Q1 2021: The Doomsday Machine
Dear Clients, This quarterly letter was written by our Investment Director, Can Esenbel. In this piece, he focuses on a dangerous feature of behavioural finance called “myopic loss aversion”. Psychological and emotional responses to investing can have a greater impact on your long-term wealth than choosing this or that fund; recognising and accounting for this is central to our investment philosophy. Faisal Sheikh, Managing Director 18th April 2021 The Doomsday Machine A few years ago, I went to a screening of the film Dr Strangelove at the Barbican. It’s still a powerful and relevant film. Before the screening, there was a talk by a complexity scientist. Complexity and complex systems theories have long been studied in the natural sciences before being extended to human systems – warfare, business and investment are ripe fields of investigation.
In a complex system, the scientist explained, all the individual elements depend on the actions of the others, but we cannot make predictions based on the behaviour of the parts – inputs do not lead to tidy outputs. This would be fine except for the human tendency to overestimate our ability to understand and control what is going on.
When I wrote the Q1 2020 letter (Fear and Destruction: Lessons from the Romans) , we were enduring a sell-off of impressive vigour and breadth. The recovery since then has been similarly remarkable. Without the framework of complex systems, we would struggle to make sense of it all and assume markets are irrational or that it is all rigged. This tweet in January 2021 by Nassim Taleb, author of The Black Swan and renowned financial scholar, sums it up nicely:
We may know someone who predicted the March sell-off last year or the pickup from April, but NO-ONE predicted the size of the moves – down and up. They can be rationalised and studied after the fact, but very rarely as it is happening.
2020 was a reminder that at any moment, anything is possible. The past is a guide of sorts, but the future need not be constrained by what has gone before. This is why risk control is central to the success of any serious investor; that is, risk in both directions (excessive risk-taking or not taking on enough risk to meet goals). Both are dangerous but on different timescales.
We were reminded of the dangers of excessive risk recently with the collapse of Archegos Capital, whose manager Bill Hwang was successful for many years until he lost his $20 billion fortune in a few days . His failure was relatively mundane: it was not due to a dramatic event, just that he was leveraged five times his capital. Leverage is akin to driving fast regardless of road conditions: in theory, you will get to your destination quicker, but the chance of crashing increases. Repeat this a few times and trouble is inevitable. To quote Taleb again, in the context of Russian roulette in his book Fooled By Randomness:
“Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. One is capable of unwittingly playing Russian roulette - and calling it by some alternative “low risk” game.”
At the Monmouth Capital monthly investment committee meeting, how we think and feel about investing is as frequently discussed as what has actually happened. In the context of the past year, a particular concept of behavioural finance relevant to long term investors has come up often: Myopic Loss Aversion.
This concept was developed by psychologists Shlomo Benartzi and Richard Thaler and comprises two elements – mental accounting and loss aversion.
Mental accounting is a process in which we mentally separate money into discrete bundles, then assign different utilities (feelings of good or bad) to these bundles. This separation is a construction of our mind.
For example, I may have £10,000 in a savings account and £10,000 on a credit card. Overall, I have a net worth of zero. Mental accounting can lead me to value the (emotional) comfort of having savings more highly than the high (financial) cost of carrying credit card debt. I am happier than I should be (according to economic theory).
Loss aversion says losses feel more painful than an equivalent gain feels good. Studies show that a £1 loss has the same emotional resonance on average as a £2 gain. This is dependent on our reference point, but in general, our natural state is to feel the pain of losses more than the pleasure of gains.
The two, in concert, lead the investor into self-sabotaging territory.
We may invest a sum of money for twenty years. The investment is a fund that matches the market, so there is no need to make any adjustments – after buying we can leave it alone. There is no reason to observe this investment, but we check our balance every month anyway. What does this mean?
Myopic loss aversion tells us that by observing the portfolio monthly, we collapse our supposedly long-term time horizon into a much shorter one. Judgments about our investment become anchored on the very recent past; instead of a 20-year investment, we have 240 investments that last one month.
This makes a big difference to our experience and probably our outcomes.
If the period observed is up, we are happy (and maybe hungry for further gains); if it is down, we are unhappy (and fearful of further losses). At some point, in a moment of concern, we may sell the investments to end the pain.
This is dangerous as the action is driven by our emotions, not our plan (which is to do nothing for twenty years).
My one-month example is a little quaint in our age of push notifications, always-on tech, and shouty headlines. It would be easy to check in daily or hourly on this 20-year portfolio. What happens to us in this world? Let’s take 2020 as an example.
Here’s the experience of an investor plugged in to the markets and world news. Each bar represents 4 hours in the S&P 500 US stock index in February and March 2020:
Our mental frame narrows with each downdraft. Over time we lose perspective in the fog of emotional pain. At best, we suffer unnecessarily; at worst, we intervene and take action that throws the long-term investment plan out of the window.
An investor who checks in less frequently (preferably on a predetermined schedule) would have a different experience. Last year, perhaps they looked at their portfolio at the beginning, middle and end of 2020. Their experience is as follows:
No drama. Almost certainly better outcomes.
In the book Black Box Thinking by Matthew Syed, he quotes an aviation safety expert, Shawn Pruchnicki, who, in discussing the reforms following the crash of United Airlines 173  summed up as follows:
“It is still regarded as a watershed, the moment when we grasped the fact that “human errors” often emerge from poorly designed systems.”
It is the same for the investment domain. As investment managers, we are always considering actions that enhance the design of our systems to minimise “human errors”. I mentioned the illusion of control earlier, so it is essential to know where our actions can have a predictable impact. I also discussed complexity and complex systems, so it is valuable to understand the workings of the domain in which we operate. Behavioural missteps such as myopic loss aversion are born out of a misunderstanding of both.
This is the nitty-gritty of investing, the hard thinking and considered action which tangibly elevates our chance of success.
Can K. Esenbel
Investment Director, Monmouth Capital
This was a crash in 1978 where a highly competent pilot, Buddy McBroom, refused to accept his fuel levels were near zero, as he was so fixated on another issue and wouldn’t listen to his crew’s warnings.