Financial Architects

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Beating the Market

There are three ways to beat the market:

  1. Know something no one else knows
  2. Process known information better that the collective wisdom of the market
  3. Exploit a structural or psychological anomaly

The first one is generally insider trading, but maybe on occasion you can learn something relevant unknown to the marketplace at large. (I had it happen once with a microcap company that I was involved with as a corporate customer.) The second one I think is pretty much impossible. On occasion someone may think something different from the market and might even be right, but I suspect that they would be wrong as often as right. In other words, it’s luck not skill and won’t lead to excess returns.

The third item is where we think there are opportunities. I have two standard examples of each:

  • Structural anomalies
    • Barely non-investment-grade bonds
    • Low volatility stocks
  • Behavioral anomalies
    • Value
    • Momentum

Let me talk about the structural ones briefly. Many investors are not allowed (by law or charter) to own non-investment-grade fixed income (i.e. junk bonds). Active managers need high returns to make up higher fees so they will own deeper junk to try to make those returns. Thus BB bonds are “under-owned” and may have a higher risk-adjusted return than other bonds. Similarly, many active managers have a benchmark such as the S&P 500 and people don’t really do a risk-adjusted return comparison, they do an unadjusted comparison. So the managers, needing alpha to at least make up the fees, will buy higher beta stocks. It’s not skill it’s just another way to get leverage. They (generally) are limited to being long-only and not using explicit leverage so they can’t really own low-beta stocks even if the risk-adjusted returns are higher.

As far as the behavioral anomalies, people like owning exciting growth stocks (aka “story stocks” or “lottery ticket stocks”) thus the expected returns on those investments are, on average, poor. (Just as with the lottery someone will likely be a winner, but on average people will lose.)  Value stocks win because people really don’t like owning boring, stodgy, or distressed investments.  Thus those investments have tended to outperform in the long run (again on average).  Momentum has a few behavioral explanations.  Investors may under-react to new developments, or assume too much short-term mean reversion (a term I dislike) in the short run.  People also like to win and don’t like to lose, but they tend to frame their winning and losing irrationally.  If an investment goes up, they sell quickly to “take the win” and if it goes down they hold on so they don’t have to admit (if even to themselves) that the investment didn’t work out.  It just didn’t work out yet.  Large numbers of investors doing those things will keep investments from rising or falling as much as they should initially which leads to momentum.

It’s important to know where you have an edge.  Knowing something or understanding the implications of what you know better than the collective wisdom of all market participants is highly unlikely to be one despite the amount of effort spent on those activities.  (Indeed, the amount of collective effort spent on those activities by market participants is precisely why an individual is unlikely to succeed by doing them!)

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Be an Optimistic Worrier

Continuing the theme from last month’s post, in a recent NYT magazine article, Madeline Albright said, “I’m an optimist who worries a lot.”

We should be optimists because, in general, economies grow and life gets better (see Triumph of the Optimists). But we should worry about risks in the short run. The concept of “permanent impairment of capital” is relevant here. While you should expect success, you should avoid risks that, if they occurred, you could not recover from (hence the “permanent”). So, it’s okay to be predominantly exposed to stocks, but not exclusively, and only in a diversified manner. Also, buy appropriate amounts of life insurance, disability insurance, umbrella insurance, etc. Have an adequate emergency fund. Save more than might seem to be strictly necessary.

Another key phrase in financial planning is, “but what if it doesn’t” and variations.

Some examples you may have heard or said yourself:

  • Stocks have earned 10% a year historically. (But what if they don’t?)
  • I plan to work until 70. (But what if you can’t?)
  • My job is safe. (But what if it really isn’t?)
  • Etc.

Bottom line: “Expect the best, plan for the worst, and prepare to be surprised.” – Dennis Waitley

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Optimizing vs. Hedging

I think I have touched on this before, but not at length and some of the things that happened in the world in 2020 are good illustrations of the point so I think it will resonate more right now.

I want to explain the difference between being a specialist vs. a generalist or, what is the frequently the same thing, optimizing vs. hedging.

If the world (or your corner of it) doesn’t change, you are more successful by specializing. But if it does change, the generalist does better. Similarly, in normal times, an all-stock portfolio has a higher expected return than one that includes bonds. But the portfolio with some bonds is more resilient (in a depression for example).

Here are some instantiations of these contrasting approaches:

  • Buying vs. renting
  • Fixed costs (e.g. automation) vs. variable costs (e.g. people)
  • One product/service/skill vs. many
  • One supplier vs. redundant supply chains
  • Necessary personal relationships vs. expansive relationships
  • All family work in the business vs. diversified incomes
  • Honing your narrow skills vs. broadening them

All of this is very clear to me, but I’m not sure I can communicate it adequately. In a steady state (no catastrophes) the first “wins.” I’m going to use a depression as the trigger in the examples, but it could be anything: pandemic, natural disaster, technology changes, societal changes, political upheaval, etc.:

  • You buy your home vs renting. Makes it hard to downsize easily (or quickly, or at all) in a depression, but it is cheaper (you keep the landlord’s profit margin) if there isn’t a depression.
  • You buy a widget-maker that costs $500,000 and can produce 10,000,000 widgets (over its life) at $0.50 each vs. hiring people to produce them more manually at a cost of $0.60 each. But the depression causes sales to plummet and now you have an expensive widget-maker that is barely running (and that no one will buy in a depression). (Ignoring TVM, the breakeven for the widget-maker is $500,000/(0.7-0.6)=5,000,000 widgets and you would have made an extra $500,000 if times had stayed good.)
  • You have been making only advanced widgets because they were the most profitable, but the market for those widgets is mostly gone and you have no other real lines of business or skill sets.
  • You sourced all your raw materials from the very cheapest supplier (because you got a volume discount to concentrate your purchases), but that supplier went out of business in the depression and it will take a while to get an alternative source lined up. So now your widget-making machine is completely idle.
  • You maintain great relationships with the people you need right now to work for you, buy from you, or supply to you. Why maintain relationships with your old college friends? Because if your business goes away, you may need contacts in other areas.
  • Your (competent) spouse and children work in the business, which, because of high trust, leads to increased efficiencies (you have lower monitoring costs and higher efficiencies if you can really trust your business colleagues) but the business fails in the depression and no one in the family has an income.
  • You chose to get a PhD in the field of widgets rather than a generalist MBA.

In general (there are exceptions), the less you have to lose (younger, poorer, etc.) the more you should specialize or do the first of the options listed. But as you experience success you have more to lose and should increasingly diversify or do the second (although renting seems to go the other way in practice for happiness reasons). As an extreme example, if you have the resources (a billionaire for example) you should maintain homes and holdings on multiple continents – just as a hedge against catastrophe in one country. At very high wealth levels it’s not extravagance, it’s merely prudence.

This isn’t all or nothing, in most cases you should be somewhere in the middle – you need to balance your risks. If you buy the house, probably don’t buy the widget-maker, and definitely don’t borrow to do both if you don’t have the cash!

So here’s the safe approach: use cheap debt to have cash on hand (i.e. instead of cash, not because you don’t have the cash), have diversified income streams (really diversified, and it can be tricky, the FIRE folks thought they were diversified because they had both stocks and Airbnb rentals but were gobsmacked last year), keep low fixed costs in business (and personally too – have low “needs” but liberally enjoy “wants” in good times), spouse and children with safer and/or very different jobs from you. All of those things will lead to lower net worth in good times (and on average), but higher net worth in bad times. In other words, the standard deviation of net worth is lower but so is the mean (just like bonds vs. stocks). In other words, your life (not just your portfolio) should get more bond-like and less stock-like as your net worth increases because the downside is more painful than the upside is pleasurable (see prospect theory).