Sunday, April 19, 2015

The Risk of Being Right and Other Lessons


I am dedicated to the mission of learning something every single day. Often I get a small insight into some relationship of minor long-term significance, but I never know its value either in the present or possibly in the future.

Was April 17, 2015 important?

One of my many advantages is that I am part of a loosely connected group of formerly senior securities analysts, portfolio managers, chief investment officers, institutional sales people and technical market analysts. We physically meet most months and we are in electronic communications daily. Last Friday, starting with the Chinese markets, global markets fell sharply. For a number of US portfolios the decline in one day wiped out the entire gain earned on a calendar year to date basis. I asked this group of former investment professionals if this drop was important or just a momentary blip. I broke the question into five parts which may or may not be related as follows:

1.  As we already knew many Chinese like to speculate, particularly with the new margin borrowing facilities. Can this kind of trading bring global markets down?

2.  Changing market regulation does not encourage liquidity when in short supply. Does the impact of various “To Big to Fail” measures to protect banks, and firms, (but not investors) actually raise transaction costs indirectly charged to investors? In periods of stress many deal with the absence of sufficient liquidity to bid for it by lowering offer prices contributing to the decline.

3.  There is no such thing as a totally fail-safe electronic system, no matter how many back ups. Those who were not too inconvenienced by the Bloomberg system being down for a few hours remembered how to use other devices; e.g., telephones, Reuters, and actual pencils and paper. Total reliance on new technology, as those of us why fly in planes know, can produce unhappy results. In the end and under stressed conditions the market has a place for human talent. Did the temporary halt of an electronic system materially hurt investors?

4.  The single day decline was not effectively captured by the volatility measures that some use as a measure of risk. Should investors not use volatility to measure the daily risk to their portfolios, but instead the depth of buy orders?

5.  Toward the end of the US trading day Friday, the size of the decline was cut significantly. Was it just a factor that there were not any new flows of sell orders hitting the market, or were there bargain hunters? Were buyers primarily long-term investors or just refreshed speculators?

Investment lessons from World War II

In a recent book review that covered the enormous contribution General George C. Marshall made to both the war effort and the European economic recovery after the war, there was a discussion that General Marshall, who at the time was US Army Chief of Staff, was not given the command to lead the allied forces for the European invasion.  There was no question by training and respect he was the logical choice, but FDR choose General Dwight Eisenhower*, a relatively junior officer for the job. There were lots of reasons for this choice, not the least is that Ike was more likely to be able to get along with the difficult British (then) General, later Field Marshall, Montgomery. Understanding this decision process I can appreciate Steve Jobs’ choice of Tim Cook to lead Apple** after he was not able to continue. Jobs did not choose someone with similar skills as his in terms of creative designs but rather someone who had a very different set of capabilities, which was the development and management of the supply chain.

* After the War and before he was President of the US, he became President of Columbia University where I graduated and received my commission in the USMC.

** I have holding in Apple.

Another lesson occurred to me last week. In reading the program for a concert by the Boston Symphony at Carnegie Hall that featured two pieces by Shostakovich, I learned how his music was evaluated by Stalin’s thought police/music critics when Stalin was alive and after his death. 

While not as draconian as Stalin’s control of the media and so called “intelligencia,” the current US Administration and much of the mainstream media have a single opinion on numerous issues including climate, inequality, economics, and foreign relations issues. Under varying political conditions it is reasonable to assume that popular opinion will change on some of these topics. The lesson for us as investors is that whenever there is a preponderance of opinion in one direction, it is likely to change in the future.  

No truer words

In his pensive column in this week's The Wall Street Journal, Jason Zweig quotes the late Peter Bernstein who I knew for many years. Peter said, “The riskiest moment is when you are right.” Not only does the correctness of the view breed arrogance, but it flies in the face of reality. No one is always right, excepting perhaps some favorite relatives. As with calling heads or tails on a flipped coin, after a correct call the odds on the next call being correct is 50/50 and certainly by subsequent calls there is substantial chances of being wrong. This awareness should prevent investors and manager selectors from being outcome-oriented. Picking winners eventually leads to losers. A better procedure is to pick managers that follow certain processes and procedures.

Two questions for the week:

1. What do you think Friday meant to your investments?
2. How do you pick winning managers?
Comment or email me a question to .

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A. Michael Lipper, C.F.A.,
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