Sunday, January 11, 2015

Three Bad Bets: Recency, Overconfidence and Volatility


One of the main differences between many brokers and a fiduciary investment manager is the focus on the time to reward. The broker gets rewarded for transactions. The ultimate rewards for the fiduciaries are the successful spending programs of the beneficiaries of their work. I am a professional member of the second tribe. Thus, I think about structure as well as selectivity as they evolve over time.

With the US and many other stock markets on balance going up more often than going down, one of my tasks is to avoid unforced declines. If the long-term secular pattern of rising stock market prices remains, my beneficiaries will receive payments for their reasonable spending plans. That is, if I as their discretionary manager avoid unforced mistakes. Three mistakes that I try to avoid are Recency, Overconfidence, and the misinterpretation of Volatility.

According to a study mentioned by Gene Epstein of Barron’s done by Professor Jeremy Siegel of Wharton and his former student at Wisdom Tree*, in the last 144 years there has never been a 15 year period when an investor who invested in the popular indices of the US stock market lost money supporting the argument in favor of the positive secular trend. Almost all of the accounts that I am responsible for have a current belief that they will need to meet their payment obligations for 15 years or longer.


Like many of our readers of last week’s post I was surprised to find that recency is an acceptable word in our language. The word was listed in a long list of biases that have hurt investors over time. Almost all discussions about the outlook for the future of the stock market devote a lot of time to the very current situation. In theory, that is what is known. (Actually all we know is the outline of what happened not what made it happen; more on this later in the discussion on volatility.)

Very little time is devoted to the terminal prices of a considered investment.  What does the current price of say $10 per share tell us as to the odds that we will terminate our position at $5, $15, $ 50 or $100? Most brokers shy away from guessing future prices over an extended period of time, while investment managers need to ponder.

The question as to future valuations is exactly why I have developed the concept of the Timespan L Portfolios. I am aware that tomorrow the market could start to decline. Based on history beyond the Wharton study I am prepared for a periodic correction of at least 10% even though we have not had a five day consecutive period of decline since 2009 and no 10% decline since, I believe, 2011. I believe that it is reasonable to expect a 20% + decline at least once every 10 years and roughly a 50% drop once a generation.

In the Time Span Portfolios construct, the shortest duration portfolio to fund operational needs should have an excess over planned spending of 10-20%, depending on when the last decline occurred. Whenever the Operational Portfolio has completed its funding mission (which may be in two years), just as a good US Marine Corps general does after he commits his front line troops, he immediately reconstitutes a reserve element to replace the tired-out or expended troops. Thus, I have created the Replenishment Portfolio which will provide the next series of funding needs. Because the Replenishment Portfolio has a longer duration of possibly five years, it is reasonable that it may have to deal with a stock market decline of 50%.

Having the first two portfolios in place, the third or Endowment Portfolio would have a duration of 15 years or possibly a little more and should be able to tolerate an all equity-like risk. The general expectation for this portfolio should parallel the return on equity that the major market indices generate from their components.

Recognizing few if any of today’s leading stocks are likely to be the better performing stocks well into the next generation, a portion of the final or Legacy Portfolio should be crammed with potential disrupters of the present structure of our economy. Smart technology creators and probably more importantly, smart technology users, will be predominate in this all equity portfolio.

Each of the four Timespan Portfolios can be managed aggressively or conservatively as long as it stays focus on its designated timespan.


Overconfidence is a risk that can grow exponentially the longer the period when doubt is appropriate. Or, as Berkshire-Hathaway* CEO Warren Buffett said, until everyone else recognizes the nakedness of those skinny dipping or in the next parade of dignitaries when the king is marching naked.

My Grandfather who spent his working life running a successful carriage trade brokerage firm used to warn his grandchildren to stop being so certain. This was a difficult message for me and I believe the others to digest. After all, we had just learned a particular “fact” or relationship. Therefore, we were certain about something and our Grandfather just was not hip enough to get it. Only with age did I get to understand and appreciate his wisdom. When I see or hear the various media pundits or others selling their wares with 100% positive statements my risk avoidance mechanisms kick into my judgment apparatus.

Where are we today? Liz Ann Sonders of Charles Schwab* quotes the late, great, an old friend and consulting and data client, Sir John Templeton saying that “bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” She thinks we are now in the third phase. Other sentiment indicators are in agreement with positive ratings of 50-70%. She is probably right, but my Grandfather’s caution comes to mind when I see the only Dow Jones stock price index that is up for this short year is the utility index. This is a continuation of the superior performance achieved in 2014. The only nagging problem is that utilities at least three times before enjoyed good performance on the basis of expanding price/earnings ratios which preceded a general market decline. I remember that from a portfolio construction standpoint utility stocks were generally used as bond substitutes.  Long-term treasuries were the best single large asset class in 2014 and so it is understandable about utilities performance. While I hope Liz Ann is correct, I am not retreating from my belief that if enthusiasm boils up we can see both a 20% gain and 20% loss from current levels based on past history.
*Held by me personally or by the private finance services fund I manage


Volatility, either as the price of the VIX or standard deviation, is not a measure of the potential loss of capital. They are useful descriptors of price movement. The fundamental problem is that they don’t explain price movements. In a prior post I warned about the tyranny of the single last trade of the year.  I find it somewhat ironic that traders from at least two major banks have had their bonus expectations cut by about 10% due to the market performance in the last two weeks of 2014. The reason this is ironic is that most traders believe they can make money out of volatile prices. That is if their bosses permit them to trade the market. A substantial portion of many trading desk’s profits do not come from executed trades but “marks to market” of the securities in their inventory. A number of financial institutions want to be early in their public reporting cycle; thus they are, in effect, restrained from trading at the end of the calendar year. Keen market observers noted that in the last half hour of the last day there was still some insistent sellers, probably for tax or statement purposes and little in the way of buyers, so in a 30 minute period market prices declined enough to make December a slightly losing month as compared to a probable winning month.

The reason for dwelling on the short-term price movement is that too many investors will interpret the fall in December and now the newly crowned peak of the market at the close of December 18th  as having lasting meaning rather than understanding it as an imbalance of buyers and sellers in the last half hour

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