me to have conviction is that they were less dangerous than a senior executive of one firm at which I worked. He imagined that his investment banking background equipped him to be a market timer. One day he upbraided me: “The market is rallying, yet your inventory is depleted.” That was true, because highly motivated buyers had enabled me to close out my longs with robust profits. In the prevailing all-buyers/no-sellers environment, I could not replenish my inventory at attractive prices, so I was biding my time. Predictably, the offered-side purchases that the self-styled market wizard forced me to make all turned into substantial losses when the rally subsided.

Why Take the Risk?

Many financial media luminaries live by the credo of “having conviction.” This is evidenced by the absolute certainty with which they present their forecasts, as opposed to making potentially defensible statements such as, “I believe the odds currently favor a further pullback.” Most adamant in their stances are permabulls and permabears who cherry-pick the latest economic indicators to create the illusion that only a dunce could possibly disagree with them.

A conundrum, however, confronts those who believe market timing can produced sustained outperformance. We periodically see traders indicted for market manipulation, that is, forcing prices to move in a certain direction. Why would these well-paid market actors risk criminal conviction if having conviction about where prices would head of their own accord were truly a dependable means of generating profits?

But Can You Do It Again?

As my career veered off into credit analysis, investment strategy and money management, I found that a long-term perspective served investors best. Chasing rallies and liquidating everything during selloffs was a recipe for underperformance. Some pundits parlayed a single “great call”—likely the product of luck rather than bona fide skill—into celebrity status or substantial assets under management, but sooner or later their supposed prognostication powers failed.

One analyst became famous for making a high-conviction bear call just before the October 19, 1987 stock market crash. Her media profile rose so high that she was even hired to star in a pantyhose commercial. Unfortunately, her purported market-timing skills did not translate into superior results as she moved into mutual fund management. In 1988, her growth stock fund was the worst performer in its category.

Conclusion

It does not follow from any of the foregoing that passive management is the only valid investment choice. Various active approaches may succeed in generating superior risk-adjusted returns, such as sector rotation, security selection, and dynamic hedging. My experience tells me, however, that having conviction about market direction is not a likely path to long-run success.