ETFInvestor (94.83)

How I try to think

November 04, 2008 – Comments (0) | RELATED TICKERS: VB , IWC , SCZ

If you can keep your head when all about you
Are losing theirs…
Yours is the Earth and everything that’s in it
-Rudyard Kipling, If.

My friends and family know that I’m interested in investing and that I’ve worked in the financial services industry. So they have been asking me the same question lately:

What do you think will happen with the current financial meltdown and what are you doing about it?

The answer is simple but not very reassuring: I have no idea what will happen, and nothing different.

Actually the real answer is more complicated and, I think, more interesting. Not only do I not know what will happen, I know that I don’t know.

This point forms my investing strategy foundation.  I don’t know the future and I’m fine with it.

Last week I didn’t know what was going to happen this week. Five years ago I didn’t know what was going to happen today, and I sure don’t know what will happen tomorrow. The Dow could stage a massive recovery tomorrow. Or it could plunge another 700 points.

The ambiguity in investing seems to give most people angst: they feel like they should know what is going to happen. For if they could put parameters around they future they would be in a better position to deal with it.

Do I want to know what is going to happen?  Of course! One look at the 2008 S&P500 Chart will convince anyone that a few good moves could make them rich. But confidently guessing wrong is the fastest path to financial ruin, and missing just a few days in a bull market from trying to guess the recovery date can ruin your returns.  

Let me provide some history to explain how I reached this point in my thinking.

When first started investing I endeavored to learn as much as I could about the topic.  I read the popular books by The Fool, Graham and Dodd, Lynch, and Fisher.  I did my best to follow their advice and researched my potential investments carefully.  And from 1997-2003 I bought and sold individual stocks based on my research, convinced that I was following a path to future financial success.  

Then in 2004 I undertook the painful exercise of calculating the net return of all of my investment decisions since 1997. 

After reading all of the books, doing all of the research, and making my own stock-picking decisions I had matched the S&P500 returns. And when taxes and transaction costs were considered I had actually performed worse than an S&P500 Index Fund.  Quite a lot of wasted work following a losing strategy.

After some painful reflections and a few stiff drinks I accepted reality that I’m no better than average at picking stocks. So I decided to read some different books.

I read Fooled by Randomness and The Black Swan by Taleb (who has done quite well lately). I read almost every essay written by William Bernstein. I started learning about logic from podcasts like Point of Inquiry and the basic mistakes we make in thinking. I read about the history of Long-Term Capital Management. I studied the scientific method.

What did I learn?  I learned that we are evolutionarily hard-wired to constantly try to predict the future.  While this is a useful and relatively straightforward task when faced with a decision about whether a lion will attack, it isn't so useful in helping us make decisions involving enormously complex situations like financial markets.  Unfortunately we often treat them the same, letting our emotions drive our perceptions and reacting on our gut instincts.  

I realized that I don’t know what is going to happen in financial markets (or anything in this crazy world) and thus buying and selling individual stocks is an unlikely road to riches. For successful stock picking involves being right and being contrarian, which is another way of saying "I can predict the future better than other people".  

Far from causing me despair, this knowledge has made it much easier for me to sleep at night.  It forced me to explore strategies that don't rely on my limited predictive abilities. Better still, it arms me with a powerful tool for “keeping my head about me”.

(Flip on the financial news media and you’ll see plenty of people who have lost theirs.)

I decided that I couldn’t see a good reason why we could not have another Great Depression that is twice as severe and twice as long as that of 1929. I also decided that technology could propel the world into a new era of economic efficiency with financial returns as good as or better than those of any other time in history.

So in 2004 I started anew with an investing approach that took into consideration the possibility of these future events in the context of my life. And every time I’m faced with a decision, a new piece of information, or a new event, I remind myself that I can’t guess the future. I try to make decisions dispassionately. This isn’t easy and it takes a lot of self-coaching.

“The market dropped today, maybe it is a good time to buy!”
“Oil has really gone up this year, it is a bad time to diversify into commodities.”
“The US will NEVER let a nuclear-capable Russian economy fail.”
“Buy land. They’re not making any more of it.”

Underlying each of these points is a belief about the near future. And each time I find my mind wandering in this direction I try to coach myself back to calmer waters.

Of course I can make some reasonable bets about very long term trends that guide my investment decisions. I can develop an approach that allows me to not only remain calm through the 2008 market madness but actually profit from it.  I can use my professed ignorance about the future to my advantage.

You all know security is mortals’ chiefest enemy
-Macbeth III;6

P.S. Just for fun, count how many predictions you and others make about the market tomorrow.  Then reflect for a second on whether there is any solid basis for these opinions.  In my next blog post I'll explain why I don't believe any of them.