Three Biggest Risks
The largest single risk is the lack
of recognition of the existence of the “unknown unknowns.” Another way to label
this is surprise risk. We are regularly surprised, not only by events but also
by the long-term significance of the events. The best defense against this
primary risk is to array our financial and intellectual assets and liabilities
in terms of their flexibility. We should be able to quickly redeploy some of
our assets and liabilities. As we get older and have grater responsibilities it
gets harder to pivot to new threats and opportunities.
The second biggest risk is the
supposed need for a perfect plan for the future. Recognizing surprise risk, we
should be able to devote some of our most precious time and investment capital
to explore areas that are unknown and probably uncomfortable. In the US Marines
we call this recon, short for reconnaissance. (It was Robert E. Lee’s discovery
of the sunken road that led to an important victory in the first US war with
Mexico. (“From The Halls of Montezuma to the Shores of Tripoli” are the
beginnings of The Marine Corps Hymn.)
The perfect investment plan belies
the only guaranteed product of investing, humility. When interviewing potential
portfolio managers to invest our clients’ money, we want to know about their
mistakes. If one has a very short list or none at all it becomes a very short
interview. One of the refreshing points in listening to Warren Buffett and
Charlie Munger is their frank discussion of their past mistakes. One of
Charlie’s biggest compliments of Warren is that he is always learning. Charlie
himself is anxious to learn every day, as am I. Being wrong comes with the
territory, hopefully it does not have to be repeated, but often it requires
multiple lessons to change behavior.
Derived from the first two big risks
is a third. The risk of lack of thoughtful assessment can be a hazard to our
survival and growth. We learn little from pats on the back and much more from
hits to the gut. While the pain of an acknowledged mistake in our thinking is
useful, the real reward for making mistakes is the eventual recognition and
adoption of new thinking. The more defensive we are, the more difficult it will
be to derive the full benefit of our mistakes. Thus, the mistakes will become
more expensive and frequent.
Comfort from Popularity Risk
As all humans are insecure, whether
they admit it or not, they look for comfort in quick solutions. To cater to our
insecurities we are drawn to what others are doing. This is particularly true
when we are under great stress. If we believe others are collectively doing
something, how can that be a mistake? That is unless one looks at the
dissatisfaction of the majority of voters at the end of a politician’s term, or
spend pleasant afternoons at the local racetrack where favorites on balance win
only 30-40% of the time. More importantly, the winnings are relatively small
and do not equal the money bet on the other favorites that did not win.
Currently, one of the big pushes by
some investment advisors, particularly those that are addicted to building
portfolios of only ETFs, is factor investing. There are many different factor
options for investing, from statistical sorting to sector investing. I suggest
looking at the latest five year record of the average mutual fund separated by
investment objective. The following data is from my old firm, now part of
Thomson Reuters:
Investment Objective Av. Annual Performance # of Funds
US Diversif. Equity + 10.71 8,385
All Equity 9.01 15,116
World Equity 6.88 4,456
Mixed Asset 6.28 5,916
Sector Equity 6.16 2,275
Domestic LT Fixed Inc 2.38 4,174
World Income 1.43 750
Sector investing is
difficult in the long run, but can be narrowly successful. The best sector for
the five years ended July 5th 2018 was Global Science/Technology +22.07%. Some
of those stocks are also in the US Diversified Equity leader, Large-Cap Growth
+15.23%. They are among the most heavily redeemed group of funds as investors
complete their risk exposure investing. The critical question is whether
performance is the best guide for the next five years. I doubt it. Much more
difficult is to guess where the new performance leadership will come from. In
the future it may be a good bet that some or all of the seven different
commodity fund investment objectives will become leaders. Since commodity
cycles are typically long, five years may be too short a period of time.
Investment Instrument Limitation
Not wanting to rely on investment judgment, regulators have limited the options available for investment. For example, many trusts and some mutual funds are not able to invest directly in commodities themselves. Other restrictions require only publicly traded securities or Investment Grade bonds. Most brokerage firms can not act as custodian for the securities traded out of their home country. There are other restrictions too; some caused by limited scope of the investment advisor’s administrative support mechanism. Almost as with the US experiment with the Prohibition of liquor, adventures beyond the walls of limitations become attractive in and of themselves. We sense that the games only a selected few can play are more exciting than the ones we are allowed to play ourselves. For some investors it may be worthwhile to find advisors or banks that can facilitate narrower investment opportunities with some lack of legal support.
Two Personal Limitations
The first limitation is the mind set of the investment advisor who wishes for sound business reasons to keep all accounts invested in the same products and allocations. Some gatekeepers object to great dispersion among a manager’s portfolio. Life would be much easier for the gatekeeper if he or she can be reassured that a new account will look exactly like the others. I am sure that you have visited museums where every picture is the same. I haven’t and don’t want to. Good investors are painters who evolve over time. Clearly, limitations faced by investors is the unwillingness for tax and emotional reasons to accept gains for tax purposes and losses for emotional reasons. Actually, the limitation may be at the advisor level, not wanting to see assets decline for fear of failing to meet tax obligations.
The final set of limitations to diversifying a portfolio broadly are our own biases. Our brains are memory devices and we find comfort in what we know or think we understand. Even with my Caltech trustee exposure I don’t really understand the science behind most biotech ideas and companies. Thus, I don’t own any biotech stocks...directly. I have chosen to use a couple of mutual funds that have medical doctors as part of their portfolio management teams. This is the way I deal with this limitation.
The Final Limitation
We only have so much time left and luckily we don’t know exactly how much. So we hope that we can learn every single day, as do Charlie Munger and Warren Buffett
Noise, Direction, and Premature Action
Liz Ann Sonders of Charles Schwab put out a piece on July 7th entitled “Just Noise or Something More.” She focuses on the ratio of noise to importance. Last week I ventured that nothing of significance would happen on July 6th. While the US and China raised tariffs, I believe these were firecrackers not artillery. The Chinese President surrounds himself with engineers who think long-term, whereas the US President is more comfortable with generals and others that have served in the military. Combine this with the upcoming NATO and Helsinki meetings and the real game is revealed. President Trump is using an imbalance of merchandise trade as a fulcrum to address a weakened US Defense position. The President sees a shift in balance in terms of technology, a sub scale Navy to fight a two ocean war, insufficient troops and the will to defend Europe, the Middle East and African proxy wars. His major strength is that the US is the single most profitable market in the world. He is attempting to force others to give him the room and time to correct for the imbalances. His great trading advantage is to make the US market less profitable. Almost none of these views will be found in the noise of the popular press or through their politicians and therefore may be more right than wrong.
I suspect many of these thoughts and concerns will become clearer by the Fall, although they’ll not necessarily be solved. Barron’s, writing about the trade war, believes that new index highs are unlikely until things become clearer. From a market analysis standpoint we appear to be in a transition. The question is whether we are seeing accumulation by smart investors or distribution of their holdings to less smart investors. I don’t know the answer, but to me the odds are that investing in global equities is not an unusually high risk currently. This might be translated into a cyclical decline in the vicinity of 25%, but not a secular fall of 50% or more. On the basis of those downsides I am looking for opportunities to buy long-term bargains.
Recognizing that I am probably premature, there are two asset classes that should be considered. The first is World Equity Funds.
I am particularly drawn to the list in Barron’s of the poorest performers in the latest quarter. A number of these funds have a history of being good performers. Some of the poor performance is due to the rise of the US dollar relative to other currencies. This is particularly true up to July 3rd in the Yuan. In addition, the Chinese market in local terms has been weak, in spite of its rising long-term prospects. The second asset class that deserves appropriate study is commodities and commodity funds. For the last five years commodity funds are just about the only group to show negative results. Commodity prices move up because of shortages, more so than an increase in demand. While many old commodity players believe they move in twenty year cycles, it is possible that the longevity of their decline will be shortened, with growing demand and the lack of capital expanding capacity.
Questions: What are your reactions to some or all of these controversial views? Please let me know privately.
__________
Did you miss my blog last week? Click here to read.
Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly atAML@Lipperadvising.com
Copyright © 2008 - 2018
A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.
Investment Instrument Limitation
Not wanting to rely on investment judgment, regulators have limited the options available for investment. For example, many trusts and some mutual funds are not able to invest directly in commodities themselves. Other restrictions require only publicly traded securities or Investment Grade bonds. Most brokerage firms can not act as custodian for the securities traded out of their home country. There are other restrictions too; some caused by limited scope of the investment advisor’s administrative support mechanism. Almost as with the US experiment with the Prohibition of liquor, adventures beyond the walls of limitations become attractive in and of themselves. We sense that the games only a selected few can play are more exciting than the ones we are allowed to play ourselves. For some investors it may be worthwhile to find advisors or banks that can facilitate narrower investment opportunities with some lack of legal support.
Two Personal Limitations
The first limitation is the mind set of the investment advisor who wishes for sound business reasons to keep all accounts invested in the same products and allocations. Some gatekeepers object to great dispersion among a manager’s portfolio. Life would be much easier for the gatekeeper if he or she can be reassured that a new account will look exactly like the others. I am sure that you have visited museums where every picture is the same. I haven’t and don’t want to. Good investors are painters who evolve over time. Clearly, limitations faced by investors is the unwillingness for tax and emotional reasons to accept gains for tax purposes and losses for emotional reasons. Actually, the limitation may be at the advisor level, not wanting to see assets decline for fear of failing to meet tax obligations.
The final set of limitations to diversifying a portfolio broadly are our own biases. Our brains are memory devices and we find comfort in what we know or think we understand. Even with my Caltech trustee exposure I don’t really understand the science behind most biotech ideas and companies. Thus, I don’t own any biotech stocks...directly. I have chosen to use a couple of mutual funds that have medical doctors as part of their portfolio management teams. This is the way I deal with this limitation.
The Final Limitation
We only have so much time left and luckily we don’t know exactly how much. So we hope that we can learn every single day, as do Charlie Munger and Warren Buffett
Noise, Direction, and Premature Action
Liz Ann Sonders of Charles Schwab put out a piece on July 7th entitled “Just Noise or Something More.” She focuses on the ratio of noise to importance. Last week I ventured that nothing of significance would happen on July 6th. While the US and China raised tariffs, I believe these were firecrackers not artillery. The Chinese President surrounds himself with engineers who think long-term, whereas the US President is more comfortable with generals and others that have served in the military. Combine this with the upcoming NATO and Helsinki meetings and the real game is revealed. President Trump is using an imbalance of merchandise trade as a fulcrum to address a weakened US Defense position. The President sees a shift in balance in terms of technology, a sub scale Navy to fight a two ocean war, insufficient troops and the will to defend Europe, the Middle East and African proxy wars. His major strength is that the US is the single most profitable market in the world. He is attempting to force others to give him the room and time to correct for the imbalances. His great trading advantage is to make the US market less profitable. Almost none of these views will be found in the noise of the popular press or through their politicians and therefore may be more right than wrong.
I suspect many of these thoughts and concerns will become clearer by the Fall, although they’ll not necessarily be solved. Barron’s, writing about the trade war, believes that new index highs are unlikely until things become clearer. From a market analysis standpoint we appear to be in a transition. The question is whether we are seeing accumulation by smart investors or distribution of their holdings to less smart investors. I don’t know the answer, but to me the odds are that investing in global equities is not an unusually high risk currently. This might be translated into a cyclical decline in the vicinity of 25%, but not a secular fall of 50% or more. On the basis of those downsides I am looking for opportunities to buy long-term bargains.
Recognizing that I am probably premature, there are two asset classes that should be considered. The first is World Equity Funds.
I am particularly drawn to the list in Barron’s of the poorest performers in the latest quarter. A number of these funds have a history of being good performers. Some of the poor performance is due to the rise of the US dollar relative to other currencies. This is particularly true up to July 3rd in the Yuan. In addition, the Chinese market in local terms has been weak, in spite of its rising long-term prospects. The second asset class that deserves appropriate study is commodities and commodity funds. For the last five years commodity funds are just about the only group to show negative results. Commodity prices move up because of shortages, more so than an increase in demand. While many old commodity players believe they move in twenty year cycles, it is possible that the longevity of their decline will be shortened, with growing demand and the lack of capital expanding capacity.
Questions: What are your reactions to some or all of these controversial views? Please let me know privately.
__________
Did you miss my blog last week? Click here to read.
Did someone forward you this blog? To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly atAML@Lipperadvising.com
Copyright © 2008 - 2018
A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.
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