Hello, again!
We’ve been busy over the summer building and growing here at Ivy Invest. We’ve overhauled our website, our app, and our onboarding flow. We’re continuing to update features and improve our customer service capabilities. And most excitingly, we’ve added two incredibly talented people to our team, our Head of Growth and our new Investment Associate. It’s all taken me away from this newsletter for a bit, but I’m glad to be back!
This week’s question has been sitting in my inbox all summer. With the ongoing roller coaster ride in markets, this seems as good a time as any to take it on.
How do institutions think about minimizing regret versus maximizing return?
When I read your question, the thing that jumped out to me was the embedded assumption that minimizing regret and maximizing return are competing impulses. I get it! When you think of maximizing returns, maybe you’re thinking of risky bets with huge, if statistically unlikely, payoffs. But chasing returns is not the same thing as maximizing returns. And so my short answer here is that institutions don’t necessarily think these two goals are in opposition to one another.
As for my longer answer, let’s start with regret. I think when it comes to investing and regret, it’s fairly simple. Regret tends to follow from one of two errors: commission or omission. For some individual investors, the degree of regret from these errors might feel similar. In other words, for some individual investors, the feeling of missing out on a “great” investment can sting as much as the feeling of making a bad investment.
For institutional investors, on the other hand, these two errors are rarely considered equally. In my experience, institutions are far more concerned with minimizing errors of commission, and as a second order consequence, avoiding the regret that might follow. Of course, institutional investors from time to time might have passing feelings of regret from declining to invest in a “great” manager or investment. I know, I keep using quotation marks around the word great, and I’ll get to that shortly.
Institutional investing is, at its core, a disciplined, process-driven exercise. Institutional portfolios operate within strategic frameworks (i.e., asset allocation policies), and new investments tend to be made deliberately. In other words, new investments are generally proactively sought after, intended to serve a specific purpose within the context of the overall portfolio.
Institutional investors are certainly mindful of opportunities that can arise unexpectedly, such as those arriving in periods of market dislocations. And they care about keeping a pulse on what opportunities might be attracting outsized attention and/or dollars. But for the most part, institutional investors don’t rush to pursue the latest trendy or momentum-driven investments.1 If an institutional investor evaluates an opportunity according to their stated investment process and passes, there’s generally not a lot of FOMO.
Back to that descriptor, “great.” It’s in quotation marks because, in my experience, too often an investment is described as being ‘great’ when instead, what the person really means is that the investment’s recent performance has been high. Of course, great investments over time do generate great performance. But that doesn’t make the inverse true – great performance by itself is not indicative of a great investment.
Now, sometimes that investment goes on to become a fund that backed SpaceX early, or maybe SpaceX itself, and that might sting a little2. Even so, if at the point of potential investment, the diligence process led to a conclusion that the investment wasn’t a fit for an institution, then it wasn’t a fit. If an investor can look back with confidence that it was the correct decision at the time, then it was the correct decision. Ex-ante, investors can only work with the information at hand.
All that said, investing is not a static endeavor, it’s full of constant learnings. That same investor that passed on a hypothetical early fund or direct investment in SpaceX might look back on the diligence process and in retrospect identify areas where assumptions were faulty, or where risk parameters were too tight, or some other place for improvement. The nuance I’ll point to here is that institutional investors are generally careful to seek the correct learnings from past experiences in order to apply them usefully toward future opportunities.
While institutional investors may not experience as much regret from errors of omission, they do try hard to avoid errors of commission. It doesn’t feel great to make an investment that turns out to be a dud. The issue is that there are almost always reasons to not go through with just about any investment. Investing inherently involves taking risks. And in my own anecdotal experience, many great opportunities are not obvious winners at the time of investment.
But, going back to my earlier point on process-oriented investing, institutional investors are responsible for understanding the quantitative and qualitative risks associated with any potential investment. A large part of that work is assessing whether the returns offered by any given opportunity adequately compensate for the aforementioned risks. Doing so requires institutional investors to calibrate the “cost” of taking those various risks, an exercise that is, frankly, part art, part science.
Interested in hearing more about how institutional investors evaluate opportunities? On the latest episode of our podcast The Investment Office, we consider the case of the hedge fund Situational Awareness.
Listen on YouTube, Spotify, or Apple Podcasts.
Institutional investors don’t always get it right, and to expect a perfect track record would be unreasonable. The goal instead is to maximize the probability of success (take good risks), maximize the returns when successful (be sure to be compensated for those risks), and minimize the negative impacts from any investment that does go wrong (size the risks appropriately). Put it all together, and I’d say it sounds a lot like the recipe for maximizing returns.
There you have it. It turns out that the same process allows institutional investors to both minimize regret and maximize returns: avoid costly mistakes, seek high risk-adjusted returns, and stay disciplined. The answer here may not be very exciting, but fortunately, it’s just as relevant for individual investors as it is for institutional investors.
Thanks for the question! Before I wrap up, I want to say welcome to all our new readers! This newsletter only works because people send in their questions. So if you have a question (an investment related one!), please send it along: askacio@ivyinvest.co!
Now that I’m back, I’ll see you in two weeks,
Wendy
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To be clear, this isn’t to say that institutions can’t move quickly to make new or opportunistic investments. But institutions that can operate with speed still typically have some pre-existing framework to manage one-off opportunities or transactions that need to be fast-tracked (e.g., a co-investment program to evaluate co-investments from existing portfolio managers).
As a side note, in the early days, it was not clear that SpaceX was a “great” investment, in the sense that it didn’t yet have a track record of generating its investors high returns. By the time SpaceX became one of the most sought-after pre-IPO private investments, institutional investors had already staked their position (or not). There’s almost certainly a lesson in here about the best time to access truly great investments being well before they’re universally recognized, but that seems like a whole different topic to tackle another time.
Very thoughtful response. Yes, it is not an either, or proposition. Many investors lament over buying at the "wrong time", or saying "woulda, shoulda, coulda" bought or sold. My experience tells me that far to many people don't have a long term perspective or think of investing the same way they think about picking a winner at a sporting event.