Ancient Greek Heroes, Lotteries, Homer Simpson, and Investment Discipline

The following is an excerpt from the quarterly letter we sent to clients.  

We are an overconfident species.  93% of us believe we are above average drivers, 86% of us believe we are better looking than the average person, and 80% of us think we’re smarter than average.  We are convinced that we know more than we do and that we can act on our unique information at the right time for maximum gain, in spite of the fact that we generally cannot. 

Collectively, we are also very poor at prediction.  Countless behavioral studies demonstrate that we overemphasize low probability events and underemphasize high probability events.  We resultantly favor lotteries, long-shots at the race track, and slot machines, despite the abysmal expected payout of all.   

Overconfidence in our ability, our knowledge, and our information coupled with an inability to accurately assess the likelihood of low probability events presents major hurdles as investors.  It is no secret that these biases exist.  Yet we, as humans, trade more excessively than we should, hold concentrated portfolios, and gravitate toward assets with lottery-like payouts (low probability of an exceedingly high return, high probability of a low return). 

The average investor holds a portfolio consisting of just four stocks.  Research further shows that larger investors own more stocks but “adopt a naïve diversification strategy” where they may own a higher number of positions but do not really have any greater diversification than the average four stock portfolio.  We see this often when reviewing portfolios of prospective clients for the first time.  In some cases, families may own 50 stocks but nearly all are concentrated in a few industries or most of the stock exposure comes from one position (employer’s stock).  In other cases, an investor owns a handful of mutual funds but they’re all US large company funds moving in the same direction as one another every day.   

Behaviorally speaking, diversification is painful.  The entire concept of long-term diversification squarely contradicts our engrained temptations.  It is an admission that we, as investors, are not endowed with more and better information than the market.  It lacks emotional thrills.  You will not own enough of the high flying glamour stock.  You are unlikely to double your money in six months-time.  There will be an emotional desire to always sell what is losing and buy what is gaining.  It means you will always own investments that perform poorly relative to something else. 

In 2013 and 2014, that something else has been large cap US stocks.  Every major asset class trailed US large company stocks over this stretch.  Owning foreign investments, bonds, commodities, real estate, hedge funds, or even small US companies meant the disappointment of not keeping pace with the US-only market barometers quoted daily on TV, radio, and the Internet.  In fairness, the S&P 500 represents approximately 25% of the world stock market and the Dow Jones less than 7%.  Yet influenced by the inertia of mass media, most retail investors think of these benchmarks as the stock market.

Temptation

It now may be tempting to consider loading up on US stocks.  They’ve done well, we know the names, recognize the brands, and the US economic story is the cleanest.  Employment gains in the US are averaging more than 200,000/ month.  Manufacturing is resurging, consumer balance sheets are strong, corporate health is at its strongest in decades, and the budget deficit has experienced the greatest one-year improvement in history.  While there is concern about slowing global growth, the United States is not the source of such concern.   

In contrast, Europe faces high unemployment, recession in several important economies, threat of deflation, export fallout from Russian sanctions, and the consistent limitations of a single monetary regime with widely different fiscal policies.  Japan is saddled with debt more than double that of the US, far worse demographics, potential recession, and weakening export growth.  Emerging economies struggle with weaker demand from China, geopolitical risks, and the uncertain impact from protests for reform in places such as Hong Kong and Brazil.

This is not the first extended period in which US stocks have led global markets and the domestic market has been the global bastion of strength.  Between 1995 and 1999, the S&P 500 gained 255%.  Other major markets trailed dramatically in this period, including emerging market equities which gained only 10% in the 5-year stretch.  Talking heads promoted the strength of the US markets, diversification was questioned, and investors scoffed at the idea of owning non-US stocks when they could make a fortune investing in high tech at home.  As things turned out, the S&P 500 would have been one of the worst possible investments over the next eight years.

Investing Advice from Homer

In the ancient Greek tale, The Odyssey, Homer (Greek poet, not Simpson) tells the story of Odysseus returning from the Trojan War.  Odysseus is warned of the tempting song of the Sirens, a group of sea nymphs who lure sailors ashore to their eventual death using beautiful songs as seduction.  Aware of the temptation, Odysseus orders his men to put wax in their own ears and bind him to the boat’s mast so that regardless of how tempting the music, he cannot break free.  The sailors, unable to hear the sweet songs, and Odysseus, unable to free himself, hold their course until free of the tempting music.   

We admittedly do not take our investment discipline strictly from Homer but his tales, the oldest extant works of Western literature, offer a useful lesson in human vulnerability to temptation.  We share the same behavioral shortcomings as all humans and like to believe that because we are smart and have access to unique information, that we can somehow predict the market’s short-term direction better than everyone else.    

The reality is that we rely on the same techniques as Odysseus and his men.  While overwhelmingly simple and unexciting, a discipline to maintain investment diversification, regardless of conditions or impulse to predict the next market swing, prevents us from making the most common of investor mistakes.  Spreading risks via intelligent diversification is the blocking and tackling of successful investment management.   Diversification is, according to Nobel laureate Harry Markowitz, “the only free lunch” – allowing investors to achieve a higher return with less risk over extended periods. 

What It All Means to You    

When asked the three most essential services a good financial advisor provides, esteemed finance author William Bernstein responded:

The three most important things are, in order, discipline, discipline, and discipline: the ability to maintain a strategy no matter what CNBC and USA Today are blathering about. After that, the humility to know that you cannot predict market movements and the historical awareness to know that economic forecasts are usually contrary indicators.

Remaining disciplined and humble are possibly the most valuable attributes that we provide to you as financial advisors but also the most thankless and underappreciated services.  Just as you’ll curse a fitness coach for keeping you to that diet of kale smoothies every morning, you’ll find plenty of opportunities to bemoan an investment approach of disciplined diversification.   

It is hard to admit that the future is unknowable and that even having the advantage of unique information sources will not allow us to predict the next market swing.  We recognize it would be more fun for our clients and behaviorally satisfying for us if we operated under the overconfident guise that we could forecast the market’s short-term movements.  But just as kale smoothies may not be as tempting as Homer Simpson’s doughnut diet, the strict discipline of doing what is right will prove better in the long run. 

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  1. Pingback: The Predictions Racket | TwinCitiesLand News

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