Refusing to change your portfolio in response to changing conditions has been one of the costliest mistakes in investing
Traders work on the floor of the New York Stock Exchange during afternoon trading in New York City. Photo by Michael M. Santiago/Getty Images files One of my favourite quotes is attributable to the late, great economist John Maynard Keynes. During a high-profile government hearing, after a critic accused him of being inconsistent, Keynes responded, “When the facts change, I change my mind. What do you do, sir?”
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Being uncertain of what to do and/or scared of being wrong can cause investors to remain passive and cling to their existing portfolios regardless of performance or changes in the investment environment.
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Moreover, the traditional buy-and-hold approach to wealth management espouses a “do nothing and hope nothing happens” approach, where investors are encouraged to refrain from making any significant changes to their portfolios irrespective of market conditions.
Ayn Rand’s famous novel Atlas Shrugged offers a behavioural explanation for investors’ tendency to remain inert, particularly during times of market stress:
“You see, Dr. Stadler, people don’t want to think. And the deeper they get into trouble, the less they want to think. But by some sort of instinct, they feel that they ought to and it makes them feel guilty. So they’ll bless and follow anyone who gives them a justification for not thinking.”
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Despite the inclination to cling to the status quo, refusing to change your portfolio in response to changing conditions has historically been one of the costliest mistakes in investing.
Sometimes it’s OK to do nothing (but it’s really hard to know when) Jazz legend Miles Davis, when asked what went through his mind when listening to his own music, responded, “I always listen for what I can leave out.” He meant there are times when less is more — restraint can be more effective than action. As is the case with music, there are investment climates in which it’s best to do nothing.
The value of sound risk management varies depending on the investment environment. The ability to manage risk has little value when conditions are favourable. During a bull market that occurs against a backdrop of attractive valuations, low leverage and a hospitable economic climate, risks are minimal and any move to take profits and reduce risk will likely make you worse off — just sit back and enjoy the proverbial ride.
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Article content Conversely, there have been (and inevitably will be) times when risk management and flexibility can prevent a great deal of financial (not to mention emotional) pain.
So far, so good: swing for the fences and make huge returns in favourable markets and apply the brakes to avoid losses when conditions turn hostile.
But wait. To pull this off, you need to do the impossible and successfully predict exactly when markets will turn from favourable to hostile and vice versa. In other words, you need to be consistently right … or do you?
Embracing uncertainty: the assumption of wrongness “It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring,” according to Pulitzer Prize winning astrophysicist Carl Sagan.
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Article content I am not a nihilist. That said, I believe neither I nor anyone else will ever have a complete understanding of anything. Nobody can consistently and accurately predict future prices. There are too many mixed signals, resulting in too much uncertainty.
The very fact that bear markets have plagued investors throughout history speaks volumes. If historical bear markets had been expected, then they would not have occurred.
If this isn’t sufficient proof that trying to be consistently right is an exercise in futility, just look at the forecasting track record of Wall Street strategists. Moreover, it can be very expensive to convince the markets that you are right.
There is a Chinese proverb: “To be uncertain is to be uncomfortable, but to be certain is ridiculous.” In our view, it is far more reasonable to embrace uncertainty and use it to your advantage.
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Article content As is the case in many spheres of life, prudence entails hoping for the best and planning for the worst. Being wrong is not a matter of if, but rather of when — it is unavoidable.
Instead of getting caught unprepared and suffering severe losses when the inevitable happens, it makes sense to build an assumption of wrongness into your strategy. Assume that occasional failure is inevitable and have a predetermined (rather than spontaneous) process to mitigate losses.
That is the essence of risk management. It is the very thing that can prevent tolerable losses from becoming “there goes my house” losses when markets turn sour.
Kenny Rogers vs. The Machine In Kenny Rogers’ famous song The Gambler, the country music legend sang:
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Article content You’ve got to know when to hold ’em
Know when to fold ‘em
Know when to walk away
And know when to run
Got the time? Auditing these three pillars can help investors find the help they need Five investing principles that should always apply no matter the season David Rosenberg: The bear market rally is unravelling — here’s why Without a doubt, Rogers’ eloquent description of chance and the role of human intuition is far more romantic and engaging than statistics and algorithms (what isn’t?). However, the latter are simply more useful with respect to investing.
Countless studies spanning several decades have clearly demonstrated that data-driven, rules-based systems tend to produce better results than human judgment and intuition. Algorithmically driven processes can analyze far more data than humans, but they are also utterly devoid of the cognitive biases and emotional baggage that often result in poor decisions.
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All investment decisions should be based on what can be measured rather than what can be predicted or felt. Investors should never do anything based on their opinions unless they pertain to mathematical phenomena and statistical distributions as opposed to predictions about future central bank actions or corporate profits.
Many investors think they can predict what will happen, which presents disciplined, rules-based strategies an opportunity to produce superior risk-adjusted returns over the long term.
Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.
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