Step 3: Focused Alignment With Suitable Strategy. Avoiding Impulse Triggers And Linear Thinking. Debunking Investment Myths.
“You’ve got to be careful if you don’t know where you’re going, ’cause you might not get there.” Yogi Berra
“With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.” Benjamin Graham
“But investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” Benjamin Graham
“You will be much more in control, if you realize how much you are not in control.” Benjamin Graham
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Benjamin Graham
In the first 2 steps we have laid the groundwork for a more optimal investment mindset. This provides a foundational basis for a new perspective on how to view investment decisions and strategies.
Let’s recap our progress so far.
Investment is complex, and decisions and assessments need to reflect that.
Understand that we are not necessarily hardwired for long term investment success. However, we can adjust for that with sufficient awareness and use of technology.
Our hardwired System 1 “athletic and reactive” brain may be more hindrance than benefit for investment decisions.
Our hardwired System 2 “strategic” brain may be a more productive source for investment decisions.
A Checklist can help clarify how to balance our thinking processes and guard against poor decisions.
Armed with this list we can now:
Start to review investment approaches and decisions from a new perspective.
Start to examine commonly quoted investment “truths”, which may turn out to be merely myths, and/or possibly misguidance.
Once poor investment concepts have been purged from our mindset. In later steps we can:
Start to develop our own checklist.
Start to develop our own investment methodology.
Focused Alignment With Suitable Strategy.
Before we start, a clear objective is needed to help frame the choices to be made, so that our decisions have a clear context and purpose.
I am going to assume that the objective for most investors is to maximize long terms returns through a full market cycle with as reliable and repeatable a process as possible, in a way that most suits the individual’s circumstances.
I define a full market cycle to be a period over which the markets and the economy have experienced every variety of the two most significant macroeconomic factors for investing, which are growth and inflation.
The chart above describes a complete framework as there are only 4 directional alternatives to the mix of two variables. Growth and inflation are either both going up, both going down, or there are 2 cases where they are moving in opposite directions.
To be truly reliable and durable over the long term, an investment methodology must be able to navigate successfully through all these 4 quadrants. Otherwise, it fails to meet basic requirements.
Now that an objective has been defined, analysis can begin about the most productive investment approaches and decisions.
There are many diversions and distractions along the way to achieving a successful outcome. So understanding what fulfilling this objective really means and staying focused and aligned at all times is essential.
Avoiding Impulse Triggers And Linear Thinking
There are very natural influences that can invoke our System 1 brain to want to override our long term strategic investment plan.
The “seven deadly sins”, which none of us are immune from, can push and pull us emotionally in different directions at different times.
As social animals making comparisons with others is only natural, but our information about others is incomplete, and our reactions may lead us into emotional judgements. Comparisons can be destructive if they draw us away from focusing on our own strategically thought out investment plan.
It is also important to recognize that we can develop biases in the way we think. Dalbar, a boston based investment firm, has done a great deal of work over decades, on the behavior of individual investors and what leads most investors to long term underperformance.
They cite the following obstacles that they believe are key factors.
1. Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.” 2.Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total. 3. Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market. 4. Mental Accounting – Separating performance of investments mentally to justify success and failure. 5. Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets. 6. Herding– Following what everyone else is doing. Leads to “buy high/sell low.” 7. Regret – Not performing a necessary action due to the regret of a previous failure. 8. Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership. 9. Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
“In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.”
In the remainder of this step we are going to directly challenge common myths on 3 major concepts that are core to investing and always will be. This is important to understand because ideas that are not fully thought through frequently can lead to suboptimal assessments and judgements, at best, and in the worst case, potentially dangerous outcomes.
Investors need the best possible tools and checklists for a successful long term strategy and so need to throw out concepts that may not serve them well.
So we need to examine:
1. Sole use of returns as an investment assessment. 2. Buy And Hold or Passive investing. 3. Benchmarks.
Sole use of returns as an assessment of investment success is potentially disastrous
One of the worst cases of linear thinking, or oversimplification of a complex environment is investors solely using return as a assessment of investment success, particularly over short term periods, but even over periods of years. It can be highly misleading and even dangerous. A wrong assessment can directly lead many investors into disastrous allocations.
Investment products are often designed to highlight great returns in the past. This is what investors want as the end result so it’s easy to understand why investors are attracted to the prospect of high returns, and it’s easy to imagine that it’s reasonable to project the past into the future. However, a great deal more care needs to be taken than just a single linear metric like return.
Here’s an example of why just assessing an investment on returns can lead to tragic outcomes.
The chart above shows the value of what became the world’s biggest hedge fund, LTCM, with a number of Nobel Prize winning economists advising the fund. If an investor solely used return as their assessment indicator, then for 3 years they would only have increased their allocation as the fund continued to outperform other investments by a wide margin.
However, the chart shows that whatever was accumulated in the first 3 years the whole investment was ultimately wiped out in just a few months.
This is the clearest case of poor assessment of a complex system using a single linear approach.
There is much more to this crucial subject, and we will go into detail on investment assessment in later steps. It is worth mentioning now as it is a very important point because so many investors simply ask about returns and then rush to judgement. Always have. Always will. Don’t do that!
Buy And Hold Or Passive Investing. No One Is Really A Passive Investor or should be.
In the mature stages of one of the longest equity bull markets in history it is not surprising that passive equity investing has never been more popular, at least at first glance.
Doing nothing, or very little, and expecting US stocks to rise over time has seemed to work, because it recently has done so for over 9 years in a row.
While all asset classes tend to go higher in a time frame of multiple decades, staying invested permanently will mean that investors not only experience the uptrends but also the downtrends.
This means that over shorter time frames there is a significant risk that you could have very low or negative returns for a number of years. Passive investing tries to offset this by using a balanced fund approach, a mix of asset classes, some of which it is hoped will be rising when others are falling. There is no timing or risk management attempted, but rebalancing periodically to maintain the chosen allocation.
Rebalancing is essentially a very long term mean reversion system. In other words it is the opposite of a trend following approach. Rebalancing, maintains a constant allocation by selling winners and buying more of the losers, and so it also produces taxes on capital gains, while not taking offsetting losses.
While mean reversion is a valid concept, it only really works in the very long term, decades, and most likely far too long a time in relation to most investors time horizon.
Passive investing accepts that negative trending asset classes and components within each asset class basket are OK to have in your portfolio on a permanent basis, and broadly avoids any timing on trends, risk management, or cyclical adjustment to allocation.
One wonders why investors would choose an investment approach that surrenders so much to inefficiency and takes so long to work!
The idea that there is any permanently appropriate and optimal static allocation is an illusion. While some are clearly better than others at meeting our objective, any static allocation is exposed to substantial drawdowns as the economy moves through the 4 quadrants.
I believe there is a great deal of confusion in the advocacy of passive investing. My article below goes deeply into this subject.
Benchmarks definitely do have their uses. They reflect different parts of the markets over time, and allow multiple ways to analyze results.However, what do they mean to you and achieving your long term objectives as set out above.
Assessing investment results by solely looking at returns is a bad idea, as discussed above. Comparing those returns to a single benchmark’s return also has significant problems.
Regrettably, investors fall into this idea all the time. So it’s important to point out how problematic this is. It could really only be valid in judging a committed index specialist, who is 100% committed to beating that index over the period of review.
However, for most investors committing to the return of a single index is a bad idea. As discussed above, no asset class can avoid periodical downturns through all the 4 quadrants. No investor should, or likely would, accept open-ended losses from an index.
Consider what would happen when the benchmark index goes down.
What would an investor who uses a single benchmark return to compare their own portfolio for assessment purposes say if their chosen index over the review period had fallen 50%?
“Congratulations! You only lost 30% of my capital! You beat my index by 20%!” ???
I have never in 30 years met an investor who I believe would either say or mean that. Yet I have met a great many investors who readily will wonder why their returns were less than a single index when that index went up. You can’t have it both ways! It is inconsistent.
Again, any single index is a bad objective for most investors. Investors therefore need to remain focused on the best long term result for them as discussed above. That objective will likely not be any single index.
I believe that investors may stray into inconsistent, and sometimes ad hoc assessments because they lack clarity on their objective, or have lost focus, on a more appropriate assessment.
In later steps much better approaches to assessment will be reviewed.
There are a number of other problems with indexes as benchmarks.
A major difference is that an index comes with no risk management. Then, also, investors have different uses for different parts of their capital with different time horizons. Indexes have no cash or time objectives. The risk of any index may vary in different circumstances, depending on trend, cycles, valuation, etc. Indexes pay no taxes and have different costs and turnover.
Comparison of your performance to an index, if not specified in advance, is inappropriate and potentially harmful to your investing objectives. This is no less true if many investors still do it!