Financial Architects

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Time Diversification, Part II

I touched on this previously, but I want to address it again.

There is widespread belief in what is sometimes called “time diversification.”

The question is really: is there mean reversion in the equity risk premium (ERP) over time? If so, if you have a bad ERP experience early it reverses later so that if you have enough time you capture that and get back to (better-than) even over a more conservative allocation. There is some evidence of that but it’s pretty small. Your risk does not decrease with time. Samuelson made this point 60 years ago, but for some reason most people still think it works.

That paper was the first time (I think) the “myth of time diversification” was debunked. I.e. stocks do not get less risky with more time. The probability of loss decreases, but the magnitude of shortfall grows proportionally. (Again, there is an argument that longer-term stock returns are somewhat mean reverting so that the volatility/risk does not increase quite as much as theory would predict – i.e. with the square root of time. I would actually tend to agree with that.) Most people misunderstand the concept because they confuse “very unlikely to happen” with “can’t (or won’t) happen.” Mark Kritzman wrote a clearer explanation on this topic here, but you may not have access. It’s also in his wonderful book which I highly recommend.

The point Samuelson and Kritzman are both making is that diversification only works cross-sectionally, not serially. If you invest all of your funds simultaneously in 100 risky ventures (1/100th in each) of which most have decent returns, a few have spectacular returns, but a few also become worthless then you win. However, if you invest all your funds in 100 risky ventures one-at-a-time, rolling gains into the next venture, if any one has a negative 100% return then you are wiped out.

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Other Risk Reduction

I’ve written about portfolio risks, insurable risks, silly risks, etc., but I thought I’d spend a few minutes here on a few other things you can do to reduce other types of risk.

Here are a few things that all of us here at Financial Architects do personally that we think many (most?) people probably don’t:

  1. Freeze your credit. At a minimum you should check your credit reports every year or so to make sure nothing is awry, but we think it is worth going to the next level and actually freezing your credit. Here’s how.
  2. Use a password manager. At a minimum you should be using strong passwords and not reusing them between sites. That’s pretty difficult do without using a password manager. Here’s a list of the top ones. In addition, for key sites such as financial institutions, we use two-factor authentication.
  3. Use a VPN. When out of your secure environment (your office, home, etc.) it is best to use a VPN when connecting to an unknown WiFi network. This risk has been decreasing as most sites now use secure connections (“https” rather than the old “http”). More here.
  4. Install updates. Always keep current versions of software not only on your phones and computers, but also on your routers and other internet connected devices (there are a lot these days). The updates include patches that fix security issues that have been uncovered. If you don’t update your software you are undoubtedly using tools with known security issues. More here.
  5. Wipe electronic devices before donating or discarding. It is amazing how many people and organizations donate or discard computers and phones with personal information still on them.
  6. Call organizations back on a public number. It is almost always a good idea to turn an incoming call into an outgoing call. When you get a call from “your bank” or “the IRS” the easiest way to know it is legitimate is to get the person’s name and extension and call them back on a number that you know is legitimate. In other words, don’t get the number from the caller!

There are many, many other things you could do but those six are those that we do ourselves yet we think most people don’t do. (I.e., you know to shred things by now so that isn’t on the list, and using disposable or multiple email addresses for security seems like overkill so we don’t do that.)

Let’s be careful out there!

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Forecasting

I read an excellent post last year, There will Always Be Sorcerers. I have written on forecasts before, here for example, and at that link, I included some good quotes on planning and prognosticating.  Howard Marks came out with a memo (here) which gave me a few more:

  • There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith
  • The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge. – Daniel J. Boorstin
  • Forecasts create the mirage that the future is knowable. – Peter Bernstein
  • The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait. – G. K. Chesterton
  • Forecasts usually tell us more of the forecaster than of the future. – Warren Buffett
  • I never think about the future – it comes soon enough. – Albert Einstein
  • It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on. – Amos Tversky
  • The inability to forecast the past has no impact on our desire to forecast the future. Certainty is so valuable that we’ll never give up the quest for it, and most people couldn’t get out of bed in the morning if they were honest about how uncertain the future is. – Morgan Housel
  • No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all your decisions are about the future. – Ian H. Wilson (former GE executive)

(The memo is worth reading in its entirety. If you get to the end of it, I am clearly in the “I don’t know” school.)

The point made in that final quote is known in philosophy as Hume’s Problem of Induction – and I think investment management is mostly applied epistemology!

The penultimate quote above from Morgan Housel reminds me of this WWII story (from Peter Bernstein’s Against the Gods):

One incident that occurred while [Nobel Laureate Ken] Arrow was forecasting the weather illustrates both uncertainty and the human unwillingness to accept it. Some officers had been assigned the task of forecasting the weather a month ahead, but Arrow and his statisticians found that their long-range forecasts were no better than numbers pulled out of a hat. The forecasters agreed and asked their superiors to be relieved of this duty. The reply was: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”

And here are two more quotes I have often used (though not in the sources above):

  • We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. – Warren Buffett
  • I think everybody who predicts the future with a straight face should be required to change out of the business suit, wrap himself in a gypsy shawl, wear one of those pointed wizard’s hats with a picture of a crescent moon on it, and make conjuring sounds over a crystal ball. That way, everybody would know exactly what’s going on and how much credibility to give it. – Bob Veres

In other words, we should just predict the market will go up. We will be right about 75% of the time, which isn’t great, but almost certainly better than any other prediction.

I wrote more elaborately on this a few years ago: What’s the Market Going to Do?

(TL; DR: “Most likely between a 33% loss and a 50% gain, but there is about a 1-in-20 chance it could be outside that range.”)