Takeaways

1. Groupthink can result in bad decisions that reflect the prevailing consensus of what has worked recently; the best decisions are contrarian ones.

2. The most successful institutions have created an environment that allows them to attract and retain strong CIOs and supporting investment staff.

3. Members of successful investment committees recognize the differences between managing their own portfolios and managing an endowment.

4. Past performance is no guarantee of future performance; successful investing often requires investing in an asset class when the outlook is dismal or reducing exposure to a sector when its benefits are widely proclaimed.

There are a number of pitfalls that may lead a board’s investment committee to make poor decisions, resulting in subpar performance. Most are due to simple human nature and, for that reason, persist over time. Therefore, investment committees must consciously strive to recognize, discuss, and actively combat performance destroyers. Common pitfalls of investment committees are listed below.

Tactical mistakes

● Buying yesterday’s best performing asset classes

● Getting out of an asset class after it has fallen because it is “too risky”

● Buying something because you read about it in the press or received a “hot tip” from a friend Rebalancing mistakes

● Not having a disciplined rebalancing policy

● Postponing rebalancing decisions subject to market events

● Not using cash flows as an efficient means of rebalancing Asset allocation mistakes

● Avoiding asset classes because of adverse prior experience of individual members (“I lost a bundle on X, and we shouldn’t touch it.”)

● Skewing the asset allocation because of a member’s positive experience (“I’ve never sold a share of X, and it’s made me rich.”)

● Paying more attention to the volatility of individual asset classes versus the volatility of the entire portfolio (leading to an avoidance of “risky” asset classes, but hurting the portfolio’s overall risk-return characteristics)

● Ignoring volatility when returns are positive, leading to the assumption of too much risk and causing problems when markets reverse course Manager selection errors

● Chasing yesterday’s outperforming managers

● Accepting someone else’s word that a certain individual or firm is a good manager instead of performing your own due diligence Spending mistakes

● Not having a spending plan that limits withdrawals in good times and prevents overspending in tough times

● Ignoring “special” or temporary withdrawals from the endowment when calculating total spending Governance mistakes

● Micromanaging—for example, focusing on security selection or short-term performance

● Having too many investment committee managers

● Not properly screening or orienting new investment committee members

● Letting a strong-willed committee member dominate the committee’s agenda

● Wasting time by straying from the agenda

The four pitfalls below warrant further discussion.

Groupthink

Groupthink refers to the negative behavioral dynamics of group decision making. Because members of a group typically seek cohesion, they often find it difficult to vigorously challenge or disagree with another member’s idea. It is the committee chair’s responsibility to ensure that such discussion takes place. Better decisions are likely if investment committee members express divergent opinions.

Groupthink is one of the most serious threats faced by investment committees because successful investing requires contrarian decision making. The most profitable decisions are likely to be those that are most difficult because they buck current trends or the prevailing wisdom.

The two best steps that committees can take to avoid the pitfalls of groupthink are: 1) keep the committee size small, and 2) delegate policy implementation to the CIO.

Chasing Performance

In the investment world, doing more of what has succeeded and avoiding that which has failed can be dangerous. It results in allocating more dollars to those asset classes, strategies, and managers that have enjoyed recent success while avoiding those with recent poor performance. For example, investment committees tend to hire managers after periods of impressive outperformance, then fire them after a period of underperformance. Regularly repeating this pattern inevitably leads to subpar performance.

Groupthink contributes to this tendency to chase performance. Successful investing, however, often requires the exact opposite—investing in an asset class when the outlook is most dismal or reducing exposure to a sector when its benefits are widely proclaimed.

Three key practices will help avoid this pitfall:

1) Strictly adhere to the investment policy, especially in the area of rebalancing,

2) Delegate implementation authority to a contrarian-minded CIO, consultant, or outsourced management firm, and

3) Ask whether a proposed action would have been a great decision three years ago. A “yes” answer means that the decision is not timely and may be an example of chasing recent performance.

Differences in Time Horizons

Most committee members possess a strong desire to avoid negative results during their tenure. This is understandable because it leads to substituting an individual’s own shorter time horizon for that of the perpetual time horizon of the institution and its endowment. Because of this time horizon difference, managing an endowment is completely different from managing one’s own personal portfolio.

The key to side-stepping this pitfall is to recruit committee members who clearly recognize the substantial difference between managing their own portfolio and managing an endowment.

Failure to Retain a Successful CIO

A competent CIO increases the likelihood of generating superior returns. Contrary to conventional wisdom, the foremost reason that CIOs depart foundations and endowments is not monetary, but a lack of authority necessary to successfully fulfill their responsibilities. The CIO’s work is thwarted by the failure of the investment committee to delegate sufficient responsibility.

Failure to provide sufficient human and other resources to the investment office is another impetus for CIO departure. Compensation may sometimes be an issue, but it is typically the lack of incentive compensation (pay tied to performance), rather than inadequate salary, that causes friction. Investment committees that retain a successful CIO—generally through an attractive work environment, significant delegation of authority, and performance-drive compensation—provide a significant competitive advantage to their institutions. An investment committee that maintains a successful CIO is providing a valuable service to its institution that should be worth millions, even billions, of dollars.

Key Questions

1. Is the investment committee large enough to perform its work and to allow for a diversity of perspectives, yet small enough (with five or six members) to be productive and encourage meaningful individual involvement?

2. Are investment committee decisions reached through lively discussion featuring a variety of  opinions?

3. Has the investment committee delegated the CIO sufficient authority to implement investment policies and to otherwise fulfill the position’s responsibilities?

4. Is the CIO provided incentive compensation?

5. How does the investment committee ensure that it performs its own due diligence instead of relying on tips from friends and information in the popular press?