Weekend Reading

As an individual investor, what’s the key to success? It’s a question Adam Grossman hears a lot, especially in volatile times like this. The answer, he thinks, is that there isn’t just one key, but rather five. The most successful investors seem to be equal parts optimist, pessimist, analyst, economist and psychologist. Together, he calls these the five minds of the investor. If you can develop and balance all five, that—Grossman believes—is the key to investment success.

1. Optimist. When Grossman thinks of financial optimists, he immediately thinks of Warren Buffett. Now, you might imagine that it’s easy to be an optimist when you’re a billionaire. But he thinks it’s because Buffett is an optimist that he’s a billionaire. His secret—which really isn’t such a secret—is to bet on the long-term growth of the stock market. When the economy is in a recession, as it is today, with millions out of work, it’s easy to feel dispirited. It is scary, and I don’t want to diminish everything that’s going on. But as Buffett wrote in that 2008 article, “Fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.” Of course, you can’t have 100% of your money in stocks. That brings us to the role of the pessimist.
2. Pessimist. Many people view themselves as either a glass-half-full or glass-half-empty kind of person. But for investment success, he thinks you want to be a little of each. You’ll notice that Buffett referred to the stock market’s long-term potential. That’s an important qualification. As we’ve seen this year, things can—and do—happen that interrupt the market’s growth. That’s why it’s important to pay as much attention to your inner pessimist as to the optimist. What’s the best way to accomplish that? It isn’t complicated: You just want to keep enough of your assets outside of stocks to help you weather these interruptions. That will give you both the financial ability and the mental fortitude to get through tough times.
3. Analyst. If the optimist believes that stocks will grow over time, and the pessimist knows that they can’t grow all the time, how do you balance the two? That’s where the analyst comes in. The role of the analyst is that of a mediator—to consider the needs of both the optimist and the pessimist. Your inner analyst should be dispassionate, focusing on the facts of your individual situation. This includes your income, expenses, assets, liabilities and goals. In short, the analyst’s job is to strike the right balance between optimism and pessimism to develop an investment strategy that’s the best fit for you.
4. Economist. Economics isn’t exactly a scientific field and anyone’s ability to forecast the future is necessarily limited. But successful investing does incorporate certain economic concepts. At a high level, these include fiscal policy (the government’s ability to set tax rates and spending levels) and monetary policy (the Central Bank’s ability to set interest rates). And finally, it includes a sense of economic history and financial cycles. None of this means you’ll be able to predict where the economy is going. None of us can. But it does mean you’ll be better equipped to respond to events as they occur.
5. Psychologist. Colourful commentary and dramatic predictions are all around us. That’s why the fifth, and maybe most important, ingredient for investment success is to channel your inner psychologist. Among other things, this will help you to understand the motivations—both conscious and unconscious—of others, and to see the subtext of what they’re saying and not saying. This will help you to tune them out, as needed, so you can stick to your plan.

Is investing easy? No, he doesn’t think anyone would (truthfully) claim that. But if you successfully balance these five ideas in your mind, Grossman believes you’ll tilt the odds in your favour.

Morgan Housel reminds investors that good things can be taken too far – helpful at one level and destructive at another. They can be more dangerous than bad things because the fact that they’re good at one level makes them easier to rationalize at a dangerous level. A lot of things work like that, don’t they? Good things – praise-worthy things – that in a high enough dosage backfire and become anchors?

A few Housel sees in investing:

1. Contrarianism is great because the masses can get it wrong. But constant contrarianism is dangerous because the masses are usually right. Identifying and avoiding times when millions of people have been derailed by bad incentives and a viral narrative is a wonderful thing. Most investment fortunes come from a bout of contrarianism. But a larger group of investors has turned contrarianism into something closer to cynicism. Their contrarianism is constant – at all times, for all things. The quirk is that if you survey the list of extraordinarily successful investors, entrepreneurs, and business owners, virtually everyone has been a contrarian. But none – not a single one – is always a contrarian. There’s a time to bet against mass delusion, and (more frequent) times to ride the progress that comes from billions of people collectively searching for the truth.
2. Optimism is great because things get better for most people over time. But it’s dangerous when twisted into the belief that things will never be bad, which is never the case. A lot of people pick optimism because they rightly, correctly, get excited about the long history of progress mixed with confidence in their own skills. But when optimism is taken so seriously that it assumes things will never be bad – that every period long or short will work out in your favour – it turns into complacency. It encourages leverage and promotes denial. It leaves you without backup plans. Worst, it causes you to wrongly second-guess your long-term optimism when faced with an inevitable setback. You can be right about optimism in the long run but fail to ever see it because you overdosed on it in the short run.
3. Being open-minded is great because the truth is complicated. But being too open-minded backfires because objective and immutable truth exist. Every smart attempt to be open-minded has to be accompanied by a strong nonsense detector. The detector should go off when any of a handful of laws are violated when the author’s incentives favour an outcome, and when a complex answer is given if a simple one would suffice. You have to be firm enough in your views to make confident decisions while being open to new views in a way that lets you occasionally update and change those decisions. “Strong beliefs, weakly held” as they say.

Nick Maggiulli asks the investors what is the risk? Wikipedia defines it as “the possibility of something bad happening.” In the investment industry, we commonly associate risk with standard deviation, or how often an investment’s return varies from its average return.  More simply, if investment A has annual returns of +4%, +4%, +4% and investment B has annual returns of +4%, -9%, +19%, then investment B would be deemed “riskier” than investment A despite having the same long-term growth rate. But is the standard deviation the best definition of investment risk?  Not necessarily.

For any prudent investor, the difference between volatility and risk comes down to what is known versus what is unknown.  As Donald Rumsfeld once said: There are known knowns; things we know we know. There are known unknowns; things we know we do not know. But there are also unknown unknowns — things we don’t know we don’t know.

Volatility is a known unknown, while the risk is an unknown unknown. Volatility is a known unknown because though we cannot predict future volatility, we can make reasonable guesses about its future range. This is why Maggiulli doesn’t equate risk with volatility.  People will say that an investment is “too risky” for them, but what they usually mean is that it is too volatile.  Some investors prefer the predictability of bond income while others want the thrill of individual stocks, options, and leverage.  This isn’t about risk, but about the kind of expected returns, an individual investor prefers.

But, the risk is another beast entirely.  Because risk is about the things that happen that can’t be expected.  As Josh Wolfe has preached many times: Failure comes from a failure to imagine failure. That’s where risk lives. Maggiulli says that 2020 has made him realize that black swans (an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences) are the only kind of risk that matters.  Why?  Because they are the only kind of risk that can’t be prepared for, and, thus, the only kind of risk that can cause catastrophic loss.

Maggiulli asks so how do you prepare for something that can’t be prepared for?  You try the best you can.  Do scenario planning.  Have ample liquid savings.  Search for flaws in your investment hypotheses.  If you spend time to think about what is possible, then you might just be able to save yourself from some of these black swans. Yes, there will always be future scenarios that you can’t conceptualize or account for initially.  But, where is the harm in trying?  Because risk isn’t the possibility of something bad happening.  Risk is the possibility of something bad happening that you didn’t plan for.

Ben Carlson reminds us that there is always going to be a good reason to sell out of the stock market. When stocks were getting slaughtered in March, investors wondered if they should sell because it felt obvious stocks would fall further. Now that stocks have rallied, investors are wondering if they should sell because it feels obvious stocks have risen too far, too fast.

So when should you sell some or all of your stocks?

1. When you need to rebalance: The simplest form of selling comes when you have a target asset allocation in mind and religiously rebalance back to your target weights on a set schedule or pre-determined threshold. The timing of a rebalance will never be perfect but setting up a specific asset allocation that takes into account your willingness, ability and needs to take risk removes the temptation to go all-in or all-out based on your gut instincts and sell based on a set plan.
2. When you’ve been proven wrong about an investment thesis: This one is more relevant for those who hold more concentrated positions in a single stock. Every investor should perform a premortem that signals when it’s time to pull the plug and bail on an investment idea that simply didn’t pan out. This can be harder than it seems because What if I just wait until it breaks even?! or What if it rallies right after I sell?! are both rather compelling arguments in a loser position.
3. When you’ve won the game: If you’re lucky enough to amass something in the neighbourhood of 20-25x your expected living expenses in retirement and have a decent handle on your spending habits, at a certain point you may ask yourself—What’s the point of playing anymore?
4. When you’ve determined your risk profile, time horizon or circumstances have changed: Every portfolio decision doesn’t have to come down to market fundamentals. You must also consider how your current circumstances impact your risk profile. Sometimes you need to dial down the risk because you’re in a better place financially than you expected. Maybe you received an unexpected windfall or aren’t spending as much as you budgeted for.

Carlson concludes that it is impossible to create a portfolio if you don’t have a handle on your goals and a reason to invest in the first place. Markets matter but you should always begin the investment decision-making process by thinking about where you are—and where you’d like to be.

With huge volatility in shares markets in the last few months, many investors are sitting on large notional losses on their investments made over the past few years. In many cases these losses led investors to sell out at wrong time and lose out on sharp rally seen since March 2020. How investors should look at the losses during their investing careers. We turn to some of the respected investors to get clarity.

“Even the most conservative investors can be paralysed by large losses, whether due to mistakes, premature judgements, or the effects of leverage. If losses impair your future decision making, then the cost of a mistake is not just the loss from that investment alone, but the impact that loss may have on the future chain of events. If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost may be far greater than the initial loss itself” Seth Klarman

“It is easy to underestimate what a 30% decline does to your psyche. Your confidence may become shot at the very moment opportunity is at its highest. You – or your spouse – may decide it’s time for a new plan, or new career. I know several investors who quit after losses because they were exhausted. Physically exhausted. Spreadsheets can model the historic frequency of big declines. But they cannot model the feeling of coming home, looking at your kids, and wondering if you’ve made a huge mistake that will impact their lives.” Morgan Housel

“I learned early in my career to be skeptical and flexible, not stubborn about a stock. I also learned to take quick, small losses rather than get emotionally involved in a stock that was dragging me down. When I am wrong about a security, I try to take my loss at the 10% level” Roy Neuberger

“There is no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or, worse, to buy more of it, when the fundamentals are deteriorating. That’s what I tried to avoid doing.” Peter Lynch

“A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” Daniel Kahneman

“Profits always take care of themselves, but losses never do.  The speculator has to insure himself against considerable loss by taking the first small loss.” Jesse Livermore

“I like to repeat to myself a rule of Philip Carret, written some 86 years ago: ‘Be quick to take losses and reluctant to take profits‘.” Francois Rochon

Source: www.masterinvest.com

Ben Carlson accepts that this is the craziest market he has ever seen. The pandemic somehow turned a bunch of people into day traders. At first, in the US, they were buying beaten-down airline and cruise stocks. Now they’ve moved on to buying shares of companies that have filed for bankruptcy. Many companies that have filed for bankruptcy recently but have seen massive price swings over the past week. It’s easy to “tsk, tsk” these types of speculative moves in the markets but this type of behaviour is nothing new.

This year is unlike anything we’ve ever seen before in terms of market and economic dynamics but there is plenty of investor behaviour that has been around since the dawn of markets. Here are some things that will never change about the markets:

Lottery ticket stocks will always find a buyer. Our brains are wired such that expecting to make money feels even better than the act of making money itself. It’s the anticipation that puts your brain on high alert. This is why investors and gamblers alike are rarely satisfied with a single win. Your brain always needs another shot of dopamine to get that high again. It’s not enough for speculators to simply accept the market’s return during a massive recovery from a bear market. This is why we’ve seen a move from sector ETFs to beaten-down companies to bankrupt companies. And the temptation to speculate increases when we watch others around us getting rich.

People with no skill or knowledge about the markets can still make money. Some of the smartest, most sophisticated investors on the planet have been caught off guard by the market surge in recent months. Not only have these titans of the investment industry watched as the market has passed them by, but the biggest beneficiaries of the rise seem to be tiny retail traders. The market doesn’t discriminate between professional and amateur and there’s no IQ test required to buy a share of stock. The market cashes checks from anyone who plays, regardless of where they have an account or how much capital they have at stake. This is not to say this will continue indefinitely but to paraphrase Keynes, “The market can keep the irrational investor solvent as long as you remain bearish.”

The “dumb” retail money will occasionally beat the “smart” professional money. Legendary investors like Druckenmiller, Tepper and Buffett have all admitted to being positioned too defensively during this rally. This doesn’t make these legends idiots just like it doesn’t make day trading investors geniuses. This is just the way things work sometimes. No one bats a thousand.

No one is right all the time. Renaissance Technologies, likely the greatest hedge fund machine ever created, has claimed to be right on just 51% of their trades. No one is going to nail every top and bottom, especially in a market environment like this where things are happening at ludicrous speed.

Cycles tend to feel like they will never end. When stocks were getting thrashed on a regular basis in March it felt like the selling pressure would never let up. Lately, it’s felt as if stock gains happen every day. Markets are always and forever cyclical and no trend lasts forever.

Hindsight capital remains undefeated. It’s easy to look back at what’s transpired this year and come up with perfectly logical reasons for the market’s manic behaviour. And there are plenty of logical reasons for a market crash that immediately turned into a roaring bull market in the span of 3-4 months. But there are no counterfactuals. Things didn’t have to happen this way. Markets have shown this year how they can be equal parts resilient and fragile.

Certain investors will always worry more about being right than making money. Markets would be a whole lot easier if hard work translated into better results; if intelligence guaranteed alpha; if fundamentals always carried the day; and if the markets always made sense. Unfortunately, that’s not the case.

Carlson concludes that simplicity often beats complexity. Temperament matters more than intelligence. And sometimes markets just don’t make sense.

Jon wonders on his blog as to what’s the biggest determinant of investing success. Smarts, information, strategy, or skill are all worthy possibilities.

The market naturally triggers emotional responses that lead to mistakes. Those best equipped to handle those triggers are more likely to succeed. That shouldn’t come as a surprise. Most things in life worth achieving require mental toughness to get through the obstacles that are certain to arise. And investing is full of obstacles. For example, markets can trick people into thinking that investing is ridiculously easy. Raging bull markets, especially, create the illusion that you can earn returns without risk and get rich quick. But once the bull market ends, as they all do, the bear market that follows presents investing as a certain money loser. And to add insult to injury, the market spreads bull and bear markets out far enough for investors to forget how the last one ended.

It’s at these opposite extremes, the major turning points in the market, where the right temperament is in short supply but needed most. Successfully navigating major market turns requires a willingness to think and act against the crowd. Stock prices reflect the obvious, not the obscure.

If the crowd believes a bull market will continue, then it’s obviously already priced in. Which means anything that might disrupt that trend is not. It’s not even an afterthought in the most enthusiastic bull markets. But you can’t wait for the disruption to surface because once the trend breaks, once the crowd realizes it, then the selling begins, and it’s too late. So you have to be willing to be early. You have to be able to sell when prices are rising while the bull market seems endless. But you also must be willing to buy when prices are falling, while the bear market appears to only get worse. Both are difficult. (If it were easy everyone would do it. And if everyone did, the market turns would just happen sooner.)

The final twist in this saga is that betting against the crowd usually fails. It’s only at the turning points where it succeeds. Except, bull markets and bear markets don’t come prepackaged with expiration dates. Being invested during the length of a bull market is very profitable. Getting out early, while profits look good, is hard. Because betting against it, will certainly look wrong, but being wrong is costly. And few investors are willing to stomach that.

Jon concludes that to be successful you have to be independent and decisive, with the courage to appear wrong but ultimately proved right. That’s why the greats stand out. That’s the uncomfortable truth.

Dan Mikulskis writes that investing over the long-term is all about balancing risk: there are always hundreds of risks that could damage your portfolio or throw you off course, but hedging them all ends up with you stashing cash under your mattress. And we know there’s good evidence that investing “works”, over long periods in spite of – or perhaps because of – the risks.

When exploring the terrain of the area between the extremes, risk management is a key discipline and language to guide us. So potentially we have a lot to learn from risk managers and risk economists right now. Of course, we’re all inherently wired to dislike uncertainty and to try and remove it. But it’s not always possible, or at least avoiding uncertainty often comes with a heavy cost in itself, which we need to think hard about before paying. It’s risk management that lets us navigate uncertainty sensibly.

Renowned risk author and economist Allison Schrager has a simple but powerful model for how to manage risk.

1. Get clarity on the objective against which you are measuring risk. It is worth remembering in day to day life we run all sort of risks leaving the house or getting in a car each day, so zero risk isn’t a reasonable objective. In investing the mistake is often to confuse a long-term income-generating objective for a short-term wealth preservation objective
2. Use risk models for what they are worth, focus on communicating results well using natural frequencies rather than percentages. Particularly relevant now, of course, helping people understand their own risks (and those of the people around them), and how these vary by age and other factors is tough, but arguably never been more important.
3. Understand how you can diversify, spread your risks/avoid concentration of risk, and do this as much as you can in your situation
4. Figure out what hedges you have at your disposal, and how much these cost you to implement. A hedge is a position that gives an offset to an existing position, so you get an offset on both upside and downside.
5. Figure out where you can deploy insurance (pay away a fixed cost to take away your downside, but you keep the upside). Insurance usually has to be put in place in the good times to work in the bad times. Fire and flood insurance get bought after fires and floods, but the next crisis won’t look the same as the previous.
6. Deploy a suitable mix of hedging and insurance strategies to help manage your risks.
7. Put resiliency into your plan so that you can keep going even if something totally out of the ordinary happens. One big challenge in building resiliency is that it has a cost, it often runs counter to optimisation and looks like inefficiency in the good times. Profit-maximising firms will struggle to build resiliency.

If you follow these steps you’ll be in a better place by judging any plan against the right objectives. Insurance, hedging and resiliency all come with associated costs, so don’t jump to paying away too much for certainty – you’ll want to explore the combinations of these approaches that can get you to an expected outcome you can live with, not forgetting to make sure that you see how far diversification can get you before you start paying for the additional certainty of insurance, hedging or resiliency.

Jonathan Clements writes on his blog that today’s economic problems won’t lead to nuclear war. But many folks seem to fear the economic equivalent: that we’ll suffer a downward GDP death spiral that sends us back to the Stone Age. Let’s face it: If the economy ceases to function, it won’t matter what you own. What if the economy recovers, which everybody—except your crazy uncle—expects will happen eventually? Stocks will go up.

In other words, owning stocks is an asymmetrical bet. As with bonds and cash investments, the most we can lose in the stock market is 100% of our investment. But with stocks, your potential gain is far larger. In fact, it’s infinite. To be sure, we haven’t yet reached infinity but we’ve been doing pretty well.

True, there have been periods—like today—when you would have been better off avoiding stocks and instead of going long cash, hand sanitizer and toilet paper. But these periods typically don’t last more than a year. Indeed, to profit from a stock market downturn, you need to be right not only about the direction of share prices but also in your timing.

History tells us that almost nobody is consistently smart enough or lucky enough to succeed with such bearish bets. That leaves the rest of us to do the sensible thing, which is to play the lopsided odds offered by the stock market’s asymmetrical bet. Over time, we should allocate as much as we prudently can to stocks, knowing that we’ll suffer occasional rough patches, but also knowing that the stock market’s long-term direction is up. That doesn’t mean we should stash everything in stocks. If we have money in our portfolio that we’ll need to spend soon, that should be in conservative investments, so our spending plans aren’t derailed by plunging share prices. Similarly, if we’re nervous investors, we might keep more in bonds, so our portfolio’s short-term performance is less erratic.

Clements doesn’t know which stocks will fare best in the months and years ahead. Some companies—both privately held and publicly traded—will never recover from today’s economic shock. Indeed, with any single individual stock, we could end up on the wrong side of the asymmetrical bet and lose 100% of our investment. Even entire national stock markets (hint: Japan) can struggle for decades. But those who bet on the global stock market for the long haul have never lost 100%. For these investors, the asymmetrical bet has always been a winner. After every stock market decline, share prices globally have recouped their bear market losses and then headed higher. Every single time. Want this upward trend to be your friend? The formula is very simple: Buy stocks. Diversify broadly. Wait patiently.

Stephen Clapham in his blog behindthebalancesheet.com has come up with ten reasons why the investment landscape in the western world will be different in post-Covid19 virus world. His points are worth pondering over by all investors. This article contains reasons number 6-10.

6. WHERE NOW FOR INCOME FUNDS? For many companies, the priority will be rebuilding balance sheets. Dividends will be a secondary issue. For those companies subject to Government rescue, dividends are likely to be capped or forbidden until debts are repaid. Income fund managers will have an increasingly narrow repertoire. A corollary may be that some perennial dividend payers may be rerated as these funds are forced into a narrower group of stocks.
7. FINANCIAL REPRESSION & CAPITAL CONTROLS One clear effect of the pandemic is that almost every government on the planet will have a lot more debt than they did in January. And the situation in January was not looking particularly attractive. My guess is that Governments will at some point feel constrained in what they can spend and they will seek to reduce their debt burdens. Most will surely be forced to (continue to) engage in a policy of financial repression so that their interest rates are below inflation. The best way of reducing debt to GDP is higher growth – timely fiscal stimulus should be a priority for all Governments, and correctly delivered, gets us all out of a mess.

8 BALANCE SHEET RESTORATION Personal and corporate balance sheets need to be restored. This is likely to weigh on economic growth for a number of years. Companies will likely rein in capex for the 2020-2022 period. Consumers will buy fewer and cheaper big-ticket items. This seems inevitable, although the impact is hard to model on corporate earnings at this point – we do know, however, that earnings will be lower than formerly forecast. The one slightly odd exception to the big-ticket expense may be the leisure sector where there will be a massive pent-up demand for holidays.

9. RIPPLE EFFECTS AND INFLATION The coronavirus crisis has created huge, survivability issues for a limited number of sectors, notably airlines, travel and hospitality. The duration may be variable. These have been fairly obvious and direct impacts. What we have yet to understand is the indirect impacts beyond the general economic decline. My candidate for the most impactful would be an increased propensity to save which would slow economic growth.
10. The Great Reset: In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the embezzlement increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. Now finance chiefs have an opportunity, presented by the virus, to engage in the Great Reset – earnings will be reset, the virus will be the excuse. Even if there were no lasting effects from the virus, earnings for the vast majority of quoted companies would be reset down. They have been stretching the elastic of earnings for some years and now they have the opportunity to get their books in order. Forecasts will go down, even before you factor in the virus effects.