I've Moved!

I've moved! I'm now writing at insecurityanalyst.com. 

Focusing On Our Economic Breath

I've noticed that I get far fewer blog hits and retweets on posts about monetary policy. I don't take that personally at all. Much of the purpose of this blog is to figure stuff out for myself, and writing helps that process. But it's an interesting observation all the same, and I have a few theories why it might be true:

1) I'm a better writer on investing.

2) The self-selecting group that reads my blog is generally less interested in monetary policy.

3) I mostly focus on US monetary policy. Perhaps European and Asian readers are still as engaged.

4) There's monetary policy fatigue. After 8 years of headline-grabbing central bank actions, people are finally getting bored of hearing about policy changes. It's way more entertaining to read about outrageous things Donald Trump has said than to scrutinize cautious central bankers.

5) People are less interested in reading about monetary policy today because they believe it's a less important driver of economic and financial outcomes.

The reality is probably a mixture of these five possibilities. If theories (4) and (5) are true, other bloggers who focus primarily on monetary policy may also be seeing similar trends. You might think that would be reassuring, because it wouldn't be about my failings as a writer; it would merely be an exogenous change in demand for commentary on monetary policy. But you'd be wrong. I'd be incredibly worried if those two were the major factors. Every time someone comments that monetary policy has lost its power to affect macro or financial conditions, I get nervous. It's precisely when monetary policy is working well that we fail to notice it. Complacency is natural as labour markets heal and US financial markets march steadily higher. But it is incredibly dangerous for investors and policy-makers to forget the role that money plays. 

If you've spent any time with mindfulness or meditation practices, you'll know that a common starting point is to focus on the breath. It's actually pretty remarkable to realize how little attention we pay to the mechanism that keeps us alive. Similarly, appropriate monetary policy is the oft-neglected factor that allows policy-makers and investors to focus on structural, rather than cyclical, change. But there's one huge problem with this analogy: when we have trouble breathing, we know immediately that we're short of breath. But when monetary factors are out of equilibrium, we see the effects but aren't always quite as adept at diagnosing the cause. Economic mindfulness requires focusing on money, our economic breath. I'm hoping that the events of the past 8 years have created new economic pulmonologists - but sometimes, I'm just not sure.

Cultural Appropriation (In Business) Is Great!

2015 was a challenging year for US universities. University administrators across the country were forced to grapple with accusations of insensitivity or even outright racism. In the public discourse that followed, I learned the phrase "cultural appropriation". According to Wikipedia, "Cultural appropriation is the adoption or use of elements of one culture by members of another culture." As I understand it, it's generally used to imply a majority culture adopting elements of a minority culture. 

Much of the commentary I saw last year was critical of cultural appropriation. Challenging prevailing sentiment, Noah Smith wrote a great blog post, simply titled "Cultural Appropriation Is Great!" (As a fan of appropriation, he surely won't mind that I latched on to his title for this post.) In it, he lists six reasons why cultural appropriation is a good thing. Commenter Harriet argued that Noah was missing the difference between cultural exchange and cultural appropriation. If there is a difference between the two, it's pretty slim. Unlike trade in goods and services, there is no explicit exchange in culture. No-one ever says, "Here, you take this bit of my culture, and I'll take that bit of yours." I think we can all agree that it's important for members of one racial/religious/ethnic group to be careful not to mock other cultures, or abuse sacred cultural artifacts. (For more on navigating this path, check out The Atlantic's Jenni Avins.) But the reality is that cultural exchange is a fluid process, and is generally a force for good. One of the best lectures I heard this year was Harvard evolutionary biologist Joseph Henrich explaining how constant cultural evolution is the basis of our collective intelligence, which in turn drives our species' evolution. If you agree with Henrich, demonizing cultural appropriation seems misguided.

It struck me recently how much cultural appropriation has benefited the business world. I just finished "Conscious Capitalism," written by Whole Foods Market co-founder John Mackey and Babson College professor Raj Sisodia. Whole Foods is a pretty remarkable story, given that Mackey co-founded it with zero business experience at the age of 22. One of the central tenets of Conscious Capitalism is to encourage a stakeholder orientation. Rather than only paying attention to investors, or even to customers, a stakeholder orientation seeks to find mutually beneficial outcomes for employees, suppliers and many other parties. Whole Foods has gone so far as to create a "Declaration of Interdependence" codifying this philosophy. It all sounds a little hokey and idealistic until you realize how much this sounds like Japanese businesses. Western analysts often find it hard to wrap their heads around Japanese companies' insistence on a stakeholder mentality. But clearly, Whole Foods has successfully adopted this philosophy. 

Ok, you might say. It worked for Whole Foods but that's just one company, and John Mackey is a self-professed student of Eastern philosophy and religion. Can mainstream Western businesses be trusted with cultural appropriation? Absolutely! Sam Walton may have called his autobiography "Made In America", but in it, he details how much he learned about building corporate culture from visiting companies in Korea and Japan (including the famous Wal-Mart company cheer). More recently, Amazon.com appropriated Toyota's "andon cord" philosophy, in which any worker on the line could stop a process that was deemed unsafe or unsatisfactory from a quality standpoint. There's a reason Wal-Mart and Amazon have been so successful: their founders are serial appropriators, relentlessly seeking out other company practices and absorbing them. But don't forget that this process happens constantly in both directions. After all, much of Japan's manufacturing success has been attributed to productivity improvements pioneered by American statistician W. Edwards Deming. 

So, my view is pretty simple. There are times when people are insensitive towards other cultures, and we shouldn't hesitate to educate those who don't understand or don't seem to care what they're doing. But cultural appropriation is a complex, unstoppable process that we should generally welcome. And who better to have the last word on this than a Hong Kong martial arts star (born in San Francisco) credited with changing the way Asians are portrayed in Hollywood? As Bruce Lee said, "Absorb what is useful, discard what is useless and add what is specifically your own." That, in a nutshell, is the best form of cultural appropriation.

Not So Predetermined

A recurring theme on this blog is the notion that events are often far less predictable than we come to believe after the fact. Our understanding of how history unfolds is deeply flawed, even with the benefit of hindsight. But this doesn't mean we need to take a nihilistic "nothing-is-predictable-so-why-bother" approach. Rather, it calls for rigorous documentation of our views at any given point, and a scathingly honest assessment of why the predictions go right or wrong. As Charlie Munger colourfully put it, "I like people admitting they were complete stupid horses' asses."

This ethos seems to underlie the work of superforecasters, highlighted by Tetlock and Gardner. In my last post, I argued that superinvestors like George Soros and Warren Buffett share the characteristics of superforecasters, despite vastly different investing styles. Speaking about his well-known bet against the British pound, Soros insisted that his success in that particular trade was "not so predetermined."

The same interview raises an interesting question: was Soros's broader success "predetermined"? Curiously, his early career offers little suggestion of the brilliance investing tenure that was to follow (details from Soros on Soros).

1953 (aged 23): "I became a traveling salesman selling [fancy goods] to retailers in Welsh seaside resorts, and that was a low point in my career."

1953-56 (aged 23-26): Singer & Friedlander. "I was made to do some very boring, humdrum jobs, which I did very badly." Moved on the arbitrage department: "Again, I didn't shine." The managing director "told me he didn't get terribly encouraging reports about my performance." "I was a fifth wheel in whichever department I was placed."

1956-61 (aged 26-31): Wertheim & Co. "I put out memoranda that you would find heartbreaking if you read them today because they were so amateurish." Benefited from a boom in European stocks and was able to produce original research. "It was the first big breakthrough in my career." When President Kennedy placed a 15% tax on foreign investments, Soros's business trading global equities was destroyed, forcing him to leave Wertheim.

1961-66 (aged 31-36): Arnhold & S. Bleichroder, part 1. "Business became scarcer and scarcer, and I retired to philosophy." "I stayed employed, but my mind was on philosophy and not on business."

1966-73 (aged 36-43): Arnhold & S. Bleichroder, part 2. "Since I didn't know much about American securities, I wanted to find a way to educate myself." He set up a model account with the firm's money and used it as a tool to develop business with institutional investors. "This was a very successful format." In 1968-69, he helped set up investment funds, First Eagle Fund and Double Eagle Fund. As potential conflicts arose, he left the firm in 1973 to set up his own hedge fund, Quantum Fund, with $12 million of mainly outside money (roughly $65 million in 2016 terms).

My point is simple: Soros's stunning track record post-Quantum Fund is widely known, but at least from the history he sketches, there are relatively few harbingers of this success until he turned 36. But the desire to continue educating himself in US equities proved to be the platform he needed. There was also probably some luck involved in his decision to set up a model account in 1966, as US markets went on a nice little run (note that these figures are for the S&P 500, not Soros's fund). 

Year	S&P 500 Return	Value of $1000
1966	-9.97%	900.30
1967	23.80%	1114.57
1968	10.81%	1235.06
1969	-8.24%	1133.29
1970	3.56%	1173.63
1971	14.22%	1340.52
1972	18.76%	1592.01
CAGR		8.06%

However, starting business in the teeth of the brutal 1973-74 bear market can hardly have been easy, and must have required the same persistence that kept Soros going through the relatively lean years before 1966. The combination of a growth mindset and some luck set the stage for a track record that most investors can only dream of. But it's worthwhile to remember that, perhaps, that track record too was not so predetermined as we often believe today.

Superinvestors, Superforecasters

The strategist Byron Wien once remarked to George Soros that on the investing equivalent of Mount Rushmore, there were two faces - Soros himself, and Warren Buffett. Soros responded, "You couldn't find two more dissimilar figures." Others who know Soros well have echoed this sentiment. In Inside The House Of Money, Scott Bessent commented, "[Soros] is the opposite of Warren Buffett. Buffett has a high batting average. George has a terrible batting average - it's below 50 percent and possibly even below 30 percent - but when he wins it's a grand slam. He's like Babe Ruth in that respect. George used to say, "If you're right in a position, you can never be big enough.""

Yet, despite the sharp differences in their styles, the two share analytical and philosophical traits that have contributed to their success. In the same interview, Wien asked Soros if his successful shorting of the British pound in 1992 was predetermined. Surely, he asks, Soros was able to participate in size and thereby influence the outcome of the event? Soros demurs, "It was not so predetermined. In retrospect, it was predetermined, but not in prospect. Believe me, speculation is not without risk, and the outcome is far from assured." This philosophical outlook might ring a bell for those familiar with Philip Tetlock's excellent work on Superforecasters, summarized here by Michael Maubossin and Dan Callahan:

Soros's non-determinism shines through in the earlier quote, but it's remarkable how many of the other characteristics he exhibits. For example, the quote that forms the title of this blog marks him as being actively open-minded. His pragmatism is apparent from his trading style, and his forays into philosophy demonstrate his reflective nature. 

While Buffett may have used the term "superinvestor" to refer specifically to value investors, it seems clear that "superinvestors" more broadly are really "superforecasters." Regardless of investment style, the greatest investors are skilled analysts of probabilities, and are able to perceive when those odds are overwhelmingly in their favour. They also possess another rare quality - having the courage of their convictions to bet accordingly. 

It's hard to know whether superinvestors are just naturally endowed with these skills. But for those of us gazing up at Mount Rushmore awe-struck, it's worth paying attention to the last characteristics of superforecasters: believing it's possible to get better, and being determined to keep at it, however long it takes.

The Power of "Because"

Superior investment results are usually attributed to some combination of better information, better analysis, and better emotion management. The first of these, information, is central to any investing endeavour. Analysis is the synthesis of information; information is its foundation. Similarly, no amount of emotion management can overcome deficiencies in the original analysis. It's no wonder, then, that investors go to great extremes (occasionally crossing ethical lines) to obtain information that can provide them with a competitive advantage. In this age of continuous, real-time data, many investors satisfy their information cravings with a steady diet of business news on TV and the Internet. But this unceasing flow of news rarely provides the advantage that some investors think it does. If anything, it's probably harmful to the investment process.

T.S. Eliot had something to say on this subject, famously writing, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" We are confronted today with a surfeit of information, but significantly less knowledge and wisdom. The financial press is always quick to construct facile narratives for market movements. "The market fell today on fears of a hard landing in China," we hear, or, "The market rallied today in anticipation of a more dovish Fed." It's much harder to admit that markets are both random and complex. 

Chalk it up to the power of "because." Harvard social psychologist Ellen Langer demonstrated this in a series of experiments asking a small favor of people waiting in line for a library copying machine. The first request was, "Excuse me, I have five pages. May I use the Xerox machine because I'm in a rush?" An impressive 94% of those in line allowed her to skip ahead. This fell to just 64% when participants were confronted with the request, "Excuse me, I have five pages. May I use the Xerox machine?" But the real kicker was the final experiment, where participants were asked, "Excuse me, I have five pages. May I use the Xerox machine because I have to make some copies?" Amazingly, 93% of those asked agreed, even though the request contained no new information. Some justification, no matter how flimsy, was enough to secure compliance. 

In the world of investing, we see this when investors get locked into a prevailing narrative. In his book "Common Stocks and Common Sense," value investor Edgar Wachenheim recounts a winning investment in Southwest Airlines. Other investors failed to realize that a tightening in airline capacity would lead to higher pricing for airline seats. But Wachenheim is most critical of sell-side analysts, who had become so focused on short-term developments that they ended up missing the bigger picture. The so-called experts, he writes, "had become reporters of recent news, not analysts."

I prefer to leave the reporting to reporters. Intelligent contrarianism, which Philip Fisher described as "correctly zigging when the financial community is zagging", is at the heart of fundamental investing. But this is hard to do when we confuse the news with information or knowledge. We all need to stop and think a little bit harder, especially when the news offers that most seductive of words: "Because."

Triumph of the Optimists

When interviewing people, the venture capitalist and entrepreneur Peter Thiel has a go-to question: "Tell me something that's true that nobody else agrees with." As it turns out, this is a stunningly hard question. But one of my answers would be simply, "That the world is getting much better."

We are bombarded daily with news coverage of threats like terrorism, global pandemic and economic mayhem. It's hard to follow the news without getting depressed about the future of humanity and the planet we inhabit. And yet, the truth is, the world is getting much better. This is true broadly in human health, economic well-being and safety, as documented by writers like Matt Ridley, Charles Kenny and Steven Pinker. On Twitter, I'm constantly impressed by the data visualizations compiled by Max Roser and HumanProgress.org, which highlight remarkable improvements in our world. This is not to deny that major suffering still exists, or that pockets of society in the US have seen only modest progress over the last 50 years. But looking at the big picture, I find it hard not to be awed by the strides we have made over several generations, and to therefore be optimistic about future developments.

Still, this appears to be a relatively unusual opinion. Even if it is something people agree with on an intellectual level, they often cannot help but feel differently at the visceral level. Why exactly this is the case is the cause of much debate. Personally, I'm always interested in trying to figure out how to apply contrarian opinions for practical purposes. It struck me that I use this particular unpopular stance all the time: I invest in equities for the long term. 

Contrarian optimism is hardly an unusual strategy when it comes to investing.  There are two quotes that every investing aficionado knows: (1) "Be fearful when others are greedy, and be greedy when others are fearful" (Warren Buffett), and (2) "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." (John Templeton). But I'm thinking here of a longer term phenomenon instead of a cyclical one. Equity investors are generally rewarded for tolerating short-term volatility and long-term uncertainty. In fact, this is one of the many findings of Dimson, Marsh and Staunton's book that produced the title of this post. I wrote a few months ago that the point of a bear market is to return risky assets to their rightful owners. Most people seem ill-equipped for a combination of volatility and uncertainty, but this prevents them from enjoying the benefits of compounding, which only accumulate over time. Looking back at long periods of history is helpful for grasping the gigantic advantage available to those who can truly invest for the long term.

Obviously, it's possible to take this optimism too far. Investors often overestimate a company's long-term prospects. And the great bubbles in history have been the unfortunate byproduct of excessive optimism, greed and a pernicious fear of missing out. There's no doubt that we all need a healthy dose of skepticism to counter the inherent bullishness of the Wall Street machine. So an optimistic outlook needs to be combined with a finely-tuned malarkey detector. But while the pessimists sit on their hands, predicting the next financial collapse or outbreak of hyperinflation, positive change continues to happen all around us. As Ben Carlson notes, "Investors now spend 90% of their time planning for events that happen 5% of the time." This hardly seems like the best way to plan for the future. Instead, the best financial strategies focus on the powerful improvements unfolding over the long term while acknowledging the short-term challenges that always exist.

Of course, only time will tell if I'm right. But I'm relatively confident in betting that the next 50 years will prove to be yet another triumph of the optimists. 

Four Goals Good, Five Goals Bad

In my last post, I argued that despite talk of the Fed's dual mandate, it is targeting at least four goals:

1) Price stability
2) Full employment
3) International stability, seeking to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes the Fed's influence on global economic, monetary and financial conditions
4) Financial stability, avoiding both unwarranted booms and busts in asset prices.

Tim Duy has two theories (again, see previous post) for why the Fed seems surprisingly keen on raising rates. I think the Fed's recent actions appear much more understandable in light of their unstated financial stability goal.

One narrative of the cause of the financial crisis is that the Fed was directly responsible for the financial crisis of 2007-2009 by keeping interest rates too low for too long. A more generous view is that, as Hyman Minsky warned, stability breeds instability, and the success of "the Great Moderation" unfortunately encouraged high leverage and complex financial instruments at fragile institutions. 

Despite the Fed's best efforts to insulate itself from political pressure, it's unthinkable that it can have remained impervious to the two views above. In this sense, "normalization" can be seen as an attempt to head off any reprise of the financial crisis. Two more concerns are extant:

1) The notion that market participants have somehow become "addicted" to monetary stimulus. (Side note: If there's one thing that automatically sets my teeth on edge, it's references to the economy or financial markets as an alcoholic or drug addict, and to the Fed as a shameless enabler.) The problem is that this bias leads observers to see the 2013 taper tantrum and the 2016 Jan/Feb sell-off as evidence that financial markets are relying on low rates indefinitely. 
2) The notion that Fed actions have pushed all asset markets to overvalued levels. 

Part of the financial stability goal is clearly aimed at keeping unbridled speculation at bay. In Paul Blustein's "The Chastening", he recounts how Larry Summers famously told his bailout negotiating team, "We want to keep markets calm and the Russians scared." The Fed is playing an even more difficult game where it wants to keep markets calm and the speculators scared. This is already attempting to thread the needle, but even more difficult given the Fed's other three goals. 

I've been endlessly critical of hard money types, but it's worth acknowledging that they're not the only ones who may find this expanded array of goals troubling. Those who advocate different types of rules-based monetary policy, such as nominal GDP level targeting, may also consider the monetary policy Apocrypha too hard to achieve. Their concerns are understandable. In its attempt to fulfil its Apocryphal financial stability mandate, the Fed is failing to meet its Canonical dual mandate. Furthermore, in doing so, as Narayana Kocherlakota points out, the Fed is jeopardizing its credibility to meet the Canonical Mandates. I was stunned to read the well-known economist (and former Fed vice-chair!) Alan Blinder lament the limits of monetary policy. "If there is a cyclical downturn in a year or in the next several months, there would be nothing in that shotgun," Blinder warns. If a former Fed vice-chair believes that the Fed is out of ammo (another image I don't care for), it's unlikely economic and financial markets fully believe the Fed can stabilize economy in future downturns.

As unwieldy as the quadruple mandate may be, it seems to be the right approach to central banking in the US. There's no doubt that it's incredibly challenging to manage these four goals, but I don't see any other way. If, for example, we're aware that our diet will affect our teeth, skin, weight and ability to build muscle, it's challenging to choose the right food - but we have no choice but to constantly manage the trade-offs between these effects. Why, you may argue, should the Fed restrict itself to four mandates? Why not five? Why not six? I don't have a great answer to that, and recognize the danger of over-reach: in fact, one of the problems here is that policy-makers do indeed seem to have taken on a fifth mandate, "Normalization", which is at odds with many of its more worthwhile goals.

One of my favourite books is John Kay's "Obliquity." In it, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity." Yellen's Fed has presumably used a dashboard of indicators to guide its policy-making thus far. It would be a huge mistake to fixate on one or two of those, despite the political appeal and intellectual comfort of doing so. While financial stability is a perfectly valid goal for the Fed to consider, the balance of risks does not appear to require a hasty set of rate hikes. If anything, it is that new mandate, "Normalization", that should be abandoned in favour of the four mandates that have historically served the Fed. 

The Fed's Monetary Policy Apocrypha

In a blog post simply titled "Curious", Tim Duy ponders why so many FOMC participants seem eager to raise rates despite failing to meet either of its official mandates (price stability and full employment). Duy has two theories: (a) the FOMC does not view the removal of QE as tightening, and therefore believes it has yet to remove accommodative policy, and (b) the FOMC views a much higher level of interest rates as "normal" and is eager to reach these higher rates.

I find the second argument more convincing (by which I mean, I find it convincing as explaining Fed policy. As I will try to argue, it is a problematic stance for the Fed to take, since giving too great a weight to "normalizing policy" makes it ever hard to reach those levels). The Fed's desire for "normalization" may also reflect some view of the "normal" size of its balance sheet. But really, this argument is a sub-set of a much broader argument - one which makes the Fed's action far less curious. Simply put, the Fed is trying to meet not two, but (at least) four mandates.

No doubt this is already raising the ire of hard money types in particular, who think central banks should be focused solely on price stability, and to whom a full employment mandate is already venturing into dangerous territory. Many of these folks are likely to lionize Paul Volcker for successfully driving inflation down, even at the expense of causing a recession. But here's the funny thing: if you listen to Volcker himself, he was focused on at least three mandates throughout his lauded career. Yes, price stability was incredibly important to him. No, he didn't think the full employment mandate was particularly helpful. But he was also focused on mandates no. 3 and 4, namely international considerations and financial stability. This is strongly apparent in an excellent two-part interview he recently gave the FT's Cardiff Garcia.

Broadly speaking, I would define the extra mandates as follows:

Mandate 3: The Fed seeks to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes its influence on global economic, monetary and financial conditions.

Mandate 4: The Fed seeks to implement monetary policy in a way that maintains financial stability, avoiding both unwarranted booms AND busts in asset prices.

These mandates are hidden from the public eye. The Greek phrase for "hidden things" is Apocrypha - a phrase most commonly used in reference to a group of non-canonical writings only included in some Christian Bibles. These books are called Apocrypha "because of the belief that the men who wrote them were not addressing their contemporaries but were writing for the benefit of future generations; the meaning of those books would be hidden until their interpretation would be disclosed at some future date by persons qualified to do so." In a similar vein, the Fed's monetary policy Apocrypha are implemented for the benefit of future generations, but are largely shielded from the eyes of current observers (presumably because they lie outside the Fed's official purview).

I mainly want to talk about Mandate 4 (financial stability), but let me make some brief comments on Mandate 3. Mandate 3a is something every central bank must grapple with, particularly if it has pegged its exchange rate. Mandate 3b, however, only applies to major central banks, like the Fed, the ECB, the PBoC, and the BoJ. David Beckworth coined this the "monetary superpower" phenomenon, which I covered in a prior post.

The hidden financial stability mandate appears to be the biggest source of controversy at this point, and I cover this in my next post.

What Do Investing FOMO and Over-Eating Have In Common?

There's nothing more frustrating than seeing an asset that you had on your watchlist go up by 50% before you've had time to do work on it, or before you manage to pull the trigger. If you're anything like me, this experience causes profound feelings of regret.

Why do we have these feelings? I see at least four possible reasons:

1) Greed. This seems like an obvious one. But I don't think it's the main driver, at least for myself. It's interesting that I usually think "I can't believe I missed that 50% move", rather than "I could have made $X! And bought so much with it!"

2) The missed opportunity to seem smart to colleagues and other investors. I confess to this one. It's totally understandable - we're social creatures and desire the approval of our peers. But dulling those urges for peer approval is necessary for actually earning outstanding returns. As I argued in a recent post, the exceptional investor will at times appear imprudent, and possibly deviant.

3) Professional pride. I see this one as related to (2), if slightly different. The feelings of regret are magnified if the recently appreciated asset is in the sectors I follow, or a company I used to own. Again, it's a natural emotion, and one which can be a positive spur to performance - in moderation. 

4) The fear of missing out. This is the one I really want to focus on. There's a fine line between greed and the fear of missing out (FOMO), but the two often appear identical to outsider observers. 

First, a quick digression on over-eating. I hate wasting food, and if someone in my family offers me the last bit of something delicious, my instinct is always to say yes. It's not just simple greed. The more I've become aware of this, the more I think it has deep underpinnings in evolutionary psychology. At some level, I believe, there is part of me that fears that if I don't use the resources at my disposal and consume the food, I will face hunger and possible threats to my survival. That might sound a bit nutty, but there is certainly some evidence for it in psychology. So despite the knowledge that I am (mercifully) unlikely to go without food for long, these pangs occasionally drive me to eat more than I need to.

Back to investing. I think, at some level, we fear missing out on investments because we fear we will never have similar opportunities again, and that we will be forever denied those scarce resources. We seem to be particularly susceptible to FOMO when we know people who have profited from the move (seeing the resources "consumed" just seems to chafe more). Investing FOMO also seems to be heightened in asset classes like real estate, where there appears to be a deep psychological fear of being denied shelter. In fact, there's academic work that backs this up. (The analogy between chasing returns and over-eating isn't perfect. Over-eating delivers an excess of calories. Chasing returns usually results in negative performance. But both of those are unhealthy outcomes!)

I take two things from this realization:

a) Be aware you are subject to investing FOMO. It happens sometimes. But it probably happens less if we restrict our investing to areas where we can build up a deep wealth of experience and information. A former boss used to sagely remind me, "You can't dance with all the pretty girls" if I was frustrated at missing out on something. (I may have taken his words to heart much more than he intended. I got married while working for him.)

Furthermore, markets are cyclical, and hard as it is to believe in the moment, it's quite likely that we'll get other shots. Rather than fixating on the opportunities we've missed, there are other things waiting to be discovered. As Irving Kahn reminded Peter Cundill, "There's always something to do."  

(As an aside, when someone offers me delicious food, I try to take it home, rather than eating it on the spot. This seems to convince me that I will in fact enjoy those resources at some point, just at a later time. Psychological tricks seem to work in eating as well as in investing!)

b) Try and recognize when other investors have been swept up in FOMO. Buffett's dictum to be "fearful when others are greedy" is generally wise. But we also need to be fearful when others are fearful (of missing out). My guess is that a great many people who got caught up in the US real estate boom prior to 2007 weren't greedy, but just misguided. Sadly, it seems a cruel truth that it's those who attempt some discipline who usually capitulate right at a market top.

Investing FOMO is a powerful emotion. But being aware of it in ourselves and others is the first step to weakening its hold on us - and our investing decisions. 

Uncool, Imprudent & Deviant Investors

I've been reading the work of sociologist Howard Becker this past week, in which he makes an argument for reasoning from cases. By this, he means using detailed knowledge of one specific case to uncover more general ideas about how society works. Becker writes, "I want to avoid the fate of researchers who relied too heavily on a relatively few easily observed facts to do their explanatory work... that insistence doesn't fit well with much contemporary thinking about how social facts or events occur and develop, which instead works by measuring the connections between measured things rather than explaining how those connections produce the results we want to understand."

Generally speaking, I'm sympathetic to Becker's viewpoint, particularly in a world where sophisticated quantitative analysis is sometimes used in lieu of clear, intuitive thinking, or where we focus excessively on past outcomes, rather than thinking about the future. More specifically, in the world of investing, I find myself resisting simplistic notions of following what has worked in the past. 

A current manifestation of this is the focus on "quality" stocks. As a self-professed admirer of Warren Buffett, I've written recently about his insistence on purchasing high quality businesses. Similarly, the academic work of Robert Novy-Marx finds that quality investing has been profitable. But it's hard to forget another great Buffet-ism: "What the wise man does in the beginning, the fool does in the end."

Rob Arnott, one of the fathers of the "smart beta" movement, recently caused quite a stir by suggesting the strategy could be in for a tough time. He and his colleagues wrote, "We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." Investors who mindlessly chase performance plow headlong into what has worked, and in so doing push prices higher, providing a further signal the strategy "works" - until it doesn't, and valuations revert to historic norms. 

To be clear, Arnott et al are not suggesting this is true of low beta investing (which I take to be similar to "quality" investing). Despite observing large inflows into low beta products, they think "normal" valuations for low beta assets may have changed. But they caution that strategies like low beta "may still be an attractive investment, but for their risk-reducing characteristics, not for the alpha they have historically provided, net of their rising popularity and relative valuation."

A slavish adherence to "quality investing", therefore, is unlikely to produce satisfactory results. We have a tendency to label companies as "good" or "bad", but the reality is that "quality" is ill-defined and is a spectrum, not binary. At the right price, investors are being compensated to own businesses that are somewhat economically sensitive and which have good, but not great business moats.

There are two strategies for dealing with this reality. John Huber, who writes the excellent Base Hit Investing blog, has taken the first route, which is to identify a watchlist of 50-100 good companies, and assume that among those, "there are almost always a few opportunities at any given time for one reason or another." The second is to pursue a flexible investment philosophy that seeks value in unloved places. While we often associate this with global macro investors, it was also the hallmark of John Templeton, who people often mistake as a traditional stock-picker. Templeton said, "If you want to produce the best results in twenty or thirty years, you have to be flexible. A flexible viewpoint is a matter of avoiding a peculiar trait of human nature, which is to buy the things that you wish you had bought in the past, or to continue to buy the things that did well for you in the past." 

Ultimately, it seems unlikely that one can generate exceptional investment returns without being an intelligent contrarian. As David Swensen has written, "Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom." With customary pithiness, Jason Zweig said, "To be a great investor, you have to want to be uncool."

Being influenced by sociology, I phrased it a bit differently in 2014. I wrote then, "To succeed spectacularly, one must be unconventional, and therefore deviant." A curious coincidence, then: one of the towering figures in the sociology of deviance, and the person whose work I was channeling in that earlier post, was the same Howard Becker.

The Point Of A Bear Market

In his classic book Supermoney, the writer Jerry Goodman (aka “Adam Smith”) tells a story of an investment group therapy session gone wrong. After a vicious bear market in 1969, he convened a group of investment professionals to discuss mistakes they had made in the "Go-Go Years". For a while it appears to be going well, with participants sharing the pain collectively. The meeting, however, takes an unexpected turn when Goodman asks David Babson to speak. Babson, described as “a crusty, amiable New Englander who heads the sixth biggest investment-counseling firm in the country”, proceeds to criticize professionals who got sucked into speculation. Looking out at the crowd, Babson tells them, “Some of you should leave this business.” He then pulls out a list of former speculative high-fliers that had declined dramatically or gone bankrupt. Goodman attempts to intervene several times:

“David,” I said gently into the microphone. The audience was beginning to rustle. You can tell something has happened to the good feelings when the water pitchers start to clink nervously against the water glasses in a rising cacophony.

Babson continues reading the names of former stock market darlings.

Goodman tries to interject again:

“Don’t read the list,” I said. The audience was beginning to scrape its chairs. My massive group therapy session had taken a sour turn. Nobody was going to confess if they were being accused.

Unrelenting, Babson continues to read names. Finally, Goodman cuts in:

“David,” I said, “you have passed the pain threshold of the audience.”

Phew. I attended a much milder version of a group therapy session gone awry in 2009. At a well-attended investment conference in New York, one panelist repeated a Wall Street aphorism I had never heard before. “The point of a bear market”, he said smugly, “is to return capital to its rightful owners.” There was an uncomfortable silence, as a noticeable tension filled the air. While the speaker had obviously avoided the worst of 2008, there were many in the room to whom financial markets had been less forgiving.

That adage has stayed with me all these years. But I don’t think our self-satisfied friend was quite right. The point of a bear market, I think, is to return risky assets to their rightful owners.

Put simply, assets exist on a continuum of safety. US Treasury notes are one extreme, while equities are another. As anyone familiar with the risk/reward trade-off knows, equities usually offer the possibility of high returns, but these returns face great variability. High returns compensate the investor for bearing risk.

In finance, we use the prosaic phrase "equity risk premium" to represent this truth. The equity risk premium, combined with a company-specific risk premium, is an important input to discount future cash flows. Together, these are the whole basis of valuation. The investor's task is to understand when the market is wrong about future cash flows or about risk. But behind the jargon lies a simple fact: risky assets aren't for everyone. Some people crave stable returns to meet near-term liquidity needs. Others are just temperamentally incapable of facing volatility. That's why people are wrong to criticize financial markets as zero-sum games. When a bear market occurs, risk premiums increase, and risky assets return to those who are willing to bear the discomfort of an uncertain outcome. The sellers discover to their horror they were accepting lower risk premiums than they should have. Some of these sellers will almost certainly be so-called professional investors, realizing they woefully underestimated the riskiness of previously beloved assets. 

David Babson, I am sure, would never have made that mistake.

If You Want Profit, Prepare For Loss

It's that time of year in the US Northeast where the weather is changing from bitter cold to more bearable temperatures. Unfortunately, something about the shift in weather seems to make people more susceptible to coughs and colds. I readily confess to being a bit of a germaphobe, so it's hard for me not to cringe when people are coughing or sneezing around me. It certainly seems like I use even more hand sanitizer than normal this time of year. But sometimes I meet people who are even more militant about hygiene:

Me: *Cough*
Them: "ARE YOU SICK?"
Me: "No, I'm choking on something."
Them: "Oh, that's fine then."

Charming, to say the least! Lack of empathy aside, it struck me that you can really take the whole hygiene thing too far. No-one wants to get sick, but there's a point when it become unhealthy to obsess over every sniffle around you, and when hyper-vigilance probably detracts from your overall health and well-being. This is especially true since common coughs and colds, while unpleasant, are usually short-lived.

Much of this applies to investing. No-one wants to lose money, but it's bound to happen at some point all the same. Despite the analyst's best efforts, markets occasionally sell off, taking good companies with them. Maybe a company's fundamentals change. Or sometimes - again, despite one's best efforts - the original analysis is proven flawed. There is an optimal level of insecurity analysis that should occur when investments go sour: too little, and you risk missing important feedback; too much, and you turn yourself into the very bag of nerves that characterizes Mr. Market.

The second part of this is ensuring that you can bounce back from losses, whether temporary or permanent. At a recent investor presentation, ExxonMobil CEO Rex Tillerson said that in his 41 years in the oil business, he hadn't learned any more about his ability to foresee the price of oil. Instead, he has learned more about how to deal with the market's gyrations. Similarly, a robust investing philosophy ensures that no one event can knock you out of the game, as unpredictable as that event may be. Reasonable diversification is one solution. Avoiding leverage is another. I'm a huge fan of the Buffett admonition: "If you're smart, you don't need it, and if you're dumb, you have no business using it." 

The final piece of this is committing to learning from losses, whether temporary or permanent. Nassim Taleb coined the term "antifragility" to describe things that gain from disorder. This is an even higher bar than merely being robust to disorder. Few securities, other than US Treasury bonds, seem to meet this criterion. Nevertheless, the investor who learns from mistakes over time is in fact benefiting from that disorder, and is thus long-term antifragile.

There's a saying: "If you want peace, prepare for war." I happen to think that rings true, even if it's often misused by people who have no desire for peace. I would paraphrase it this way: if you want profit, prepare for loss. Recognize that losses will happen at some point, and (1) prepare to approach them with equanimity and clear thinking, (2) prepare so that losses will be manageable, and (3) prepare to learn from the episode. This is the foundation for dealing with, and ultimately benefiting from, adversity in the investing arena.

Berkshire Hathaway: Come For The Returns, Stay For The Philosophy

The release of Berkshire Hathaway's annual letter to shareholders is always a wonderful opportunity to learn from Warren Buffett. As usual, the letter has already been picked over by the media and blogosphere, but I wanted to record some of my own thoughts. This post can be read in tandem with an older piece I did on Buffett's shareholder essays. 

1) Simplicity. Buffett's letters are remarkable for their clarity. This is extremely unusual in a world where investment managers often aim to wow their clients with technical sophistication and jargon. Instead, with Buffett, we are left with the impression of someone who is able to take the complexities of investing and cut right to the core of the problem. Here's one example: Buffett notes that he and Munger expect Berkshire's normalized earning power to increase every year. This is a simple statement, but powerful in conveying that every investor can dramatically simplify his life and improve his returns by focusing on his portfolio's normalized earning power, rather than explicitly trying to generate high returns.

2) Dealing from strength. Buffett highlights Berkshire portfolio companies that pressed their advantage over competitors by making investments in new equipment. He notes, "Dealing from strength is one of Berkshire's enduring advantages." The source of strength is having dry powder when others don't, which requires patience and discipline. Buffett famously said, "Lethargy bordering on sloth is the cornerstone of our investment style." Similarly, there's a Munger quote that I love: "We don't mind long periods in which nothing happens...You look at [Buffett's] schedule sometimes and there's a haircut. Tuesday, haircut day." Instead of fretting about his portfolio, Buffett reveals that he spends ten hours a week playing bridge online - one way to combat boredom, which I've referred to in the past as the third emotion of investing. But of course the flipside of this is being aggressive when opportunities arise, and when competitors are unable or unwilling to act. 

Obviously, no-one sets out hoping to operate from a position of weakness, but prioritizing it as a strategic goal helps. As I've noted before, one of the mortal sins of investing is compounding earlier errors, and this typically happens when one is operating from a position of weakness and reacting to events in a haphazard fashion.

3) Business quality. For someone who is known as the doyen of value investing, Buffett makes surprisingly little mention of the prices paid for the businesses he purchased. Rather, he focuses on their quality. I'm not suggesting that Buffett ignores price; his discussion of insurance underwriting reveals, as always, a keen grasp of risk and reward, as does a note of caution on prices paid for bolt-on acquisitions. Nevertheless, his emphasis on quality, rather than cheapness, is telling. Despite his ability to be patient, Buffett is clearly not just waiting for cyclical lows. Unlike most investors who agonize endlessly over whether equities are cheap, Buffett continues to pour money into investments that he believes will pay off over the long run (Precision Castparts, Wells Fargo, Coca-Cola). 

4) Optimism. We're bombarded by soundbites from pundits (and truth be told, investors) who usually appear smarter for being negative. Buffett, on the other hand, comes across as unusually optimistic (a view shared by his friend, Bill Gates). Having a long-term horizon helps, but Buffett's success is supported by Dimson, Marsh and Staunton, who lauded the "Triumph of the Optimists".  

5) Come for the returns, stay for the philosophy. I'm guessing that most people start following Buffett and Munger because of the prospect of mimicking their investment success. I'm also willing to guess that most of those who stick around do so because they're attracted by the duo's integrity and life philosophy. In this year's letter, Buffett wrote, "There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings." In a world of relentless asset-gathering masquerading as investing, Buffett's easy manner is why I, like many others, look forward to his letter year after year. 

Adventures In The Bargain Bin

I was at my local grocery store last week, and noticed that salmon fillets were 50% off. I stood in front of the display for a good two minutes, racked with indecision. I like salmon. It's usually more expensive than other meat, and it's rare to see it on sale. I vaguely recalled a Buffett quote about being happy to buy merchandise when it went on sale. And yet, I just couldn't bring myself to buy it. The fact that salmon is rarely on sale suggested to me it might not have been the freshest fish. Also, that store doesn't have the best reputation for selling the freshest meat & produce. And so I walked away.

I've written before that it's one thing to be a value investor, and another thing to be a cheapskate. But the salmon episode got me thinking: why couldn't I pull the trigger on what appeared to be something on sale? Two issues seemed key:

1) I couldn't be sure of the fish's quality. I looked up the Buffett quote when I got home: "Whether we're talking about socks or stocks, I like buying quality merchandise when it's marked down." The word "quality" is very important in that quote. The salmon price mark-down was in fact signalling something about the quality of the merchandise, and I didn't like the signal I was getting.

2) The consequences of being wrong could be deeply unpleasant. If you buy a cheap pair of socks and discover the elastic is already worn, the worst that happens is that you've wasted a few dollars and have to toss the socks in the trash. Not true of food, though: if the salmon had been less than fresh, it probably wouldn't have been life-threatening, but could easily have made me miserable for a day or two!

My adventures in the bargain bin have some clear implications for investing. Value-oriented investors are often drawn to stocks that have been beaten up, but it requires some genuine judgment to assess if price declines are warranted. Similarly, they may shy away from companies trading at lofty multiples, believing that valuations are excessive, even if the underlying company has excellent fundamentals. As with fish, this judgment depends on accurately evaluating the quality of the stocks and the consequences of being wrong.

Assessing quality is aided by the following:

a) Deep fundamental research. This should be a prerequisite, of course, but without this kind of work, it becomes far too tempting to use price as a signal of quality.

b) Stress testing/scenario analysis to understand if quality is genuine. I'm reminded of a great Ben Graham quote: "The risk of paying too high a price for good-quality stocks - while a real one - is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions. The purchasers view the current good earnings as equivalent to "earning power" and assume that prosperity is synonymous with safety." I suspect there are many investors in the natural resources complex who have become painfully aware of the truth of Graham's words over the past 12-18 months.

c) Long ownership or familiarity with a company/industry. Most people value a long-term investment horizon because when done right, it is easier to implement and more profitable than a trading strategy. As Phil Fisher wrote, "Finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear." This long-term ownership, however, serves another important purpose. Over time, the analyst has the opportunity to observe the company through different economic conditions, and develops an understanding of its economic sensitivity.  Following a business for a long time reduces the risk that one will mistake cyclical earnings for true earnings power.

Finally, it's worth noting that one's willingness to take a risk should depend on the severity of a negative outcome. Socks with loose elastic are harmless, rotten fish less so. As Sanjay Bakshi points out in a wonderful speech, the eventual consequences of risk-seeking or risk-blind behaviour can be dire in many aspects of life. This is certainly true for one's long-term financial well-being. Sometimes, when something smells fishy, it's best to just walk away.

What Manchester United Can Learn from Yahoo

These are dark days for Manchester United fans. Darkness is relative, of course - the club remains an icon of sporting history, with a passionate fan base second to none. But, as the line from James goes, "if I hadn't seen such riches, I could live with being poor." The team's desperately abject performance in a loss to FC Midtjylland underscored the poverty fans have become accustomed to. For United fans, there is perhaps no greater fear than the looming possibility that a cycle of greatness has ended, and the club is on its way to become the new Liverpool - a mighty club rendered irrelevant, forced to watch as its great rivals chip away at its success. 

I spend a lot of my professional life trying to understand when sentiment has swung to extremes in financial markets, trying to be even-keeled when panic appears at odds with positive fundamentals. In an age when sports fans take to Twitter with vicious speed, demanding management and personnel changes at every little blip, my attempts to be sanguine are frequently challenged. While Man City's capture of Pep Guardiola is a knife to United's ambitions, I do think some are being too quick to anoint Guardiola's future City side as champions. But sometimes public opinion is spot on. I can't really explain why the Louis van Gaal era has shuddered to a halt so abruptly (to be honest, it never really gathered steam, despite the occasional flicker of promise). But it's safe to say the last few months have been truly hard to watch, both as a Manchester United fan, and a fan of the game. An excellent, if depressing, post by Paul Gunning perfectly captured my sentiments. And as the spectre of "Liverpoolisation" lurks ominously, I thought this week of another fallen giant of yore - Yahoo.

I'm not a tech analyst, so I haven't followed the demise of Yahoo in gruesome detail. All you need to know, however, is that the stock market currently ascribes negative value to Yahoo's core business. If that sounds crazy, here's a little piece by the New York Times explaining what that means. Basically, the stock market is saying that the only thing valuable about Yahoo is its stake in Chinese e-commerce behemoth Alibaba. Even if the market has gotten the valuation wrong, it's a damning indictment of Yahoo.

Where did Yahoo go wrong? Venture capitalist Paul Graham wrote a piece in 2010 taking a stab at the root causes. I highly recommend it - it's both short and fascinating. He identifies two major issues, easy money, and Yahoo's ambivalence about being a technology company.

First, the curse of easy money: "By 1998, Yahoo was the beneficiary of a de facto Ponzi scheme. Investors were excited about the Internet. One reason they were excited was Yahoo's revenue growth. So they invested in new Internet startups. The startups then used the money to buy [banner] ads on Yahoo to get traffic. Which caused yet more revenue growth for Yahoo, and further convinced investors the Internet was investing in." The story ends with Yahoo neglecting its search business because of its booming banner ad business. What it failed to realize was that the search business was far more sustainable, and that Google was eating its lunch there. 

This leads to Graham's second point, which was that Yahoo was ambivalent about being a technology company. Yahoo insisted on calling itself a media company, with negative consequences. "What Yahoo really needed to be was a technology company, and by trying to be something else, they ended up being something that was neither here nor there. That's why Yahoo as a company has never had a sharply defined identity...The worst consequence of trying to be a media company was that they didn't take programming seriously enough... In technology, once you have bad programmers, you're doomed."

Which brings us back to United. The club has increasingly positioned itself as a "global brand". Similar to Yahoo's loss of identity, Manchester United seems to have forgotten that it is first and foremost a football club. CEO Ed Woodward has proven himself adept at signing bumper commercial deals for the club. Yet the tail seems to be wagging the dog more and more. Recent reports suggest that Wayne Rooney could be on his way to China, assuming the club can "offset his potential departure with an eminent replacement their global partners would approve of to promote their products." Pause and let that sink in for a second. If that is true, it is diabolically misguided. The decision to replace a senior player should be driven entirely by footballing considerations. Yet Woodward's apparent obsession with "marquee players" seems to be spurred by commercial incentives, and possibly his desire to solidify his reputation as a deal-maker. A bit too much of the investment banker, then, about Woodward. 

Perhaps easy money has tainted United the way it tainted Yahoo. The circumstances are different, of course: this isn't the Internet bubble, and I'm sure Woodward works very hard to sign those commercial deals. But the focus on "global superstars" worthy of a "global brand" is unsustainable. Commercial partners appear to be salivating to capitalize on United's global cachet, but that won't last long if the club's leadership neglects the footballing core of the club. Furthermore, rather than hawking the brand at every turn, I believe it makes more sense to think of Manchester United as a luxury brand. The best luxury brands are obsessed with maintaining their aura, which is their greatest asset. Similarly, the fanatical support of a global fan base is a valuable asset that should be treated with the utmost care. I cringe when United players are forced to promote movies on their Twitter feeds. Don't get me wrong; I of all people understand there are commercial considerations. But Manchester United the commercial juggernaut is at serious risk of killing the golden goose that is Manchester United the football club that produced Charlton, Best and Law. 

Ultimately, there is only one group who can change the club's direction, and that is the Glazer family, who control its ownership. I've cautioned in the past about blaming the Glazers for all of United's ill fortune, while being critical of the club's ownership structure. But we've reached a crucial juncture for the club. While the Glazers may never understand the importance of the club to fans around the world, I can only hope they have an interest in protecting the long-term value of their investment. If they fail to grasp the seriousness of the situation, it may be a long time yet before United fans can reclaim the riches of the Alex Ferguson era.