By Robert Seawright, Proprietor, Above the Market
I asked a number of my friends to participate in The Carnival of Dangerous Ideas. I asked them to describe an idea they think is true or likely to be true that has dangerous consequences or implications. Here are their fascinating (and unedited) responses. If you would like to participate with a dangerous idea of your own, drop me a line at abovethemarketblog at gmail.com.
Tom Brakke (The Research Puzzle):
A Dangerous Idea: The Numbers of the Past Foretell the Future
In the investment world, we are surrounded by numbers. We grab onto them to support (or to fit) our theses and our decisions. Doing so is unavoidable in a sense and certainly defensible if done in a way that acknowledges the shortcomings of historical information. Alas, there’s the rub.
My nominee for a dangerous idea is that the numbers of the past foretell the future. We all know that they don’t – that they can’t – but often we proceed as if they do. Even among investment professionals and asset owners of the greatest size, decisions frequently get made within an historical frame that distorts the picture of the future.
In one way or another, I have written about this general tendency and specific instances of it many times in the past. Therefore, I’ve included in the brief set of examples below links to other pieces for those who want more detail.
We have a great desire for models of the complex world in which we invest, but they can’t live up to our expectations, even though they are frequently used as if they will. For example, I have heard a prominent institutional investor talk about portfolio changes, flatly stating that they have “reduced the risk in the portfolio,” with no one asking basic questions about the shortcomings of the underlying notions of risk being assumed or the historical relevance of the statistical evidence for the range of possible market environments ahead.
We have public pension plans debating a quarter-point move in expected returns as if that degree of precision is meaningful in any way. For those plans, as for individuals, the frameworks used should focus on a margin of safety and any judgment about expected returns ought to be extremely conservative.
“Risk management” too often becomes an exercise in risk measurementusing historical numbers. Many investment data platforms allow the users to conduct stress tests on a portfolio, but invariably the scenarios available are those that we have witnessed in the recent past. That amounts to fighting the last war. It’s not that such an analysis is without merit, it’s just that it conditions us to think of the past as prologue rather than one particular set of outcomes which may or may not be representative of anything.
The whole business of investment manager selection – by individuals, advisors, and institutions – is rife with examples of using numbers inappropriately to make decisions, despite perfunctory warnings not to do so. (Scott Adams noted that there are two things managers will tell you: “1. Past performance is no indication of future performance. 2. Hey, look at how good my track record is!”) Just observe at how broadly misusedthe Sharpe ratio is in making decisions throughout the industry.
Equity investors, especially “growth” investors, ironically enough, can easily get tripped up by misleading historical growth rates (and the related growth promises of managements). The projected growth rates that you see bandied about are among the least reliable measures around, but they form the basis for analyses from the simplistic (the PEG ratio) to the complex, often distorting decision-making.
There are, of course, many other examples that could be cited. You often hear that historical numbers are “the best we have” and that therefore they are appropriate anchors for our expectations. That is a dangerous, if sometimes correct, supposition. To avoid the pitfalls that come along for the analytical ride, we should always be assumption hunters, aggressively seeking and debating our underlying assumptions, to see whether they are mere vestiges of the past or in fact are reasonable guideposts for the future.
David Merkel (The Aleph Blog):
The main danger of the USA is what we have deferred. We have deferred maintenance on most infrastructure, and we have deferred making payments on entitlement programs. This is true of the States as well; none of them have fully funded pensions, retiree healthcare, and other accrual items in their budgets, like transportation and “rainy day” funds.
But Medicare is biggest, and Social Security is merely big. How will we fund these as the Baby Boomers age? Will we cut benefits, raise taxes, inflate, or default? There are no good solutions here. Shared Sacrifice is best, but who will lead us to do it?
Lauren Foster, a content director at the CFA Institute:
When I first started thinking about something I “believe to be true or likely to be true,” and what the implications may be, my mind leapt to ideas like: I know it to be true that, in the years to come, water will be more scarce (implications of water scarcity); temperatures will continue to rise (implications of more wild fires, superstorms, Arctic ice melting); cyber-attacks will become more sophisticated but cyber-defense capabilities may not keep up (implications of cyber-crime and the systemic risk from an attack on securities markets); and a quarter of the American diet, from apples to cherries to watermelons to onions, depends on pollination by honeybees, which have been dying in record numbers in recent years due to Colony Collapse Disorder (implications of bee shortages).
But then, after reading a recent post on Farnam Street, a thoughtful blog on decision-making, I settled on something seemingly more mundane but with potentially important ramifications: I believe it to be true that people are apt to jump to conclusions too quickly. Perhaps the underlying issue, or the real problem, is that people are overconfident and think they have more information than they actually do and so make poor choices (too quickly).
Dangerous and/or remarkable consequences or implication/s?
This has both dangerous and remarkable consequences and implications.
There are times when we are blind to the facts, or when we massage the facts to fit a theory, and ultimately reach a false conclusion – this applies to investing; inferences about relationships, and motives and/or complicity in a crime. Arguably, these are “dangerous” consequences. As Sherlock Holmes put it in a conversation with Watson in Wisteria Lodge: “I have not all my facts yet, but I do not think there are any insuperable difficulties. Still, it is an error to argue in front of your data. You find yourself insensibly twisting them round to fit your theories.”
But following a discussion with my colleague Jason Voss, CFA, author ofThe Intuitive Investor, I realized I had jumped to an initial conclusion about impulsive conclusions without considering the role intuition plays in fomenting “remarkable” outcomes. In other words, it’s not always a bad thing to jump to a conclusion ahead of a full set of facts.
As Jason explained to me in an email exchange: “I, along with dictionaries and many brain researchers, think of intuition as direct knowing of something; that “Aha!” moment. You have a realization that just appears and without relation to anything else you know. This is like Newton’s recognition of gravity and ‘the calculus.’ Newtown told friends that he developed calculus after his realization about the importance of motion on gravity and forces. This flies in the face of Sherlock Holmes. Einstein said essentially the same thing about his “Aha” about relativity. He had to support it after the realization…As for the costs of ‘jumping to conclusions’, I think it all depends on the consciousness of the person doing the jumping. In general, it is a very bad thing to jump to a conclusion without deliberation of the facts…In general, I would say that most people are walking around with, what Buddhist’s call, ‘monkey minds’. That is, most people have very little control over their mental processes.”
Ken Silber, Senior Editor, Research magazine:
All types of money require a leap of faith. Neither a gold standard nor bitcoin nor any other conceivable monetary system eliminates the role of trust and belief. There is no guarantee that the issuer of gold-backed money will be willing and able to meet its obligation to back paper with metal on demand. There can be no assurance that any technological solution doesn’t have some backdoor or flaw, perhaps including some arcane coding that will make your value vanish tomorrow. Paper money, with its capacity to be inflated, devalued and counterfeited, actually carries an advantage in that people know it is fallible.
From Ironman and the Political Calculations blog:
Here is a chart showing what nominal GDP in the U.S. would have been as a result of the government spending cuts and tax hikes that have taken place since 2012-Q3 versus how GDP has actually been recorded through 2013-Q2 (the just released second revision):
We found the “would have been” GDP by starting with the GDP for 2012-Q3 and projecting how it would change only in response to the amount of actual changes in government spending and taxes for each subsequent quarter. In doing that, we applied the Keynesian GDP multipliers that the Fed has found applies to government spending (60%) and that Romer & Romer (one of the Romers is the former chair of President Obama’s Council of Economic Advisers) found applies for taxes (-300%).
The vertical distances between the “would have been” and “was” nominal GDP figures for each quarter since 2012-Q3 turn out to be within a few hundredths of a percent of the cumulative net increase in Fed’s balance sheet from the end of 2013-Q3. The Fed’s total assets have increased during this time because of the Quantitative Easing (QE) programs it has operated, in which has bought up both mortgage-backed securities and U.S. Treasuries to boost the economy.
In simple terms, it appears that the Fed’s QE program overcame the fiscal drag associated with major tax hikes and minor government spending cuts to supply all the growth observed in the U.S. economy from the end of 2012-Q3 through the end of 2013-Q2. The Fed’s QE is the *only* reason the U.S. economy avoided recession and grew at all during this period.
In the absence of all of these factors, the U.S. economy would have experienced a mild recession with near zero growth during these quarters, which we see reflected in how stock market earnings data has been revised from what was originally reported for 2012-Q2 through 2013-Q1, which confirms that the private sector of the U.S. was experiencing recessionary conditions through the end of 2012 and into 2013.
(That’s really old news however, since stock market dividend data indicated that would be the case in real-time.)
James Osborne, CFP® (Bason Asset Management Blog):
“I was right” may be the most dangerous thought that presents itself to an investor. Maybe you have a friend who bought Apple under $50. Maybe a friend “foresaw” the 2008 financial crisis and sold most of his stocks in late 2007. Maybe it was something as small as dipping into high yield bonds when spreads were at historic highs or shortening the average maturity of his bond portfolio earlier this year.
Whatever the circumstances, your friend now sees that he did something right. And therein lies the danger. When we’re “right” about a one-time investment decision, all of our behavioral biases kick in. Suddenly, we’re geniuses! Certainly it wasn’t luck that had us buy into Apple early or bail out of the markets at a fortuitous moment! It was purely our skill, and not a random but fortuitous series of events that led to this outcome. Our self-serving bias tells us that of course we could see the bear market coming and of course we knew that Apple would increase 1000% and of course bond yields were headed up. We rebuild our memory of the event in the most flattering light possible.
In turn, this makes us overconfident. We take credit for being right, and assume that we’ll be right again! We’ll find the next Apple before a historic run, we’ll dodge bear markets with grace, we’ll always take the right risks at the right time, because we’ve done it before!
If we cannot recognize our limitations, we’ll fail. Our portfolios will become too concentrated, we’ll rely too much on timing the market and believe too strongly in our ability to execute winning investment strategies. We must take a more objective view of our abilities, and we must rely on a well drafted investment policy to reign in our otherwise misguided minds.
Kent Engelke, Chief Economic Strategist, Capitol Securities Management, Inc.:
Short AAPL (NASDAQ AAPL $498.69)
Why: One year ago Apple around $705/share was the most overowned and over recommended stock in history where income funds were buying the company on the felonious justification of an anticipation of a dividend. AAPL could do no wrong and will conquer the entire known and unknown world.
If I am not mistaken it overtook GE for this distinguished position, a position GE held around September 2000 trading around $60/share when GE and Jack Welch could do no wrong. According to Bloomberg, since 2000 GE has dropped about 60% and its total return is around -43% vs. a negative 0.64% total return for the S & P during the same period. [Note: The S & P is 10.2% lower today than in September 2000 according to Bloomberg].
It is widely accepted when a dominant person/leader leaves a company, a person who the popular media has coronated, the company begins to radically underperform (i.e. Jack Welch’s retirement from GE in 2001). Similar to Jerry, Steve Jobs is dead and is not living in Argentina with Elvis.
I think the odds are over 65% Apple will trade under $200 share in two years, permitting one to make $300/share or 60% on the Apple short, as Apple loses market share to new entrants, a loss of market share caused by a combination of the company’s arrogance and inability to innovate.
As noted above, AAPL is/was the most overowned/over recommended stock in history. Who is left to buy the shares when selling commences as overly optimistic/giddy assumptions do not materialize. Obviously no one.
We are told past performance is not indicative of future performance. One can take this statement in any manner similar to defining what “is” is and what constitutes “A red line.”
However I think GE offers great precedence and evidence to AAPL’s potential performance. The similarities are uncanny where only the name and industry has been changed.
I will either be regarded as a genius or lunatic with idea.
Sheryl Moore, CEO of Moore Market Intelligence:
The life insurance/annuity industries’ distributions must stop recruiting their neighbors’ reps for an additional [10 bp] compensation. Not only are you reducing your spreads, and therefore reducing your resources, but you are risking the loss of said rep to the guy who can offer him/her [15 bp] more compensation.
Michael Kitces of Nerd’s Eye View:
If there’s one staple of financial planning wisdom that virtually everyone will agree upon, it’s stocks for the long run. Sure, we all acknowledge that markets can be volatile in the short-term, but we all seem to still agree that in the long run, stocks are still where it’s at. So as long as you have a long enough time horizon – whether you’re a young person still accumulating, or a retiree looking at a multi-decade spending phase – stocks are still a material portion of the portfolio. But within the past hundred years alone, there was nearly an entire generation – who grew up during the Great Depression – that gave up on stocks for their entire lives. What if that happened again? Has the financial planning profession hitched itself to the stocks-for-the-long-run wagon so tightly that if stocks fall off a cliff, so too will the profession?
Keep reading here.
The most dangerous idea is that investors believe that they (or some expert/guru/advisor) have the ability to forecast accurately. That leads to the start and stop approach to investing that is the cause of the poor risk-adjusted performance most investors experience. Overconfidence is an all-too-human characteristic. and unfortunately many investors are overconfident about their own abilities (or the abilities of so-called experts) to forecast events or market direction. This overconfidence persists despite the overwhelming body of evidence demonstrating that there are no good forecasters. That knowledge is why Warren Buffett offered the following advice (which investors ignore at their peril):
“We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
Cheap and Easy Self-directed Investment Options
Congress provides US taxpayers with many different tax-advantaged options for retirement saving. Qualified self-directed employer sponsored retirement plans are some of those options. They included 401(k), 403(b) 457 plans, SEP IRAs, SIMPLE IRAs, and others. There are trillions of dollars invested in these plans. This is a good thing for workers and for America.
What Congress didn’t provide was a short list of investments that plan participants could put their money into. That was a mistake. As a result, many plans are load up the a wide range of costly investment products that pay Wall Street billions of dollars in annual fees and, to make matters worse, kick-back some of those fees to the employers in the form of administrative services.
My radical idea is for Congress to create a very short list of three (3), government approved, low-cost, diversified index fund options for participants in qualified self-directed plans – and that is it. Every plan in the country were employees are able to save tax deferred would be required to offer these three funds, and only these three funds in their plan to keep their tax exempt status:
- Conservative growth: 25% total global stock index fund + 75% total US bond index fund.
- Moderate growth: 50% total global stock index fund + 50% total US bond index fund.
- Aggressive growth: 75% total global stock index fund + 25% total US bond index fund.
The default for all employees would be the moderate growth fund. They would then have the option to invest in Conservative Growth or Aggressive Growth. Fund providers would compete for then qualified plan business on cost only because the funds would be all the same. There would be no incentive to compete based on performance of their funds. This will drive investment costs down to only a few basis points, a level enjoyed by participants in the government’s own Thrift Savings Plan (TSP).
There would be no need for middle-men such consultants who earn fees by recommending investment products. It will also end the flow of cash from fund companies back to plan sponsors. Administrative costs would be paid fully by either the employer or employees. All costs would be fully disclosed. Finally, this idea will end most lawsuits against plan sponsors for impudent investment decisions.
The government created qualified self-directed employer sponsored plans with the thought of helping Americans save and investment for retirement. They did not do it so that Wall Street could get rich. Limiting all plans to these three extremely low-cost portfolios is a prudent move for employees and their beneficiaries, and it’s also prudent for employers who wish to have safe harbor from litigation due to bad investment decisions.
Dan Moisand, CFP® :
I just saw a blurb which reminded me about some research Wade Pfau did that showed owning an immediate annuity instead of bonds in a balanced portfolio helps sustain withdrawals over long life spans. Given the parameters he outlined, he is correct.
I can’t help believe however, that a portfolio consisting of an annuity in payout and 100% of the rest in stocks would be quite dangerous. It’s not that his simulations are wrong, it’s that I don’t see many people being able to actually pull it off. The annuity ceases to be an asset and becomes an income stream. It is only a matter of time before it is viewed by the client strictly as an income stream. Bear markets are inevitable. Few clients can handle a 100% equity portfolio in retirement but that’s what it would likely feel like. Clients monitoring their assets would be exposed to far more volatility than most could handle. If they (or their caretakers) bailed on the approach, they reduce its effectiveness. What would you tell an 80-year-old if he had all his money in stocks, the bear growled, and he was nervous even if he had a nice pension? That’s the position a person would be in if they actually did this. In a bad market, they either hang on or sell to some extent and that changes the math. The math is interesting but who could really pull it off?