Relationships as Emotional & Intellectual Diversification

In a recent post, I discussed some strategies for dealing with volatility in financial markets. I was reading a blog post by Robin Rifkin this week, and realized that I’d focused exclusively on what one could do at the individual level. Reading Rifkin, it became clear that a strategy I’d missed was to surround oneself with people who were able to be calm in the face of market vicissitudes. Finding a community of thoughtful investors should certainly be a priority – and this includes both the living and the “eminent dead”, as Charlie Munger calls them.

I almost wrote about finding a community of “like-minded investors”, though, and that struck me as a dangerous turn of phrase. I’ve written before about the risks of dogmatism and herding. In some ways, portfolio theory offers a useful analogy. A portfolio is improved by including assets that are uncorrelated. Similarly, one’s emotional and intellectual life is improved by diversity (within reason, of course. In a portfolio, you don’t want lack of correlation for its own sake – naturally, you want assets with positive future returns. In life, people who offer emotional and intellectual diversity may have other flaws that make it less worthwhile to associate with them. And of course the analogy has its limits. In portfolio theory, the Holy Grail is finding negatively correlated assets. If I had a friend who was delirious happy when I was very sad, I’d find that either rude or downright bizarre!)

So, to summarize: Rifkin is 100% correct that the right commentators and investors can provide a steadying hand during uncertain times, and he seems to have assembled a diverse group to lean on. The latter point is essential, and perhaps under-appreciated, in a world where we need relationships for emotional and intellectual diversification.

You Are Not Your Investments

Have you ever noticed that parents, especially those with small children, can be incredibly touchy? Reprimand their kids, and they quickly get huffy because they think you're criticizing their parenting indirectly. 

People are the same about investments. Bring up an investment that's gone badly, and 9 out of 10 investors quickly get very defensive. Same story - criticize the investment, and you're basically criticizing them. 

It's a natural reaction. In an old post, I called it a symbolic interactionist approach to investments. Humans act toward things on the basis of the meanings they ascribe to those things. The meaning of such things is derived from the social interaction that one has with others and society. Our investment decisions are tied up with our self-worth as investors, and our wealth is joined at the hip to our perception of social status.

But it's the wrong reaction. Jerry Goodman, aka Adam Smith, wrote about this in The Money Game. "A stock is, for all practical purposes, a piece of paper that sits in a bank vault. Most likely you will never see it. It may or may not have an Intrinsic Value; what it is worth on any given day depends on the confluence of buyers and sellers that day. The most important thing to realize is simplistic: The stock doesn't know you own it. All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of these things are unreciprocated by the stock or the group of stocks. You can be in love if you want to, but that piece of paper doesn't love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate." 

You are not your investments. Thinking otherwise puts us at risk of committing a mortal sin of investing, if we allow defensiveness to cloud our scrutiny of a prior decision. 

And by the way, the same logic should apply when your investments are doing great. Congratulations on the victory - but you're still not your investments. 

Mortal and Venial Sins in Investing

Financial markets have been roiled in 2016 on fears that China's economy continues to slow, and that the Fed will pursue a more hawkish tightening path than anticipated (the two are related, indirectly by the Fed's status as a monetary superpower, and directly by the RMB's link to the dollar). It has once again been a time to reflect on the challenges a fundamental investor faces. Macroeconomic concerns are hard to weigh when you're considering places like the US, and considerably more so when you're trying to assess an opaque economy in transition like China. So should an investor simply throw his hands up in the air?

I see a few potential strategies.

1. Learn all you can about macro. In his outstanding paper "Investing in the Unknown and Unknowable", Richard Zeckhauser notes the outsize returns to investors who can marshal complementary skills. Being a sophisticated macro observer has always seemed to me one such complementary skill. Some of the greatest trades of all time incorporate macro elements, whether intended or not. But I suggest with this a fair amount of trepidation. First, much of macro is unpredictable, and the product of a complex adaptive system, so it seems like a poor use of time trying to analyze it. Second, even where macro knowledge is helpful, there is a trade-off of time spent on macro analysis vs. asset-level analysis (such as knowing more about a company whose stock you own). Third, an excessive focus on macro fluctuations can lead to distraction from long-term trends, and prevent fundamental investors from appreciating the positive outlook for assets. So, perhaps the best idea is to focus on understanding the long-term drivers of economic growth, and to avoid being swept up by emotion during cyclical booms and busts. 

2. Invest in assets that are relatively insensitive to economic fluctuations. There are two variants of this strategy. The first is to invest in assets whose prices are relatively stable. This will likely lead an investor into low return strategies like investing in government bonds. For obvious reasons, I don't recommend this, even if it will help you sleep better at night! The second variant is to look for assets whose prospects are relatively bounded in a variety of economic scenarios (note there is often a great deal of overlap between these two variants: it is precisely their occasional divergence that is worth exploiting). The traditional version of this is to invest in various types of utilities. But there are obviously many high quality businesses out there who are resilient to most economic downturns, through a combination of competitive positioning and financial strength. These businesses generally trade at premium valuations (i.e. with low implied returns) for that reason, so when they go on sale, it's best to be prepared to act swiftly.

3. Be realistic. Understand that there will be ups and downs in any portfolio. Just as important, one has to differentiate between forgivable and unforgivable mistakes. Or, to draw a parallel to Roman Catholicism, we should differentiate between venial and mortal sins in investing. Charlie Munger has a great quote: "I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." But there's a limit to how harsh we should be with ourselves. I'm constantly wary of being a pattern-seeking, story-telling animal. It's okay not to know whether Chinese growth will be 3% or 6%. It is much less okay to lose money on a company that is modestly cheap if Chinese growth is 6% and in dire straits if growth is 3%. 

If I had to highlight one unforgivable sin in investing, it is getting swept up by emotion at market tops or bottoms (only identifiable in retrospect, unfortunately). But what's worse is that we have a tendency to compound these errors. It is really, really not okay to lose sight of the long-term prospects of a wonderful business, sell one's stake in that business, and compound that error by refusing to buy at a higher price. So, if you make a mistake, so be it - wipe the slate clean, lest a venial sin turn into a mortal one.

I wish all readers a happy, productive and - just maybe - sin-free 2016.

P.S. John Huber has an excellent post touching on some similar themes. 

Books I Enjoyed In 2015

The end of the year is rapidly approaching, and it looks unlikely I'm going to add to this list in the next few days. I modified this list somewhat from last year's in that I decided to include titles that I wasn't reading for the first time. I define "2015 Favourites" as books I can see myself re-reading, while "Honourable Mention" names are things I enjoyed but am unlikely to tackle again. Happy reading, and a very happy end to 2015 to one and all!

2015 Favourites

The Incredible Shrinking Alpha (Swedroe & Berkin): A quick and readable survey of the challenges facing active asset management. Anyone engaged in active management simply must grapple with these issues, as a matter of intellectual and professional honesty as well as to consider the business challenge posed by passive management strategies (be they indexers or rules-based quantitative strategies). Swedroe is a good follow on Twitter too.

The Greatest Trade Ever (Zuckerman): I have a longer post on this one, but it's just a terrific read to understand John Paulson's stupendous success in profiting from the housing debacle of 2007-2009. As I say in the other post, it's hard to write a page-turner about credit derivatives, but Zuckerman does an amazing job.

Efficiently Inefficient (Pedersen): This is a clear and entertaining read on hedge fund strategies. It features interviews with some of the leading lights in the hedge fund world, though I must confess I was a little disappointed with some of the interviews. The main material is excellent, though.

Becoming Human (Vanier): I first heard of Jean Vanier through an "On Being" interview. A philosopher and Catholic social innovator, he started the L'Arche movement for people with intellectual disabilities. His simplicity and compassion were deeply moving.

The Dhandho Investor (Pabrai): I have long heard of Pabrai's book, and finally got round to it this year. I wish I'd read it earlier. It's funny and readable, but a deeply wise book on value investing. His mantra of "Heads I win, tails I don't lose much!" is as good an explanation of how to think about achieving asymmetry in investing as you'll hear anywhere.

The Art of Charlie Chan Hock Chye (Liew): In a year when my beloved Singapore celebrated her 50th anniversary as an independent nation, this sharp graphic novel traces the country's history in parallel with a fictional graphic artist.

The Looming Tower (Wright): Everyone wanted to talk about ISIS this year, but I was a few steps behind. I bought this thinking it was an account of the 9/11 attacks, but it was much, much more. A wonderfully crisp read on the rise of modern Islamic fundamentalism and al-Qaeda.

The Outsiders (Thorndike): An excellent book on how contrarian CEOs created shareholder value, recommended by no less a luminary than Warren Buffett. It's a shame that most CEOs (and boards) think "capital allocation" = doing share buybacks when their stock is at record highs, rather than when it's the most accretive to shareholders.

Buddhism Without Beliefs (Batchelor): Batchelor is one of the giants of secular Buddhism, the movement that distills the wisdom of Buddhist thought while shedding traditional Buddhist ritual and beliefs on cosmology and reincarnation. In this volume, he makes a strong case for understanding the historical and social context in which Buddhism developed. As good as I remembered the second time round.

A Guide to the Good Life (Irvine): This is a wonderful introduction to Stoic philosophy, updating an obscure and misunderstood set of beliefs for modern times. The parallels between Stoicism and Buddhism are interesting, and goes to show you can find wisdom in disparate places if you look hard enough.

Superforecasting (Tetlock): Quite simply a must-read on decision-making and prediction. I think this is one I will read and refer to many, many more times.

The Alliance/ The Start-up of You (Hoffman/Casnocha): I enjoyed these two books by the LinkedIn founders. At times they seem a little too much like ads for LinkedIn, but I think there's a lot of wisdom in here about how to think about careers and organizations in the modern world.

The Essays of Warren Buffett: Buffett is so well-covered that it was hard to imagine that there would be much original in this collection, but I still found it useful and insightful. I did a longer post on the key messages.


Honourable Mention

Exorbitant Privilege (Eichengreen): It's really hard to write a book on the international monetary system for popular consumption. I think Eichengreen does a pretty good job here, although some may prefer a deeper look at specific events (e.g. Ahamed's Lords of Finance and Connolly's Rotten Heart of Europe). Reading it in 2015, it's funny how the book was written at a period of extreme concern about the dollar - something which seems to have vanished from the mainstream. But who knows what people will say in 5-10 years?

Poor Economics (Duflo & Banerjee): I've been hearing about Duflo & Banerjee's work for years, and enjoyed their take on the global fight against poverty. So much of what we think we know about poverty, and the poor, seems to be wrong, but it's gratifying to see people tackling the field in novel ways.

The Hard Thing About Hard Things: Entrepeneur and venture capitalist Ben Horowitz writes about his experiences in the business world. There are some great anecdotes and lessons here. Definitely one for those interested in start-up world.

Leaving Alexandria (Holloway): I've had this on my reading list for ages. In 2003 or so, I discovered a book called "Godless Morality", and was stunned to discover the author was the Bishop of Edinburgh. Since then I have been an avid consumer of Holloway's talks. This autobiography details his eventual departure from the church. While my thinking on religion is more in line with Holloway than Vanier, I preferred the simplicity of the latter's prose. Still, there was much to appreciate here.

The Novice (Schettini): Continuing the theme of those who had given up the robes, Schettini recounts his life as a Buddhist monk. Like Holloway's book, there was much to enjoy, even if the prose wasn't always quite to my taste. The epilogue was my favorite part of this, with Schettini describing the changes in his life after giving up the robes. A shame it's a relatively small part of the book, but it would be impossible to really understand without hearing first about his prior journey.

Benjamin Graham and the Power of Growth Stocks (Martin): This is an unusual take on Ben Graham as a growth investor. Martin argues that the 1962 edition of Security Analysis reveals Graham's shift in investment philosophy.

Damn Right! (Lowe): I hadn't read this since 2006, but decided to pick it up again as I re-explored the value investing classics. I found I enjoyed it less than I remembered. It's possible that Munger has become such a popular subject in the past 9 years that this edition no longer seems quite as original. Still, always worth a read for Buffett/Munger fans. And for those relatively new to the world of investments, it's a wonderful reminder that Munger didn't meet (and go into business with) Buffett till he was 36 years old, which seems positively ancient in the modern age of 30 year-old hedge fund wunderkinds.

The Education of a Value Investor (Spier): Part autobiography, part investment guidebook, part discourse on the good life. Spier's honesty was refreshing. This led me to Pabrai's book. The friendship between the two investors inspired a longer post as well.

Pattern-Seeking, Story-Telling Animals

One of my favourite quotes about macroeconomics comes from Ed Leamer, who wrote, "We are pattern-seeking story-telling animals." The brilliance of this quote (which he originally heard from a radio commentator) is that it applies to many other aspects of human thought, such as physical and social science, as well as religion. I've been thinking this week about the ways in which we seek patterns and tell stories, both in trying to understand past events and trying to predict future ones. The original impetus was a captivating talk by Bruce Riedel on JFK and the Sino-Indian crisis of 1962. One of the most remarkable things about this crisis is how many unanswered questions remain, despite it involving some of the world's largest and most scrutinized countries, and the passage of more than 50 years. Many questions will never be answered. These are the hypothetical "what if?" questions that are amusing fodder for speculation but will never be answered definitively.

I was reminded of a wonderful passage from Ed Catmull's "Creativity, Inc." (a book I wrote more about last year). Catmull writes:

"In thinking about...the limits of our perception, a familiar, oft-repeated phrase kept popping into my head: "Hindsight is 20-20." When we hear it, we normally just nod in agreement - yes, of course - accepting that we can look back on what happened, see it with total clarity, learn from it and draw the right conclusions.

The problem is, the phrase is dead wrong. Hindsight is not 20-20. Not even close. Our view of the past, in fact, is hardly clearer than our view of the future. While we know more about a past event than a future one, our understanding of the factors that shaped it is severely limited. Not only that, because we think we see what happened clearly - hindsight being 20-20 and all - we often aren't open to knowing more. "We should be careful to get out of an experience only the wisdom that is in it - and stop there," as Mark Twain once said, "lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again - and that is well; but also she will never sit down on a cold one anymore." The cat's hindsight, in other words, distorts her view. The past should be our teacher, not our master."

The Catmull quote identifies 2 distinct issues related to hindsight:

1) Looking back and thinking something was obvious, when it wasn't
2) Looking back and drawing the wrong lesson, i.e. that the future will resemble the past.

It's easy to look back at a 10-year chart of the S&P and think to oneself how easy it should have been to have picked the bottom on Mar 6 2009. Indeed, I have lauded the courage of investors who were steadfastly buying cheap securities in the face of financial panic. But only some of these people are worthy of praise. I think of these as mainly being (a) those who made well-reasoned estimates of valuation, (b) those who understood the likely mechanisms of QE and Fed policy, and (c) those who, for other, thoughtful reasons decided that the odds of investing were in their favour. The common thread is that these groups relied on facts as the inputs to weigh the odds of investing. This is intelligent speculation rather than hopeful gambling.

The fact of the matter is that it was far from clear that the economic and financial panic were over. Most investors faced genuine uncertainty as to the efficacy of Federal Reserve policies, and the implications for financial assets. One of many communication problems we have in finance is the double meaning of the word "cheap". Some mean it to mean "low-priced". Many mean it to denote "lower than fair value". I prefer the latter definition, and by that definition, assets are cheapest not when their prices are the lowest, but when their prices deviate most significantly from an informed view of their true value. Apart from the groups listed above, there are others who may have bought in the depths of 2009, but were merely lucky (or perhaps foolhardy). For some, the lesson was to buy the dip, and in particular the most leveraged, economically sensitive assets. I hardly recommend that lesson. For others, hindsight has taken the form of stricter drawdown control measures, and a heightened jumpiness when faced with any market turbulence. These nervous investors seem sure to forego the benefits of long-term compounding as they sell winners prematurely.

It seems to be that the follies of hindsight and extrapolation are closely related. John Templeton reportedly said that the four most dangerous words in investing are "This time it's different." This is usually taken to mean that only the foolish ignore the fact that asset prices are cyclical, and mean-reverting. To me, this is second-order thinking and assumes the deluded investor has enough knowledge of history to believe that this time will be different. I actually think most people respond in a far simpler fashion. The more dangerous words for them are "this will go on". Most people are probably not as greedy as we may them out to be after the bust. Rather, they make the perfectly understandable error that the future will look similar to the recent past. Nominal GDP will grow at rates similar to the past. Interest rates will look similar to the past. Corporate profits and economic moats will look like they did in the past. Markets will look like they did in the past (up, down or flat depending what they looked like most recently). Megan McArdle had it spot on when she wrote: "Bubbles are not fundamentally about evil people doing evil things. They are not even about stupid people doing stupid things. No, the problem with bubbles is worse: It's quite ordinary people, doing stupid things that a trick of the light has made appear very smart."

I don't have any bold prescriptions for these problems. Acting in an unknown and unknowable environment is the central problem of investing. I defer here to the thinking of Richard Zeckhauser, who says some very interesting things in "Investing in the Unknown and Unknowable" (some of which the most conservative value investors will disagree with). Nassim Taleb is clearly another deep thinker on these issues. My modest additions include the recommendation to document our beliefs in real time, and judge ourselves honestly on how events match up to our predictions. Another of my favourite quotes is physicist Richard Feynman:"The first principle is that you must not fool yourself - and you are the easiest person to fool." It's also an argument for focusing on process, rather than individual outcomes. But again, caution is warranted: the process should be well thought through, and not merely "Sell when the market is down X%" (the investor's version of "Don't sit on stove-lids"). This focus on process makes us simultaneously harsher on ourselves, when we've been lucky rather than good, and more forgiving, when we made the best possible (but ultimately wrong) decision with the information available. If we can avoid getting knocked out of the game on any one bet, a robust process should deliver returns over time.

But don't take it from me. I'm just another pattern-seeking, story-telling animal.

The Third Emotion of Investing

It's often said that financial markets are driven by two competing emotions, greed and fear. Skilled investors attempt to control these emotions, and to capitalize on the failure of other investors in that regard. Warren Buffett has repeatedly said that while he focuses on fundamental value, his behaviour is dictated by a simple dictum: "Be fearful when others are greedy, and be greedy when others are fearful."

There's a third emotion that requires constant management: boredom. 

It's exciting when assets go up or down by a lot. Generally, they don't. It's boring to watch things that don't do much in a hurry. And it's boring to wait for the market to validate your assessment of fundamental value. 

It's boring to sift through financial statements or filings and then discover a company is fairly valued. It's boring to wait for a better opportunity to purchase an asset. It's boring to own a company that has excellent prospects but that no-one has ever heard of (or is likely to ever hear of). It's boring to remain invested in a company that is quietly compounding its value (and whose business you understand well), when new opportunities appear more alluring. It's boring to invest the same way you always have, when the world around is full of "sophisticated" investors raising a lot of money for complex strategies. 

Sitting through long periods of boredom is a prerequisite for the fundamental investor. Dealing with this boredom is every bit as important as avoiding being swept away when valuations are high, or being decisive when it seems like businesses, economies or financial markets will never improve. 

Pascal said, "All men's miseries derive from not being able to sit in a quiet room alone." I doubt he had investment portfolios in mind, but subduing the third emotion of investing goes a long way to preventing misery of the financial variety.

Sometimes An Investor Wears A Mask So Long...

The debate over "nature vs. nurture" pervades biological science and the social sciences. Unsurprisingly, the debate even wends its way into the world of investing. Are great investors born, or can they be moulded? In a previous post, I took issue with Warren Buffett's search for "someone genetically programmed to recognize and avoid serious risks" (emphasis mine). But Buffett himself has always been a proponent of how investors - and people, more generally - can change themselves through the force of habit. In a speech to business school students, he said "You can't change the way you were wired much, but you can change a lot of what you do with that wiring. It's the habits you generate that matter." I watched that speech on YouTube maybe seven years ago, and was deeply struck by this multi-billionaire preaching the virtue of habits and character, rather than cutthroat competition or iridescent intellect, as the way to success.

I consider myself pretty firmly in the habit-forming camp. Many of you have probably seen hackneyed secret agent/undercover cop movies, and heard some version of the cliche "Sometimes a person wears a mask so long, he doesn't know which one is his real face." That's usually meant to convey the costs of duplicity, but the flipside of that seems true to me as well: act in the appropriate way (despite your instincts to do otherwise), and eventually that will become second nature. Easier said than done, perhaps, but it still seems true. As with investing and corporate strategy, a long horizon helps. For example, business strategy researcher Robert M. Grant recommends taking an inventory of a firm's resources and capabilities as a start to formulating corporate strategy. Then, he suggests (a) exploiting key strengths, (b) managing key weaknesses, and (c) capitalizing on "superfluous strengths" (more on this below). He notes, "Converting weakness into strength is likely to be a long-term task for most companies. In the short to medium term, a company is likely to be stuck with the resources and capabilities that it inherits from the previous period." The same is true for individuals.

That said, I don't think that it's a simple matter of identifying one's bad habits, targeting good habits, and then replacing the bad with the good. Rather, it is a constant and dynamic process of change and growth. My thinking on this has been influenced by a variety of sources:

- Neuroplasticity, i.e. the notion that the brain is constantly changing and rewiring itself
- Growth mindset, i.e. Carol Dweck's work on how attitude shapes success.
- Non-self (or anatta), i.e. a tenet of Buddhist thought, which, in the words of Stephen Batchelor, focuses on "an authentic vision of the changing, contingent, and creative character of ourselves and the world"

Given these prior beliefs, I see these precepts in action everywhere. Over the past 2 weeks alone, I came across examples which supported my notion (possibly confirmation bias, I'll admit!):
- Kaizen, i.e. the Japanese philosophy of continuous improvement
- Life as improvisational art, in the words of writer Mary Catherine Bateson
- "Superforecasters" - as written about by Philip Tetlock and Dan Gardner, and summarized by Michael Maubossin - who see themselves as being in perpetual beta mode, constantly updating their knowledge and revising their beliefs. (Side note: If I were ever to get a tattoo, a pretty strong contender would have to be, "Beliefs are hypotheses to be tested, not treasures to be protected.")
- Sufi poet Rumi: "Yesterday I was clever, so I wanted to change the world. Today I am wise, so I am changing myself."

I don't want to give the impression that I discount "nature" completely. In a prior post, I referred to investor Guy Spier. Spier has gone so far as to place a bronze bust of Charlier Munger in his office, while simultaneously acknowledging that he will never be Munger or Buffett, and can only be the best version of himself. I, similarly, have spent a great deal of time thinking about how best to achieve high risk-adjusted returns in a manner that is both in line with my personal temperament and actually fun.

And yet even these inherent characteristics can be harnessed creatively. Again, there are parallels with corporate strategy. As mentioned earlier, Grant suggests (a) exploiting key strengths, (b) managing key weaknesses, and (c) capitalizing on "superfluous strengths". As an example of (b), he cites Harley-Davidson, who is unable to compete with Honda and Yamaha on technology, and has instead chosen to make a virtue out of its outmoded technology and traditional designs as a key part of the Harley-Davidson experience. Item (c) refers to developing innovative strategies that turn apparently inconsequential strengths into key strategy differentiators. As an example of this, he cites the brokerage firm Edward Jones, whose network of brick-and-mortar offices appeared outdated in the Internet era. However, "by emphasizing personal service, trustworthiness, and its traditional, conservative investment virtues, Edward Jones has built a successful contrarian strategy based on its network of local offices."

So if I had to summarize this rambling collection of thoughts, it would be as follows: We have some inherent endowment of qualities, but we can use them creatively, and can in fact change those qualities far beyond what we thought was possible over a long enough period of time, given sufficient determination. Or perhaps more succinctly, sometimes an investor wears a mask so long, he doesn't know which one is his real face. And that can be a good thing.