Insight Out

September 2018

“There are two kinds of people who lose money: those who know nothing and those who know everything”

– Henry Kaufman, former Salomon Brothers Chief Economist

I dipped my toes into the world of investing around 22 years ago, long before the days of Monmouth Capital. In that time I have enjoyed, or at least lived through, some wild markets.

The first I recall clearly was the Russian debt crisis of 1998, when the Russian government under Boris Yeltsin defaulted on their debt and sent global markets into a temporary tailspin (see S&P 500 chart below):

Back

The Russian Debt Crisis of 1998 - disaster averted

Then there was the innocence and hope of the dot-com boom leading to a bear market that would have been historic, were it not followed by the big one, the one that nearly brought the house down, namely the Great Financial Crisis of 2008 (1).

Since I started investing, we’ve experienced numerous events that are rarely seen – a US housing debt bubble that nearly collapsed the world economy; a couple of crashes caused by machines (flash crashes); monetary stimulus on a scale that defies imagination; negative nominal interest rates (still a headscratcher); and the usual wars, frauds, scandals and such like.

With any of the above I had little inkling of what was on the horizon. This is despite my best efforts.

When I bought my first iPod back in 2003, I didn’t consider for even a moment that a decade and a half later Apple would be the largest company in the world and valued at one trillion dollars. Similarly when Google floated in 2004 I thought little of it. I had invested in a search engine that was supposedly far better back in 2001 and they eventually went bust; everyone knew search engines had little competitive advantage.

https://www.theguardian.com/technology/2004/aug/19/business.newmedia

After the fact we tend to readjust our views (to appear more prescient and make the world more coherent) but based on my notes and writings over the years, for the most part and without the benefits of hindsight I was relatively clueless.

What I have managed to do is engage, survive and steadily progress despite this blindness. How have I managed this without great insight into the path of future events?

Stepping back: lessons on fear

Back in the early 2000s I was a scalper, someone making small fast profits trading many times a day. I was young, impatient and hooked on the fast track to big money. Each day was a high-octane adrenaline rush.

Around the open at 8am my habit would be to trade smaller positions to ease into the flow of the day. That morning I was long a sliver of Astrazeneca stock when the price started to surge, wave after wave of buying. It was electrifying. My normal trading range was 10-20 points – this move was 200+ points, at that moment it felt like a tsunami even if in the grand scheme it barely registers.

When the buying surge started to fade I sold, breathed and glanced at the news: they had received positive results from a trial. The action had lasted 2 minutes or so and I had locked in a nice win especially for a small position.

Was I pleased? There was euphoria from this. But in the end, overriding the euphoria was an icy block of fear. I had witnessed the raw power of the market and could not hide from the knowledge that only luck had me positioned correctly. Just as I was not to be credited for this gain, I would not have been at fault if I had made a loss.

The experience scarred (and scared) me: if I had been holding a full-size position and it had gone the other way I would have lost a large slice of my capital. All through bad luck.

Or would it have been? On reflection, I realised I was wrong, or at least it was an incomplete model of seeing the markets. That even if this one instance could be ascribed to chance, the way I invested opened the possibility for outsize and unmanageable gains or losses.

I was still responsible.

Delving into a minefield

Let me frame it in a different way. If we close our eyes and run through a minefield and survive, should we be congratulated on our skill and bravery? We were in a minefield. Only luck delivered us to the other side.

In life we must traverse many minefields. Should we close our eyes and hope, or respect the dangers of stepping onto that field?

To continue successfully is to adapt and act respectfully and constructively, not to continue to leave our faith in luck.

Markets are a minefield of sorts – the unexpected and the unplanned drop into the system regularly and far more often than neat models imply. Often they are unexpectable – negative nominal interest rates were completely alien until a few years ago.

A market is not a mechanical system or a closed system as in a game of chess. It should be viewed as a complex dynamic system, an entity that inherently suffers from a disequilibrium– the perceptions, actions and assessment of agents are constantly destabilising. The nature of complexity means outcomes are not predictable from observing the inputs. This nature is hidden to us as humans because the system feels and acts as if it tractable. But it is not.

Seeing behind this façade is, in my opinion, one of the key waypoints to becoming a skilled investor and gives us a shot at transcending the vagaries of chance.

Investing is more forgiving than crossing a minefield but the thought process is similar. To reach the other side we must minimise the likelihood of being blown up without relying on luck to save us. In statistical parlance we want to reduce the standard error of outcomes.

There are challenges to this. If we realise how little we do and can understand, the natural reaction is either:

not to participate, in which case we face the existential risk of not achieving our investment goals;
or we try and outwit the market by being increasingly clever, which places us at the mercy of an ambiguous, impersonal and violent master which billionaire fund manager Ken Fisher calls “the great humiliator”.

Perhaps even worse is the danger of believing we have it all worked out. Our eyes gaze only on opportunity. We can go all in with faith. “There is no minefield; or if there is I know how to get through it.” This is to throw oneself into the turbulent waters of randomness. Time it right and you will look and feel like a genius; time it poorly and you risk ruin.

Here and now

Looking out on current markets we see some of this dynamic.

Old dogs, those of us that have been through the cycles before, are cautious. I, for example, am shaped by the habitus of my formative years: the 2000s were the worst decade for index returns since 1900. What lessons are imprinted into my style? People like me have looked out of place these past few years as expensive markets, such as the US, continue to rise in value.

Young guns, unencumbered by the scars of past wars, hold an advantage in such an environment. They can be present to what is in front of them. “This minefield is ok, I get it,” they say. “Look: I am walking up and down with no damage.” They can meet with huge success while the stars align. Their challenge will be to recognise the difference between success and truth. When they aren’t looking, the minefield will change; will they realise it and be able to adapt in time?

It isn’t the case that being an old dog or young gun is better or worse. There is nuance in the application of these distinctions. Legendary investor Stanley Druckenmiller tells a story about how his boss’s boss promoted him to director of research in the late 1970s even though, at 25 and with only 1 year’s experience, he was decades younger than others on his team.

The senior manager’s reasoning: the others would be too imprinted by their experience in the moribund 1970s to see what was in front of them. If the environment changed they would not accept it, whilst Druckenmiller, without the baggage, would. It was a wise call and the bank made a large profit in the ensuing bull market (2).

Over and over

Investing isn’t a one-shot event. Getting it right once isn’t enough. We are crossing an endless series of minefields. Can we navigate and profit in this phase and reach the next in good shape? And the next? And the one after?

This, I feel, is where the skill really kicks in.

A successful investor must perform contortions to succeed over the long term, over many phases, through many cycles. We must exhibit seemingly contradictory characteristics – respect history yet be present to the possibility of change; hold our course yet retain curiosity; be decisive but respect the conviction of our opponent. The list goes on.

This is not something confined to investment; nor is it a challenge to be solved like a crossword puzzle. The game is constantly evolving.

Notes:

First Trust has produced this excellent picture of US bull and bear markets on one page: https://www.ftportfolios.com/Common/ContentFileLoader.aspx?ContentGUID=4ecfa978-d0bb-4924-92c8-628ff9bfe12d
From an interview published in New Market Wizards by Jack Schwager (https://www.waterstones.com/book/the-new-market-wizards/jack-d-schwager/9781592803378).