September 2020
IN THIS ISSUE
Financial advisors might want to get their Doctorate of Psychology
What can Wile E. Coyote teach us about investing?
This should be self-evident, but isn’t.
When does dumb money become smart money?
Jumping off roller coasters
If you got to meet the President, what question would you ask?
I would hope to ask a question that:
The President has not been asked 37,000 times before
Breaks through their public facade and negates canned political responses
Leads the President to appreciate my question
Teaches me something meaningful about the Presidency
My question would be:
What can your experience as President teach us about investing?
I have speculated way too much about answers that a President may give. I have never been President so what do I know. But perhaps their answers might include:
Staying true to one’s principles (objectives) even in the face of changing polls (market sentiment).
Maintaining a focus on the long-term interests of the country (portfolio objectives), even when one loses short-term political battles (losing trades).
Remembering the reason one had for becoming President (purpose), then remaining focused on making a difference (legacy).
The question “What can your experience as ________ teach us about ________” has been asked in other contexts too:
Ed Thorp asked “What can beating the dealer teach us about beating the market?“
Ryan Murphy asked “What can Olympic swimming teach us about investing?”
Logan Kane asked “What can NFL And NHL Statistics Teach Us About The Stock Market?”
I’ll ask one more variation on this question:
What can roller coasters teach us about investing?
It has been said that the only people who get hurt on roller coasters are those who jump off. Finance professionals use this metaphor to convince clients to “stay the course” during times of elevated volatility. Not surprisingly, among Vanguard retail investors who panic-sold entirely into cash during the March COVID-19 crash - which could metaphorically be described as “jumping off the roller coaster” - 86% of them were already worse off by the end of May.
The folks at Fidelity’s Market Insights shared the graph below that shows the short-term benefits but long-term costs from the move to cash, even given the deep selloff and slow multi-year recovery.
The impulse to sell at inopportune times, in fear of incurring further (unrealized) losses, is deeply rooted in the psychology of loss aversion. Kahneman and Tversky found the pain of a loss to be roughly twice as powerful as the pleasure of an equal gain. Insurance companies’ entire business model monetizes the twice-as-painful loss aversion.
A better approach is to anticipate and understand the market’s “roller coaster” prior to boarding, then follow a disciplined strategy informed by mathematical, economic, and psychological principles to navigate the coaster’s predictable ups-and-downs.
Building on the roller coaster metaphor, that understanding could include:
Inspecting prior and current engineering certificates attesting to the structural soundness of the track
Relevant qualifications and ongoing professional development for ride operators
Observing a long history of successful operation of the roller coaster prior to boarding
Conducting an honest self-assessment to anticipate and commit to how one will react to the inevitable volatility that in the end makes riding the coaster rewarding.
Unpacking how each of these understandings relate to effective investing can be instructive and revealing.
Metaphors can help us conceptualize, relate to, and ultimately understand complex phenomena based not only on the similarities between two contexts but also on the differences. The ups-and-downs in equities markets are not nearly as predictable and repeatable as those of an immutable physical coaster. And importantly, plenty of investors have been hurt precisely because they should have jumped off and did not. The judgment to recognize the differences between the two are Likely more important than the similarities.
Speaking of roller coasters… (you knew this was going somewhere)
In July we considered several charts that distinguished volatility from risk, two measures that are widely equated in the investment management industry. Take another look at Chart 1 in which PulteGroup (PHM, blue) is visibly less volatile than McKesson Corporation (MCK, red).
Source: Interactive Brokers, Likely Capital Management
Over this one year period, despite ending with the same return, these two companies took shareholders on very different “roller coaster rides”. Perhaps the most elementary question to ask is “How much outperformance would an investor require as compensation for enduring the additional volatility?” A more useful question to ask is “How will investors manage volatility that increases their risk of ruin beyond an unacceptable level?”
Volatility itself is not problematic unless and until that volatility brings investors near their point of ruin.
The crucial observation here is that investors must be able to remain solvent through the maximum drawdown in order to participate in any recovery. Volatility itself is not problematic unless and until that volatility brings investors near their point of ruin. Risk management that centers on reducing volatility is distinct from risk management that centers on reducing the risk of ruin. If investors manage their authentic risks appropriately, the rewards of recoveries will Likely take care of themselves.
Finally, reconsider Chart 3 in which Accenture Plc (ACN, red) and SPDR S&P 500 ETF Trust (SPY, blue) are virtually identical in both return and volatility. Can one say that their “risk” is also identical?
Source: Interactive Brokers, Likely Capital Management
Surely not. For one, the internal components of SPY consist of a broadly diversified mix of companies with zero Likelyhood of bankruptcy, whereas any one company is subject to a small but non-zero Likelyhood of bankruptcy. Individual companies are far more vulnerable to sector rotations, black swan events, or any number of other risk factors from which broad-based indexes are more insulated.
Ultimately, I have far more confidence in the construction of the S&P 500 “roller coaster” to mitigate risk factors relative to actively managed stock-picking strategies.
What Election?
Despite conventional wisdom, Presidents do not matter as much as we think. Admittedly, I geek out on politics and enjoy a thoughtful debate with my political opposites. Trading elections, however, usually renders a false sense of control and is often harmful to returns (the Action Bias and Overconfidence Trap). Taming the instinct to trade elections is essential to steadfast management toward long-term objectives.
Markets like certainty, and by corollary do not like uncertainty. Long term investors can discount any uncertainty leading up to and immediately following the election and instead can strategically capitalize on favorable buying opportunities created by the elevated market volatility. If no such opportunities present themselves, that’s fine too. I am content to play the hand that I am dealt, and when warranted do nothing. Doing nothing is in fact doing something, most notably when doing nothing leads to loss avoidance - see Value, Margin Of Safety, And The Art Of Doing Nothing.
ONE MORE THING…
Financial advisors might want to get their Doctorate of Psychology. Age is certainly a primary variable in asset allocation and volatility tolerance. But really, the issue is the capacity for withstanding a permanent loss of capital. Financial advisors assuming role of financial psychologists
What can Wile E. Coyote teach us about investing? This story writes itself. Stock market looks like ‘hapless Wile E. Coyote, running off the edge of a cliff,’ says behavioral economist. Stock market looks like ‘hapless Wile E. Coyote, running off the edge of a cliff,’ says behavioral economist
This should be self-evident, but isn’t. Palihapitiya says election won't matter, stocks going higher next 4 years: 'You need to be long'
When does dumb money become smart money? We might find out. Robinhood 'dumb money' may be fueling big Wall Street lie
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