Sunday, April 30, 2017

The Fallacy of Investment Certainties


In the worlds of politics, economics, and investing there are no real certainties. By definition a certainty is guaranteed to happen. The guaranty makes it inevitable now and in the various, undefined, futures. We are not equipped to define all the possible futures. Events as presented, particularly unpredicted events, shape reactions often differently than expected.


I am incredibly lucky as to the people and situations that I have been exposed to over many years. Perhaps, the other side of that lucky coin is rarely can I be exposed to someone or an event that my mind does not search for an investment meaning. My two great educational experiences, the US Marine Corps and the racetrack have shaped a good bit of my thoughts. The Marines have taught me how very ordinary men and women can do extraordinary things with the proper leadership and training. Further, the USMC taught me that the single best defense is an offense, which tends to drive my impatience into action. The racetrack where I really learned the process of analyzing people and events introduced the concept of the odds of comparing potential payoffs versus a range of probabilities. Out of these analytical exposures I became aware of weighting my bets and the elements of diversification.

I am reaching my investment conclusions by analyzing this week's inputs and my investment reactions.

This Week's Inputs

Discussions with fellow Caltech board members, faculty, and senior staff separately focused on how unnerved they were about the future for its lack of certainty in terms the impacts of changes in political and government grants. My reaction was first “Do not confuse votes in favor of a candidate with votes against another one or policy.” On both sides of the Atlantic and the English Channel people were fundamentally voting against the past. These wise people in Pasadena were very much worried as to what the future would bring to Caltech and to the Jet Propulsion Laboratory that it manages. Caltech staff also had many personal concerns. 

While they were worried, I could empathize with them; however I was not sympathetic. I have always grown up in an uncertain world - if you really looked at it carefully. To me it always comes down to understanding the odds on various future results with a keen awareness that events often override plans. When I mention odds I am not looking for mathematical precision but views arrayed in probabilities which at best could be divided into quintiles. Further, I am totally convinced that if some very unfortunate low probabilities occur that the secondary reaction of all these bright people would change some of the negative impact. Further, to some degree for those who choose to survive there is always a Second Act or next race.

I already mentioned how lucky I am by being exposed to a large number of people, many of whom are bright and accomplished if not both. This week a respected good friend sent to me a very small book entitled "The Usefulness of Useless Knowledge" by Abraham Flexner with a companion essay by Robbert Dijkgraaf. Flexner was the founding director of the Institute for Advanced Study at Princeton and Dijkgraaf is its current director. Flexner’s essay was first published in Harper’s in 1939 . In a period of increased applied research, the book is a plea for basic research. I thought the essay was particularly telling and could provide some comfort for my friends at Caltech. Some of the highlights from the book are as follows:

  • 30% of US GNP is based on inventions

  •  More than half of all economic growth comes from innovation. Einstein said "Imagination is more important than knowledge, but added, "Knowledge is limited and imagination is not."

  • Richard Feynman said "Scientific creativity is imagination in a straitjacket."
(Both Einstein and Feynman did some of their best work at Caltech.)

Inputs from Other Reading During the Week

New products, processes, and systems create new solutions to old and new problems and thus create new and different jobs.

There is a new way to measure the industrial growth in China by measuring the night time lights. (This is interesting in that this can be a commercial venture because of the suspicion as to the quality of the government released data. Of course that wouldn't be an issue here in the US! Also this is not dissimilar to the old analyst's technique of measuring a business by counting cars in a movie studio or industrial plant.)

Europeans seem to be more savings-oriented including their use of Money Market funds whereas in the US there is a more investment orientation including the use of Inflation Protected Securities funds (TIPS). Few seem not to share my long-term concern that materially higher inflation will be a concern.

Moody's* view is that credit conditions will improve due to M&A activity. (This is the reverse of historic experience, as M&A activity led to over-leveraged balance sheets which led to some bankruptcies.)
*Held in the private financial services fund I manage

Daily stock price gaps are most often filled before prices move very far. For the first time in my limited memory in all three US stock price indices (DJIA, S&P500 and NASDAQ) there are recent two price gaps in each.

My Investment Reactions

First the beauty of the TIMESPAN L Portfolio® approach is that it helps to separate one's thoughts about current actions by likely impacts in future timespans.

1.  Our overweight in the Legacy Portfolio (our longest term portfolio) in disruptive growth remains in place. However, growth is not exclusively technology-oriented. Demographic and political changes can be equally disruptive opportunities globally.

2.  Endowment Portfolios need to be keenly aware of any changes to the range of spending needs and have enough portfolio flexibility to accommodate possible radical changes and opportunities. 

3.  Replenishment Portfolios need to watch likely swings from excessive enthusiasm and fears as we negotiate the next markets on the way to a recession. 

4.  Operational Portfolios should be concerned with interest rate reversal patterns to ensure that it can fund short-term expenditure plans.

Bottom line: as long as there is little enthusiasm, the odds seem to me to range relatively small on the downside (less than 25% ) and materially higher blow-off of 100% or higher.

Questions to Ponder: What are the likely ranges for your portfolios for the next five and fifteen years? 

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A. Michael Lipper, CFA
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