By Nick Fisher, Portfolio Manager
We just finished hosting a few open houses for friends of the firm, and whether it was one too many glasses of wine or the volatility we saw in the first quarter, I think we stumbled on an interesting topic. Truth be told, we are a little late publishing this newsletter. But in spite of some volatility in the first two months of the year, not much has changed. Thus, at the risk of sounding like a broken record, we wanted to revisit a discussion (see last quarter's newsletter) regarding the emotion investors experience during market volatility.
Of course, we would all like to think we are smart enough to harness the mysteries of the market and believe that we buy low and sell high as all good investors do. But is our behavior consistent with what we say? The answer can be found in the first few months of 2016.
Volatility Revisited
In general, the greater the volatility we can stomach, the greater our return will be. The mispricing created by market volatility is what we depend on in our search for underpriced assets. We therefore view volatility as our friend, rather than our foe.
Examining the recent downturn, however, are we reacting negatively to the volatility? Or are we seeking opportunities and allowing rational thought to prevail? Only through mental preparation and a healthy dose of self-reflection can we adequately answer these questions. Yet, no different than the axiom of “buy low, sell high”, self-reflection is much easier said than done. It requires the ability to examine oneself by looking beyond the defense mechanisms that get in the way. More than any other, we find denial to be the most pervasive defense mechanism we encounter.
Denial can range from mild disavowal to outright repudiation, yet at its core the inclination is the same – a refusal to accept the truth that we were wrong. Behaviorally, denial is rooted in the need for one to control their environment because when one is perceivably in control, they feel safe.
When it comes to investing and what informs the decisions investors make, denial plays a subtle, yet insidious hand. For most investors, confirmation comes through the most recent headline or event, rather than empirical evidence. For others, a bias towards over-optimism affirms we know something most others do not. In either case, in the absence of performing the necessary due diligence the outcomes are unpredictable. In as much, the wisdom of self-reflection and what constitutes good decision-making cannot be understated.
Exhibit I. Decision Tree for Cocktail Party
The tree is made up of a series of nodes and branches. At the first node on the left, the host has the choice of having the party inside or outside. Each branch represents an alternative course of action or decision. At the end of each branch or alternative course is another node representing a chance event—whether or not it will rain. Each subsequent alternative course to the right represents an alternative outcome of this chance event. Associated with each complete alternative course through the tree is a payoff, shown at the end of the rightmost or terminal branch of the course.
So, how do we get there? Frameworks can be helpful in this regard and while we endeavor for self-reflection, simply starting out with a good decision making process utilizing decision trees can go a long way in helping us get there. The chart at right is excerpted from an article written in 1964 on Decision Trees and it provides a great illustration of how the process is put to use.
As John Magee demonstrates, by analyzing the payoffs in each branch of the tree, the interactions between present choices and uncertain events become clarified. Furthermore, it brings to reality the assumptions inherent in any decision-making.
When we think about the possible outcomes in a decision tree at this point in the market cycle, the consequences of being wrong risks a permanent loss of capital, and the reward for being right is very low. In other words the expected value is too low to warrant taking the risk. If this is the case, a static allocation to domestic stocks for example should be receiving our scrutiny. As we’ve indicated in the past, perhaps the better decision is to go fishing instead (reference prior newsletter).
“You have to find a centerpiece idea that will be important in driving the market. Such opportunities do not happen very often. So you have to pick your moments in the financial markets, 80% of the time it’s a coin flip, but the other 20% of the time you have a very high confidence and its not a coin flip.”
To master the markets, 80% of the time an investor should be psychologically subdued, in other words the outcome could go either way. The rest of the time the investor should be excited and fully paying attention. The vast majority of investment ideas will provide an average or below average return. Only a few investments will do incredibly well. Discerning the difference will provide a piece of mind during uncertain times.
Undoubtedly there are many investors who made great investments back in 2011. There were a plethora of opportunities that provided a substantial return in that environment. If you were aggressive back then, you did well – it’s time to go fishing. If you were conservative, then don’t make the mistake of jumping in at the first sign of something that is attractive. Either way, do not deny the emotion at work. In today’s environment something that is eye-catching is nowhere near as attractive as those that did well back in 2011, therefore you cannot expect the same return. What you can expect is greater risk for marginal return.