Like Hollywood and the music industry, the investment industry also feels the need to give out awards. But unlike those other industries, I’m not sure the investment world rewards what’s actually valuable.

Here’s what typically gets awarded:

Exciting, popular investments. Implementing a new sleeve of long-short hedge funds? How impressive! What a proactive way to manage risk yet retain the equity upside. Of course, that’s the promise, not always what gets delivered. No matter, it’s exciting and it gets an award. Nothing against hedge fund strategies, other than the fact that like many popular strategies, they are blindly anointed as superior, before delivering what they promise.

I’ve never seen a firm win an award that implemented a new, low-cost passive strategy. I mean, how old-fashioned and barbaric! Well, some of us in the industry realize that many, but not all, plans would be better off giving up the chase of active/private/complex strategies. However, many egos and organizations require the pursuit of the strategies to justify their existence. Again, the solution is easy: awards based on long-term results, not hopes and promises. Speaking of promises…

Grand proclamations, promises, and forecasts of future action. Net zero by 2050? You get an award, despite making marginal, if any, actual progress toward that goal. New sustainable/ESG strategies? Also award eligible, despite not actually having any tangible evidence to show if the strategies delivered on their promises or the risk/reward as initially advertised. Perhaps we should see how decisions play out before we grant awards.

Size. I know several under-the-radar pensions and endowment funds that put the big plans to shame by delivering better results over the long-term. But alas, that’s not enough. Size and popularity are always better in the world of awards, because the big players have their hand in just about every strategy, and by random chance, something will always be working.

Here’s a quick test of your organization’s health. When you need to find out the truth, where do you turn?

Do you get it straight from the leaders?

Or do you have to rely on gossip and rumors at the water cooler and in the hallways to figure out what’s going on? Usually these discussions begin with, “Don’t tell anyone you heard this…”

Ed Catmull, founder of Pixar said, “If there’s more truth in the hallways, you have a problem.”

No leader likes to announce bad news. No leader likes to admit a strategic or business failure. No leader likes to admit when there’s been bad behavior among employees.

But the truth will always come out. It’s only a matter of the path that truth will take and how much rumor, gossip, and wasted time will be generated along the way.

A leader has two choices. The first is a quick and decisive delivery of bad news. Yes, it will be painful and embarrassing, but I swear if there’s one thing employees want, besides perhaps getting paid more, is a leader that will call it like it is and not hide behind bullshit or company policy.

The second choice, and the choice that many leaders make, is to assume their people are just plain stupid, naïve, or gullible. Deny and cover up the bad news, and figure people will just accept it, get back to work, and move on, because if the leader says everything is ok then it must be ok. It’s management by condescension.

When people don’t get the truth, they know it, and they don’t move on. Instead, they double down on trying to find out what happened, which makes it even a bigger issue than it already was.

Few words incite resistance faster than the idea of imposed constraints or limitations.

For example, if you give someone the option of a project with no deadline and nearly unlimited budget, or a project with a tight deadline and strict budget, they’ll pick the no constraint option anytime. The appeal of boundless freedom and unlimited resources is too tempting to pass up. But if your goal is to actually deliver a project, and an innovative one at that, you’re better off embracing the constraints, not fighting them.

While freedom from deadlines and budgets is exciting, it drowns you in a sea of never-ending optionality, constant second guessing, unfocused activity and distraction.

Constraints are not the limiting factor we assume. They are powerful tools, forcing us to think differently and act with urgency. A lack of resources isn’t the failure point on a project. Excessive scope creep and ambiguous goals are the bigger issues. Constraints don’t crush productivity and creativity, they enable it.  

Legendary choreographer Twyla Tharp praises the power of constraints and cautions against unlimited resources:

Whom the gods wish to destroy, they give unlimited resources...remember this the next time you moan about the hand you’re dealt: No matter how limited your resources, they’re enough to get you started. Time, for example, is our most limited resource, but it is not the enemy of creativity that we think it is. The ticking clock is our friend if it gets us moving with urgency and passion. Give me a writer who thinks he has all the time in the world and I’ll show you a writer who never delivers.

An army sent off to war, even if victorious, will return a bedraggled, maimed mob of madmen. Whatever proportionality between means and ends that may have once existed on the field of battle no longer exists. Even the victors must pass through a slaughterhouse on the way to victory. - No More Heroes: Madness and Psychiatry in War

We all want to reach our goals, but are you sure you understand the price you will pay?

You’ve heard of Pyrrhic victories, based on Pyrrhus, the king of Epirus, who defeated the Romans in 279 BC but paid a terrible price in losing many of his troops. There are many areas in which the costs of winning are greater than the win itself.  

Society obsesses over victory and success but often ignores the costs of getting there. Whether it’s getting to the coveted CEO position, winning a gold medal, or being an entrepreneur, all are incredibly worthy goals, but with potentially enormous costs.

That’s not to say the cost is not worth it. For some people, the cost is absolutely worth it and they pay it with a smile on their face. But then there’s many people who never consider or don’t even know the cost it will take to achieve what they think they want. The focus is always on the benefits, never on the costs.

For many people, 20 years of experience is one year of experience repeated 20 times. - Andy Hargadon

When we seek out an experienced professional, perhaps a doctor to treat us or a mechanic to fix our car, it’s not really experience we seek. It’s skill we’re looking for. Experience just happens to be a convenient proxy we use to judge skill. And for the most part, it works for simple skills, but it’s an imperfect and often misleading signal for complex activities.

It’s an easy idea to prove. Most of us have been driving a car for 20 or 30 years. Yet, none of us are anywhere closer today than we were decades ago to driving professionally in Formula 1, despite all the hours we’ve put in behind the wheel. Sure, we improved for a couple years after getting our license. But then we got to “good enough,” hit a plateau, and have been going through the motions ever since. Experience doesn’t count when you just show up.

A lot of experience is mindless repetition. There’s no detailed training regimen. No skill is specifically targeted. Activity is done for activity’s sake, not to improve a specific attribute. There’s no feedback. It’s nearly impossible to evaluate our own performance. One reason is psychological. Our ego overestimates our ability and conveniently ignores the flaws that are obvious to an unbiased observer. We see what we want to see, which makes us look better than we really are. The other reason is physical. We physically can’t observe everything that’s going on with us, so we miss mistakes. We can’t fix what we don’t see. When we don’t get feedback on what we’re doing wrong, and when there’s no coach to help correct our mistakes, improvement is constrained.

The solution to mindless repetition is deliberate practice, an idea pioneered by K. Anders Ericsson. If you want to improve, it’s the guide you need. Deliberate practice specifically addresses your weaknesses. It’s fun to practice what you’re good at. It’s hard and unnatural to practice the things you’re bad at. Deliberate practice also slows down the skill so you can expose and correct all the little mistakes that are typically neglected. That can become tedious and mentally exhausting, which is why it’s rarely done.  

If your team doesn’t do what is expected of them, it’s often because of a difference between what you say and what you tolerate.

It’s easy to create clear rules and expectations on the front end. Making new standards is simple. But it’s the back end of this process that’s difficult and where problems arise. People care about what is enforced and tolerated, not what is said.

In his book Extreme Ownership: How U.S. Navy SEALs Lead and Win, former Navy Seal Jocko Willink explains:

When leaders who epitomize extreme ownership drive their teams to achieve a higher standard of performance, they must recognize that when it comes to standards, as a leader, it’s not what you preach, it’s what you tolerate. When setting expectations, no matter what has been said or written, if substandard performance is accepted and no one is held accountable – if there are no consequences – that poor performance becomes the new standard. Therefore, leaders must enforce standards.

Well-intentioned standards don’t matter at all if they’re not rewarded or enforced. People quickly know the “real” rules for an organization. What gets rewarded and punished is often different than what is said. It’s this gap that creates frustrations for leaders and teams when desired behaviors don’t match actual behaviors.

Mistakes are unavoidable but covering them up is not. Mistakes are part of life. Everyone screws up. It’s not about eliminating mistakes. Instead, it’s ensuring they don’t get buried. Mistakes are valuable when they are embraced, but destructive when ignored.   

Admitting mistakes is tough. Even in the NFL, where you’d think given the high expectations that mistakes would be freely admitted, you witness mistake suppression. Michael Lombardi, author of Gridiron Genius: A Master Class in Building Teams and Winning at the Highest Level, describes the idea of “scouting blinders,” where scouts fail to admit when they’ve made a mistake on a player:

The second destructive form of bias we see all the time in NFL team building is “scouting blinders”: whenever drafted players are kept around long after it has become obvious that the evaluation that got them where they are was dead wrong. Like many crimes, the cover-up is even worse than the initial mistake.

While it’s embarrassing to admit a mistake, it’s madness to pretend like they don’t exist. Not only do the mistakes then continue unimpeded, but organizations double-down on the foolishness by continuing to invest in the same bad hires, bad projects, bad acquisitions, and bad investments.

How do we move from ignoring and covering up mistakes to embracing and facing them?

In Ozan Varol’s book, Thinking Like a Rocket Scientist, Ed Catmull, former President of Pixar, explains how we don’t always control failure, but we always control how we respond to it:

There are two parts to failure. There is the event itself, with all its attendant disappointment, confusion, and shame, and then there is our reaction to it. We don’t control the first part, but we do control the second. The goal, as Catmull puts it, should be to uncouple fear and failure—to create an environment in which making mistakes doesn’t strike terror into your employees’ hearts.

You may recall that after 9/11, Homeland Security implemented a color-coded advisory system to inform U.S. citizens on the risk of terrorist threats. There were 5 levels:

• Severe: Severe Risk of Terrorist Attacks

• High: High Risk of Terrorist Attacks

• Elevated: Significant Risk of Terrorist Attacks

• Guarded: General Risk of Terrorist Attacks

• Low: Low Risk of Terrorist Attacks

How often do you remember relying on this system? What exactly is the difference between significant and high risk? Did you ever change your behavior because of the threat level? Did you ever not go to work or not take your family to the park because the threat level was bumped up a notch?

Of course not. It was completely worthless. No one paid any attention to this except the bureaucrats paid to run it. 

As with most responses to catastrophic events, imaginary solutions are implemented quickly in response. It happens in both business and government. Citizens and clients want easy, immediate answers to complex problems. “Do something,” people demand. Well, something is done, with no benefit to anyone.

As soon as you begin any debate, your immediate priority is to figure out if the other side is willing to change their mind.

Most people don’t argue to learn. They don’t argue to further their understanding. They argue to confirm their beliefs and prove their superiority. These discussions never go anywhere, never change any minds, and never uncover new evidence. In short, they’re a complete waste of time. Avoid these arguments.  

The good news is that there’s a simple test to figure out if the other person is open to changing their mind.

Adam Grant, author of Think Again, explains:

In a heated argument, you can always stop and ask, “What evidence would change your mind?” If the answer is “nothing,” then there’s no point in continuing the debate. You can lead a horse to water, but you can’t make it think.

Any variation of “What evidence would change your mind” will work. The exact message isn’t as important as the meaning.

Alan Jacobs, author of How to Think: A Survival Guide for a World at Odds, recommends the following:

…this is true of many communities of conspiracy theorists, those who believe that the Holocaust didn’t happen, or that Lyndon Johnson was behind the Kennedy assassination. “The question is, ‘Could you show to those people a set of facts that would lead them to abandon what we consider to be their outlandish views?’…the answer to that question is no, because all people who have a story to which they are committed are able to take any set of counter-evidence and turn it back, within the perspective of the story they believe in.”

Paracelsus, a Swiss physician and philosopher born in 1493, is credited as the father of toxicology. He coined the phrase, “Only the dose makes the poison.” Geoffrey Kabat, author of Getting Risk Right, explains the concept:

The magnitude of one's exposure matters. This is true of micronutrients, such as iron, copper, selenium, and zinc, which our bodies need…but which, taken in large amounts, are highly toxic. It is also true of lifestyle and personal exposures, if to cigarette smoking and consuming alcoholic beverages, and medications, as well as pollutants in the environment. Many toxins and carcinogens exhibit a dose response relationship: that is, as the exposure increases, so too does the observed toxic or carcinogenic effect. Even compounds and foods we think of as healthy can be lethal when consumed in excess…Clearly, consumption of excessive amounts of water can lead to an electrolyte imbalance and heart failure.

This concept applies to all aspects of life. Most decisions should involve getting the “dose” right, not making absolutist, binary claims. It’s a lazy trap to judge ideas without regard to the amount, exposure, or duration.

• Investment risk is needed to growth wealth, but excessive risk leads to ruin

• Striving for greatness is great, but demanding perfection leads to paralysis

• Working out is great, but a lack of recovery leads to injury

• Regulation is necessary, but excessive regulation crushes innovation

• Meetings are necessary, but excessive meetings are not

• Management is valuable, but micromanagement is disabling

If there’s one fantasy I see repeated in both public and private equity markets, it’s the idea that companies can grow without reinvestment.

Pull up any company model from a sell-side analyst or PE shop, and you’ll see projected sales and EBITDA go up while capex and net working capital growth is flat, if not declining. I see it in almost every model. Somehow, these companies are expected to undergo a magical transition that will accelerate incremental returns on invested capital and negate the requirement for reinvestment to grow in line with sales.

It’s easy to make these assumptions. It’s an entirely different matter for a company to deliver them. They rarely do.

This doesn’t mean the company isn’t a worthwhile investment or won’t make money. But it does mean a few things.

First, investors rarely understand the business. They have a trader mentality, only worried about fast growth because fast growth sells well in the short run. The cost and investment need to fund that future growth, however, is usually neglected with the hope someone pays a nice premium before the lack of reinvestment becomes apparent.

Second, it’s a way to dress up the company and solve for the valuation that you want. Nothing drives cash flow higher than not reinvesting in the business, at least for a while. Higher cash flow means higher valuation. That is, of course, if those cash flows are sustainable, which they are not. If you underinvest today, you’ll have to make it up in the future. Most of the PE industry is built on others not realizing this fact.

The world is obsessed with optimization. There’s nothing wrong with improvement, efficiency, and effectiveness. But many times, optimization goes to far. As with anything, there’s a point where the costs of optimization exceed the benefits.

For example, corporations optimize their capital structure with substantial debt, but end up in bankruptcy when a recession hits. Investors optimize their portfolios through leverage and mean-variance analysis, but forget the inherent flaws embedded in the data and assumptions. Even individuals who optimize their health end up wasting time and money chasing useless biomarkers and other hacks.

At some point, optimization breaks down. Optimization often relies on the assumption of near perfect knowledge of the future. That’s why those optimized companies go bankrupt. They planned on one future but got another. Optimization is fragile. It’s great if the world unfolds just as you expected. It’s awful in every other scenario.

Since we don’t know the future, robustness, not optimization, should be the goal.

On February 12, 2009, Colgan Air Flight 3407 crashed in New York, killing all 49 on board and one person on the ground. In an effort to improve airline safety, Congress passed the Airline Safety Act of 2010. One of the requirements required pilots to accumulate 1500 flight hours before becoming a first officer.

Seems reasonable, right?

Paul Craig, author of The Killing Zone: How and Why Pilots Die, explains the unintended consequences of that law:

This is why the Airline Safety Act of 2010 is a bad law. The law ignores the fact that quality flight training is better than quantity alone… The law requires pilots to have accumulated 1500 flight hours and hold the airline transport pilot certificate before they can become eligible for hire as a first officer on a Part 121 air carrier. It sounds reasonable that an airline pilot should have an airline pilots license, but here's the problem: the pilots are required to acquire 1500 flight hours before they can move into this career field, then two things will happen. First, pilots will go back to “boring holes in the sky.” This is the phrase used for building a flight time in the fastest and cheapest way possible. That means find the most inexpensive (read slowest and least well equipped) airplanes… Second, if a pilot has to pay for this flight time on his or her own, then the temptation will be strong to cheat. There will be a few pilots interviewing for those first officer positions with falsified records.

As stated previously, the research indicates that it is not how much flight time you have but what you did during that time that makes a difference… Military pilots flew supersonic jets in combat over Iraq and Afghanistan with approximately 400 total flight hours. Those pilots had structured, targeted advanced training, and nobody doubts that they aren't the best in the world. None need to wait to acquire 1500 hours to fly in combat.

The promise of change is exciting, but the execution of change is painful.

It’s not just a lack of willpower or toughness, which are the usual culprits we blame when failing to change. Biology is where we should start…

Anders Ericsson, author of Peak: Secrets From the New Science of Expertise, explains the resistance of change:

The human body has a preference for stability…The technical term for this is “homeostasis,” which simply refers to the tendency of a system to act in a way that maintains its own stability…So to keep the changes happening, you have to keep upping the ante: run farther, run faster, run uphill. If you don’t keep pushing and pushing and pushing some more, the body will settle into homeostasis, albeit at a different level than before, and you will stop improving. This explains the importance of staying just outside your comfort zone: you need to continually push to keep the body’s compensatory changes coming…

Because the work of change is uncomfortable, the promise of change becomes intoxicating: we get to imagine all the benefits of the expected change without any work or investment. It’s all a fantasy at this point. And one we hope comes true. But hope isn’t a strategy, and eventually it becomes a handicap.

In 2015, Pete Carroll, then head coach of the Seattle Seahawks, was vilified for an awful play call. This wasn’t any ordinary call. It was a call made with 26 seconds left in Superbowl XLIX, with the Seahawks down by four. The Seahawks had the ball on New England’s one yard line.

Annie Duke, in her book Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts, describes what happened next:

Everybody expected Seahawks coach Pete Carroll to call for a handoff to running back Marshawn Lynch. Why wouldn’t you expect that call? It was a short-yardage situation and Lynch was one of the best running backs in the NFL…Instead, Carroll called for quarterback Russell Wilson to pass. New England intercepted the ball, winning the Super Bowl moments later.

The headlines the next day were brutal:

• USA Today: “What on Earth Was Seattle Thinking with Worst Play Call in NFL History?” 

• Washington Post: “‘Worst Play-Call in Super Bowl History’ Will Forever Alter Perception of Seahawks, Patriots” 

• FoxSports.com: “Dumbest Call in Super Bowl History Could Be Beginning of the End for Seattle Seahawks”

• Seattle Times: “Seahawks Lost Because of the Worst Call in Super Bowl History” 

• The New Yorker: “A Coach’s Terrible Super Bowl Mistake”

To the average person, the headlines delivered poetic justice for such a dreadful play call.

But to a select few, the criticism was flawed, if not wholly unwarranted.

There’s a lot that comes with a big title. More pay, more responsibility, more control, and more recognition.

But there’s one thing that doesn’t come with a title: the ability to call yourself a leader.

Titles don’t make you a leader. Your people do.

Leadership can’t be decreed, no matter how much power comes alongside a fancy title. While titles are awarded from above, respect is earned from below. It’s colleagues under the boss that will decide when leadership is earned. It’s never given on day one.  

Noted Silicon Valley coach Bill Campbell, in the book Trillion Dollar Coach, explains:

If you’re a great manager, your people will make you a leader. They acclaim that, not you…You need to project humility, a selflessness, that projects that you care about the company and about people.

One test of organizational health is how often titles or positions are used to justify decisions. As in, “I’m the boss and I’m telling you what to do.” Or, “I’m the highest ranking official in the room so it’s my call.”

Underperforming organizations rely on titles, rather than discussion, to make decisions.

A structure without redundancy is called fracture critical, meaning that a single broken component can collapse the entire structure.

Fracture critical extends beyond engineering to describe many firms in the finance industry:

• Hedge Funds: Excess leverage on top of bad trades

• Banks: Illiquid long-term assets funded by fleeting short-term deposits

• Funds: Illiquid assets with daily redemptions

• Allocators: Overcommitment to illiquid/opaque strategies

• Managers: Reliance on the one-person, “star” investor model

• Firms: One person holding together critical IT, treasury, or operational functions

We know the names of firms that suddenly blew up: SVB, LTCM, Sowood, Amaranth, etc. Why do firms choose this model when the lessons are evident?

Because it’s optimal in the short-term. It’s optimal when you believe you know what the future will hold. It’s optimal when you surround yourself with very talented people that have only experienced success. It’s optimal when the press and investors reward you for excessive risk taking in an up market. Operating in a fracture-critical environment is seductive because disaster never seems close.

No investor desires underperformance. Not the managers delivering it and not the investors receiving it.

You can’t get away from it. You can’t solve it. You can’t eliminate it. It’s not a flaw in the system. It is the system.

In 2019, Warren Buffett underperformed the S&P 500 by 20.5%! In 2020, he followed that with a 16.0% underperformance. Despite his tremendous track record, Buffett still underperforms at times.

So if Buffett hasn’t figured out how to eliminate underperformance, what in the hell makes you think your manager can?

I hear this every time I’m at a conference: allocators demand that an underperforming manager “fix” their underperformance.

“What are you doing to address the underperformance,” they proclaim to the manager. As if the manager just needs to find the one bad formula in excel that’s screwing everything up. As if the manager just needs to resolve to work harder by putting in 16-hour days instead of 14-hour days. As if the manager just needs to find a new formula or crystal ball that will magically crank out winning stocks.  

At the end of every argument or debate, the “winning” side has a choice. Accept their win with humility and graciousness. Or go in for the kill shot by humiliating their opponent.

We’ve all been in heated disagreements where emotions ran high and we said something we soon regretted. Even though we may have “won” the argument, we still felt the need for some instant retribution by humiliating the other side. The immediate desire is overwhelming during a conflict.

But be careful how you proceed after victory. While it may feel good to humiliate the other side when they are at their weakest, you may create an enemy for life.

FBI Hostage Negotiator Gary Noesner, author of Stalling for Time: My Life as an FBI Hostage Negotiator, describes how General Grant handled his victory of General Lee at the end of the Civil War:

No one…wants to be humiliated. I was always moved by General Grant’s gesture to General Lee in allowing the Confederate leader to keep his sword during the surrender at Appomattox that ended the Civil War. That small but symbolic act cost Grant nothing, yet gained so much by allowing the venerated Lee to maintain his dignity and positively influence his loyal followers. Many of the individuals we deal with are hardly venerated warriors, but they are repeat offenders. If we treat them poorly when they surrender, they may not be so willing to cooperate with us the next time they’re in a jam.