Notions About Us And Our Investment World

We are in the midst of one of the greatest periods of creative destruction since the Great Depression. The invisible hand of the market economy, indeed, the invisible hand of economics, is reallocating resources from those things that don’t work to those that are our future.

While Washington is working valiantly to ease the so-called pain of this evolution, the evolution nevertheless proceeds and affects all of us in ways we have never anticipated. In retrospect, many of us will remark on the changes as though we actually saw what was coming. The notion that we can anticipate the future with any kind of reliability is just rubbish. What we are actually doing is formulating reasons ex post facto. Some would call this rationalization.

Investment salespeople are great at convincing folks that they really are good at providing great investment returns to persuade you to invest with them. Sometimes it is the implied authority of the surroundings (mahogany woodwork and leather chairs with massive polished wooden desks and lots of computer monitors flashing market statistics) and at other times it is the cut of the clothes that convince clients that these folks are good at what they say they do. Rarely is real proof offered in terms of measured returns over time. Rarer still is the distinction between luck and competence. What should your investment person actually bring to the table that is worth your time?

First is the notion that continually measuring investment results is crucial to proper investment management. We need to kill the notion of hindsight base (where we think we did better or worse than we actually did) and base our decisions and learning on facts and not on opinions, however strongly held. If our learning is not based on facts, we are being led astray. If we don’t measure, we just don’t know and our opinions are just based on our emotions or feelings.

Second is to realize and practice that the world is largely a series of discontinuous events that are not predictable. We are generally married to the idea that much of the world occurs in predictable, continuous patterns that behave like standard bell shaped curves, statistically speaking. This is how we project the future and how we make sense of what happens in retrospect. The stories always occur after the events, not before the events. In reality, much of what happens are outliers and fat tails (excuse the statistical speak) and we are not prepared for it and have no plan to deal with it.

The BP oil disaster in the Gulf comes to mind. Neither the U.S. government nor BP had the resources nor plans put into place to deal with such an event. So we are all muddling through with more than enough blame to go around. Yet a new opportunity now presents itself for those that are not overwhelmed with emotions or stuck playing the finger pointing game. Will oil spills happen again? Absolutely. Hopefully we will have better response plans and the equipment on hand to minimize the damage. This is called learning. The notion that changing the practices of the industry so that this ‘never happens again’ is unrealistic at best and at worst, ignorance.

Third, since the world is largely unpredictable (we still don’t know why the markets dropped a thousand points on the Dow Jones Industrial Average several weeks ago) and we often fool ourselves with our reflections of our own history, then our investment schemes must take into account our shortcomings: the self delusions of hindsight biases and the discontinuous nature of reality.

So then, to hedge your human limitations, you must continuously measure investment results and pay continuous attention to your holdings so that you can cut losers early in the game. Mutual fund managers cannot and do not do this for you, nor does your 401(k) plan administrator or bank comingled trust. Good portfolio management is active (not passive) and is replete with errors and self-correcting behavior. This is called capital allocation by the economists and is an important part of the economy. As investment advisors, we are selling that which doesn’t work and buying what does work now and that which we anticipate will work the future. We are often wrong, yet we are self-correcting as we measure consequences of our actions. In the final analysis the test of our work is measured by are we beating the markets or lagging them?

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