Tag Archives: james-osborne

Things Won’t Stay The Same

My kids keep growing up, and it continues to surprise me. One who was just learning to stay upright is now a constant chatterbox and a daredevil on her Strider bike. The other seems to have grown a foot this year, and has gone from quiet and reserved to confident ringleader of her friends. But the realization I’ve recently had is that it is so easy for us to assume the current state of affairs will perpetuate into the future. The little baby who was so happy to sit and play with a toy was suddenly gone, whether I was prepared for it or not. Someday soon, both of my girls will be in high school fighting over clothes and car keys. In the moment, that is hard to remember. Whether things are great and everyone in the house is sleeping and happy and playing nicely together or we’re up four times a night and separating a fight every twenty minutes, it is easy to believe that this is how things will always be. In behavioral finance, this effect is known as recency bias . It is our strong tendency to extrapolate recent events forward into the future. And investors do this all the time. I mean all the time . In March 2009, as the stock market was approaching generational lows, the most popular headlines and predictions were that the Dow Jones Industrial Average, having just passed below 7000, would continue to drop as low as 3000. And of course, the most famous example of recency bias is the book Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market . Published near the height of the stock market in 1999, when the DJIA was just above 11,000, the book was wildly wrong. But it was a perfect example of how easy it is for us to see a pattern and project it into the future. We haven’t learned much since the 2008-2009 bear market or the late ’90s tech bubble. Oil prices seem to been in a near free fall for the past few years. So guess what is being predicted? More declines! Goldman Sachs suggested that oil prices could go to $20 a barrel in September. Of course, in 2008, Goldman Sachs also predicted that prices, then over $140 a barrel, would eventually surpass $200 a barrel. Making professional predictions is fairly easy – you take the recent changes and extrapolate them into the future. Tada! And of course, it isn’t just professionals making outlandish predictions that fall prey to recency issues. Individual investors are just as bad. Emerging markets have been dismal for the past several years. Returns have been negative so far in 2015, and emerging market stocks lost money in 3 of the last 4 calendar years. In May 2015, EM stocks started a nasty slide. By September, investors assuming that the recent past would continue indefinitely had had enough, and started pulling money out of these funds. Here’s what flows out of Vanguard’s Emerging Markets ETF looked like this year. Investors love to hear and talk about what is going on in the market “right now.” We love this idea because we assume that “right now” will continue into the future. But what is true today won’t necessarily be true tomorrow. The world is a changing place, and always has been. Don’t be fooled thinking anything else.

What Is And Isn’t ‘Risk’

It’s a popular thing to bash on measuring the risk of an investment portfolio with standard deviation, the preferred metric of most academic studies. If you skipped stats in college (congratulations, by the way), standard deviation measures how much movement around an average return you might expect in an asset or portfolio. So higher standard deviation = bigger “swings” in, say, annual stock market returns. Of course, standard deviation is far from perfect. Most commonly cited is that no one cares about big swings to the upside – a big up year is hardly perceived as risk by any investor! A popular line from many institutional investors, especially value-oriented stock pickers, is that “the only real risk is the permanent loss of capital.” Such a nice little soundbite. You hear this all the time, including from giants like Seth Klarman and Howard Marks. And for a stock picker, I suppose avoiding the permanent loss of capital is huge. Especially if you run a concentrated portfolio of 20-30 stocks. Right now I wouldn’t want to be the guys managing the Sequoia fund, which at the end of the second quarter had a 28.7% stake in Valeant Pharmaceuticals (NYSE: VRX ). Valeant is down big ($96.65 today from $178 and change less than a week ago) this week after becoming the target of a short-seller accusing the company of massive fraud. I don’t know or particularly care how Valeant shakes out, but if you have a stock that is over 25% of your portfolio, you don’t want it to go bankrupt. There’s no coming back from that. The trouble with the “permanent loss of capital” risk definition for most investors is that it is laughably easy to avoid. Anyone who owns one single diversified index fund has done it. Sure, if you have a fund with 3,000 stocks in it, a few are bound to go bankrupt. But those fractional losses are indistinguishable from the day-to-day 1% swings in the broad market. Any diversified investor has effectively eliminated the permanent loss of capital. So we’re back to other definitions of risk. Despite its imperfections, standard deviation (or volatility, call it what you want) is a pretty decent measurement of risk. No one is shocked to learn that a 90-day T-Bill has less volatility than an emerging market stock. Or that a 30-year Treasury Bond has more volatility than that 90-day T-Bill. And sure, standard deviation measures big swings to the upside right alongside big drawdowns. But the thing is that you can’t find me an asset class that has big upside swings without the big drawdowns. Here’s everybody’s favorite chart: (click to enlarge) Emerging markets stocks were up 66.42% in 1999! Of course they were down 25% the year before that and down 30% the following year. Small-cap growth stocks crushed it in 2009-2010 up 34.47% and 29.09%, but they were down -38.54% in 2008, worse than the S&P 500. Nothing gives you high double-digit gains without the occasional double-digit loss, unless you’re Bernie Madoff. The last argument against using volatility as a measurement of risk is usually, “So what?” Many value stock managers like to act as if huge one-year drawdowns don’t matter in the long run. They don’t want to talk about risk-adjusted returns. Well, maybe they don’t interact with their investors very much, but volatility matters to investors for two very real reasons. Drawdowns are hard to deal with, emotionally. Big losses can make for skittish investors. I don’t care how “experienced” you are as an investor. It is still hard. I remember in 2008-2009 talking to very intelligent, longtime investors who were really convinced (for a myriad of reasons we’ll get into some other time) that this time was worth being scared. Each new bear market is scary. It’s different, the economy is different, your life is different, your portfolio’s behavior is different. Each and every time. Successful investors have to stick to their investment strategy throughout these periods. We are often the greatest risk to our own portfolio, and a very real risk indeed. Drawdowns can be hard to deal with, financially. Warren Buffett is famous for saying that his favorite holding period is “forever,” but you aren’t Warren Buffett. At some point in our lives, most of us will spend money regularly from our investment portfolios. If you’re taking regular distributions, volatility matters a lot. A big drawdown can put a portfolio’s longevity at risk if liquidity is insufficient, withdrawals are too large or the drawdown is too deep. Platitudes about indefinite time horizons are lovely, but real life doesn’t always work that way. Volatility as risk matters to the bottom line of any portfolio funding regular withdrawals.

Built For Action

We humans are doers. We want to move, to make, to accomplish, to act. We do not take kindly to sitting idly by. We do not enjoy being bored and most of us struggle to sit quietly alone. It is increasingly easy to distract ourselves, to push away the quiet. Unless I’m asleep I am within arm’s reach of my phone about 95% of the day. Why sit quietly when Twitter and Instagram await?! Last year I read 10% Happier: How I Tamed the Voice in my Head by Dan Harris (at the recommendation of this post by Shane Parrish at Farnam Street). It is a great reflection on the difficulty of our busy lives and our ability to focus and slow down. Harris, after having a panic attack on national television, explores a path towards meditation and trying to relieve his anxiety. In doing so, he finds that meditation is hard. It’s really hard. Sitting and trying to focus on a single thing (typically breathing) without being distracted by thoughts of work, family, hobbies, to-do lists, dentist appointments and everything else. We are just not very good at doing nothing. This is especially true as investors. And we really don’t like it when are portfolios do nothing. We’re sitting in the doldrums right now. Returns everywhere are nowhere. Here’s a quick rundown of 12-month returns through 9-15-15: S&P 500: 1.77% Russell 2000: 3.05% Barclays Aggregate Bond: 2.32% MSCI EAFE: -6.34% MSCI Emerging Markets: -23.58% US Real Estate: 1.89% Other than Emerging Markets being pretty painful, those are some pretty unexciting numbers. A weighted average of those for a balanced investor is probably going to put you in the -3%ish range for twelve months. A little painful, but probably not panic-inducing for most. And yet, it itches. You get your statement and look at the numbers and it just tickles your nerves a little bit. “Should I do something?” it asks. “What’s not working?” it wants to know. “Have I made a mistake?” “What should I do?” “How do I fix it?” They are quiet questions, but there they are, lingering in the back of our minds. We only get one chance at this investing thing, and we’re terrified that we’ll get it wrong. We’ll miss out on opportunities or hire the wrong advisor or buy at the wrong time or have to listen to our brother-in-law at Thanksgiving talk about how he nailed it AGAIN this year. Hopefully, we have the other voice too. The calm, rational one that reminds us that we have a plan. A pretty well-thought-out plan. A plan that involves boring years and periods where returns don’t meet our expectations. This voice should remind us that we knew about that going in. It doesn’t necessarily make it easier to remember that, but it ought to handcuff us. Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.