Why Cant Investing Be as Simple as Going from Here to There?
After traveling more than 20,000 miles over the last month, my mind is overflowing with strong impressions gained from my travels. The richness of the culture, the beauty of the lands, and the friendliness of the people in Australia and New Zealand cannot be overstated. As Americans, we tend to think of ourselves as the youngest kid on the block with a freshness and youthfulness that puts Europe’s stodginess to shame. Yet “down under” there is a land as big as the USA with a history half as long and economies just in the earliest stages of expansion.
And, now that I’ve been there and returned, while I will never come to grips with the international dateline, where a day in my life seemed to disappear at both ends of my trip, evaporating at one end and being chewed up by travel on the other, I have to say that I was extremely impressed by the “miracle” of modern travel. To leave a spot in Michigan and arrive in Sydney within minutes of the expected arrival time always blows me away. And then navigating around a new continent with a map and, sometimes, a GPS; leaving from yesterday’s destination and arriving at tomorrow’s, repeatedly, over weeks of time without a mishap, is phenomenal.
Yes, there was that time when we went around the block three times before the GPS sorted itself out, and working around the rubble and new construction in the Red Zone in Christchurch was frustrating. But overall, the ability to plan a trip from afar and then execute it with incredible precision is mindboggling when one considers the nature of the logistics involved. Modern investing has a long way to go to match that exactitude.
Compare the certainty of such navigation to what is offered to investors by most of today’s investing profession. Passive asset allocation with its focus on the average return, average volatility and average correlation of the various asset classes that are brought together to form an investor’s portfolio, is like setting out to tour the United States but only going to Lebanon, Kansas, because it is the geographical center of the country. (Of course, that’s the center of the contiguous United States, if you add in the land masses of Alaska and Hawaii, the center shifts to Belle Fourche, South Dakota!)
Unfortunately, even active management using quantitative methodologies does not provide the certainty of today’s navigation devices. The state of the knowledge in the industry is such that we can only deal with probabilities. (Are we likely in a bull market or not?) If we had relied on that same level of exactness with our trip, when we set out for Auckland, New Zealand, we could have landed in any of the 48 volcano cones that ring the city instead of arriving at our hotel in the central business district, where we intended to go.
Still, it’s far better than the “average” destination of passive asset allocation. With quantitative analysis we can target a level of risk that we will be exposed to and we can create specific allocations to the actual asset classes that we want to go to for our returns without being constrained by having to own a little bit of everything.
Yes, that still means that when we aim to get out at a top or invest at a bottom, we may instead miss entirely or get only partially there. As investors, we need to realize that the science of investing is not as far along as the science of navigation.
It would be wrong for investors to think that they can “book a flight” to a 10% return with less than a 1% risk given the current state of investment science. Yet it would be equally wrong to think that throwing darts at the stock listing page of the Wall Street Journal is the best an investor can do in trying to navigate the world of investing today.
Maps and GPS devices work because they are based upon fixed measurements between places with exact locations. They are unchanging. When you apply the equally invariable methodology of mathematics to these measurements, precision is the result.
In contrast, when investing, we are dealing with the less precise laws of supply and demand that involve imperfect information about both and which is filtered by the emotions of a multitude of humankind. These can still be manipulated by the precise methodology of mathematics (the basis for the science of statistics), but statistics can only yield probabilities, not certainties.
In setting investor expectations, we must always remember that investing must lag navigation in terms of exactitude. But it is precisely for that reason that we need to apply as many of the statistical tools available as possible, rather than only using the few chosen by conventional wisdom to navigate the still largely uncharted waters of today’s investment landscape. A portfolio of quantified, risk-managed strategies seeks to do this, while a passively managed portfolio of asset classes falls far short.
Last week, the US stock market extended the rally that began with the bottom that I discussed in my last In My Opinion feature before my travels began five weeks ago. The market gained ground in each of those weeks, as investors overcame their fears of Ebola, a European slowdown, and impending US rate hikes.
The intermediate-term indicators continue to point toward more gains on the horizon. Interest rates remain low, more economic indicators are outperforming expectations than disappointing, and we have
just completed a very positive earnings reporting season. Furthermore, investor sentiment has actually been becoming less bullish as this rally wears on, indicating that the complacency usually seen at market tops has not surfaced as yet, and, finally, year-end positive seasonality is just around the corner.
However, while Thanksgiving week has normally been bullish, during the current five-year-plus bull market, it has been flat to down, and the S&P 500 and all but two of its sectors remain very overbought. As a result, some short-term price weakness should not come as a surprise here.
Yet, just as was the case before I set off on my travels five weeks ago, this does not mean that one should abandon stocks. No, the advice remains to continue to hold a portfolio of quantified, risk-managed strategies with a primary emphasis on stock market strategies, as further gains are expected from that quarter yet this year.
While investing may never offer the exactitude that navigation provides, when done properly it does provide the opportunity to travel from one’s present state to a future goal, with the added bonus that should the unexpected occur along the way, active management can employ many tools to reduce the chances for dead-ends and detours along the way.
All the best,
Jerry
