Mistakes of Boredom

Flying back to Los Angeles after Christmas, somewhere over New Mexico, I rediscovered an article written by Ted Lucas of Lattice Strategies in 2011, quoting mathematician and logician Blaise Pascal’s Pensées on the psychological propensity of humans to seek out diversion and action, and the boredom caused by inaction:

“Sometimes, when I set to thinking about the various activities of men, the dangers and troubles which they face in court, or in war, giving rise to so many quarrels and passions…I have often said that the sole cause of man’s unhappiness is that he does not know how to stay quietly in his room…

Imagine any situation you like, add up all the blessings with which you could be endowed, to be king is still the finest thing in the world; yet if you imagine one with all the advantages to his rank, but no means of diversion, left to ponder and reflect on what he is, this limp felicity will not keep him going…with the result that if he is deprived of so-called diversion he is unhappy, indeed more unhappy than the humblest of subjects who can enjoy sport and diversion.

The only good thing for men therefore is to be diverted from thinking of what they are, either by some occupation which takes their mind off it, or by some novel and agreeable passion which keeps them busy . . . in short it is called diversion.”

If true, as asset prices move ever higher, this psychological tendency has immense implications on investment decisions. Avoiding overvalued assets/securities and holding cash may be easier said than done, for psychological reasons beyond whether or not your mandate/investors allow you to hold cash.

Perhaps it’s time to convince your boss that a paid vacation / sabbatical to pursue distractions (other than investing) during expensive market environments may actually help improve performance returns by avoiding mistakes born of boredom.

There’s Something About Humility

Readers know that I’m a fan of Ted Lucas of Lattice Strategies. He recently wrote a piece (Applied Risk Strategy 1-21-13 - Humble Confidence and Creativity) discussing the impact of overconfidence on performance, as well as why a good risk management process should involve anticipating how assets behave in certain environments (in other words, predicting future volatility) – a task that requires both creativity and humility (awareness of what you don’t know). Psychology

“Indicators of overconfidence (said differently, lack of humility):

• Self-serving attribution bias – people attributing success to their own dispositions and skills, while attributing failure to external forces or bad luck
• Self-centric bias – individuals overestimating their contribution when taking part in an endeavor involving other participants
• Prediction overconfidence – the overestimation of the accuracy of one’s predictions
• Illusion of control – belief that one has more influence than is the case over the outcome of a random or partially random event.”

Interestingly, in the study referenced, the results showed that neither overconfidence nor over-trepidation were conducive to superior performance in the future. Perhaps we are at our decision making best when striking a fair balance between "gumption" (as Charlie Munger calls it) and healthy skepticism.

Risk, Volatility, Creativity, Psychology

“We need to look no further than the financial crisis five years ago to conclude that statistical artifacts like an asset’s historical beta or volatility – which are, respectively, the orthodox risk measures employed in Modern Portfolio Theory and its handmaiden tool, mean-variance optimization – fail to capture many far more critical elements of risk… A comprehensive philosophy of risk also seeks to understand the conditional dynamics of risk as the backdrop evolves – how do assets respond during varying risk regimes (particularly the most turbulent periods), and across changing macroeconomic contexts?”

“Effective risk allocation – the primary driver of long-term portfolio returns – is at heart a design problem…The most productive efforts here are likely to be those benefiting from the constraint of personal and predictive humility and the cultivation of humility’s companion, expanded creativity.”

For risk management, Lucas advocates that investors pay attention to how “assets respond during varying risk regimes” – something I interpret as anticipating future volatility. Not an easy task and one best approached with healthy doses of both creativity, and humility (awareness of what you don’t know).

The Math of Compounding

Here is an interesting piece from Ted Lucas of Lattice Strategies (2010 Q4 The Oracle of...Risk Management) on the complementary relationship between compounding and capital preservation, plus a few other insightful topics of discussion. Compounding, Capital Preservation

“Losses are linear, but the appreciation required to recover from losses scales exponentially as they deepen.

Thought experiment: Imagine a portfolio that was down 20% during the 2008 implosion, versus a portfolio that was down 40%. In the 2009 rebound, assume the first portfolio recovered by 25%, while the second rebounded by 40%. At the end of the two periods, the first portfolio would be back to its starting point, while the second – after knocking the lights out in 2009 – would still be down 16%, requiring another 19% gain to get back to even (i.e., a 40% gain on 60 cents on the dollar yields 84 cents; to get 84 cents back to a full dollar requires a 19% gain).

The key takeaway? Avoiding big drawdowns – and thereby limiting the destructive force of negative compounding and unleashing the power of positive compounding – is the critical driver of long-term returns.”

Simple concept, yet often ignored by investors. This is something that those with trading backgrounds do better than traditional value investors. For additional mindblowingly good commentary on this topic, be sure to read Stanley Druckenmiller’s (protégé of George Soros) thoughts on capital preservation and compounding.

Volatility

Using Warren Buffett andBerkshire’s historical price performance, Lucas also discusses volatility, and the concepts of upside and downside capture. (I should highlight that the concept of volatility or beta only makes sense when there is an underlying benchmark or index for comparison.)

As you well know, the world has been taught to avoid “volatility.” What terrible advice! One should only avoid downside volatility, and wholeheartedly embrace upside volatility. After all, the holy grail of all portfolios would provide super efficient upside capture and little or no downside capture.

Benchmark

Additionally, Lucas warns about the dangers of certain industry benchmarking practices which are not conducive to maximum return compounding because fan portfolio managers’ need to keep inline with the benchmark (or a particular index), and therefore exacerbate the likelihood of loss.

“It is the ‘shape’ of returns through a market cycle that is of infinitely greater importance than relative benchmark outperformance over a short time window. How does this factor into building resilient, long-term investment strategies? When constructing portfolios, investors would be well served by a willingness to trade off some upside during positive markets in order to disproportionately mitigate the downside experienced during negative periods. While this may not sound like a blinding insight, it is hard to reconcile this idea with an industry where strategies are promoted – and often chosen – based on relative benchmark outperformance over short time windows, typically when conditions are conducive to a particular strategy.”

More from Ted Lucas

In this piece, Ted Lucas of Lattice Strategies discusses the relationship between correlation and diversification, as well as the intricate task of building investment portfolios that remain resilient during market drawdowns, yet retain upside participation during bull markets. To explore some of his other writings, they are all archived on Lattice Strategies’ website.Risk, Capital Preservation, Compounding

“But ‘risk management’ on its own is an abstraction, as is ‘beating the market’ over a short time period, if the end goal is to generate a real capital growth over a longer time window…For an asset manager seeking to generate long-term real growth of capital, the design problem is creating a portfolio structure that can both withstand periods of market turbulence and capture returns when they are available.”

Lucas highlights a very real dilemma for all investors: the tricky task of reconciling the goals of capital growth (compounding) with capital preservation. The frequently mentioned “abstraction” of “risk management” is merely a tool available to each investor to be incorporated, if and when necessary, to assist with this task.

Correlation, Diversification

Prior to the financial crisis in 2008, people believed that correlations between asset classes had “decoupled” given new breakthroughs on how risk was redistributed in the financial and economic markets, etc. Investors paid dearly for this assumption when many asset classes (equity, high yield, real estate, commodities, etc.) originally believed to be uncorrelated, all plummeted in value at the same time.

With investors still licking 2008 wounds, the opposite is now occurring. As Lucas writes, “There is much recent discussion about asset correlations rising to such elevated levels that diversification has been rendered useless.”

Correlation of assets/securities has a meaningful impact on the effects of diversification. Afterall, as Jim Leitner astutely points out, “diversification only works when you have assets which are valued differently…” Therefore, if all the assets/securities in your portfolio are highly correlated, diversification would be rendered useless regardless of how many positions you hold.

Lucas believes that investor fear of high asset correlations are overdone. I don’t have enough evidence to either agree or disagree with this view. However, the investing masses have a tendency to project the near-term past into the long-term future, and today’s assumptions about elevated levels of asset correlation could very well be overdone.

Regardless of whether you believe today’s asset correlations are high or low, the takeaway is that your view on future asset/security correlations will (or at least it should) influence your portfolio allocation decisions, because it directly impacts diversification and the volatility profile of your return stream.

Definition of Investing

“Here is a basic idea: the purpose of investing is to grow whatever capital is invested in real terms.”

Look Forward, Not Back

Ted Lucas of Lattice Strategies produces many worthwhile reads (conveniently, they’re all archived on Lattice’s website). The man is so well-read I wonder when he finds time to sleep. In this article, he references Antti Ilmanen’s new book Expected Returns, producing a wonderfully succinct piece highlighting the dangers of “conventional price history-based risk measures,” such as risk models that use historical volatility and historical correlation.

The chaos of 2008 was a fantastic example of the aftermath when investors are lulled into a sense of false comfort by relatively tame levels of historical volatility and low correlation from 2003-2007.

As Lucas eloquently writes:

“If you want to manage portfolio risk one must focus efforts on understanding the implied future expected returns built into how an asset is being valued at any point in time and avoid being lulled into complacency that might be suggested by standard risk models focusing solely on the asset’s recent price history.” 

For additional thoughts on forward-looking expected returns investing, be sure to check out a previous article on Jim Leitner.