In The Birth of Plenty: How the Prosperity of the Modern Work was Created (Amazon,) author Bill Bernstein illustrates how the prosperous west got that way and presents a hypothesis on how growth happens.
Prosperity flows naturally once a society acquires the four crucial factors—property rights, scientific rationalism, capital markets, and modern transportation and communication.
The wretched masses of the third world suffer not because they are deficient in factories and machines but because they lack institutions—property rights, a scientific outlook, and capital markets—while at the same time their countries experience explosive population growth from their glancing encounter with the advances of modern medicine.
It is a fascinating book and you should read it even if your interest in developmental economics is tepid, at best.
Volatility measures changes in price. Price is a measure of sentiment. Volatility measures changes in sentiment.
Most of the time, it is impossible to tell the difference between the two.
Exhibit A: AIG
American International Group, AIG, had enjoyed a AAA rating for 22 years and had been just one of eight US companies to hold the top rating from both S&P and Moody’s.
As mortgages started to go bad, AIG stock began its long journey to zero from July 2007. During that time, a majority of investors thought that every dip was a buying opportunity.
The problem with trying to be too smart about “volatility” vs. “risk” is how do you know what is priced-in vs. what is panic-selling?
If you are going to panic, panic early!
Panic is good only if you panic early, and as a trader the first thing you learn is to panic early. – Nassim Taleb
Discretionary investors wax eloquent about the strength of their conviction. Having done their homework, they claim, they have the “diamond hands” to hold onto their investments during bouts of volatility and to buy the dip.
However, these narratives are heavily driven by survivorship bias. You will never hear about conviction and diamond hands from investors who bought the dip in Bear Stearns, Suzlon or Kingfisher Airlines.
As an investor, you get no points for being a hero. If there is a whiff of something unpleasant, it is better to get out of an investment entirely, take a beat, re-evaluate, do a relative-value assessment to figure out how it compares to other opportunities and only then decide whether you want add it back to your portfolio.
Exit first. Ask questions later.
Compounding works both ways
Losers average losers – Paul Tudor Jones
We have all seen the Whatsapp forward about compounding: (1 + 0.1)^10 = 2.59 i.e., 10% compounded over 10 years will turn every rupee into 2.59 rupees. Rarely do you see the reverse: a 50% loss requires a 100% return to get back to even.
If you care about compounding your portfolio, stop compounding your losses!
Investing is risk management
… and risk management is not free.
Most investors focus on the glamor part of the process: scuttlebutt stock-picking to find the rare “hidden” gem that will 100x in 5 years. They would have better odds buying lottery tickets instead.
There are plenty of investors who became millionaires simply by grinding away at harvesting risk premia and managing risk.
Avoid blowing yourself up and allow statistics to do play out.
The only investors who shouldn’t diversify are those who are right 100% of the time. – Sir John Templeton
There is a big difference between the advice professional investors give to other professional investors (like the ones above) and the advice that savers need to follow. The media often focuses on the former because it is exciting and there’s always something new whereas the later is mostly timeless and boring.
The media’s sampling and survivorship bias ensures that only large, successful, telegenic professional investors get the spotlight. And media’s short attention span ensures that most of them are never held to account for their pontifications. As far as the media is concerned, the only crime is to be boring.
The tragedy is that there are only so many ways in which you reframe “save into a diversified portfolio by dollar cost averaging into a low-cost, broad-based equity fund and a short-term bond fund.” So it is guaranteed to never get the airtime in proportion to how important it is.
— Dividend Growth Investor (@DividendGrowth) April 22, 2021
Diversification means that your incremental dollar is buying the asset that has not appreciated as much as the other. For example, if you keep a static 50/50 equity/bond portfolio and equities are up 10% but bonds are up 2% then the next dollar you put into that portfolio is going to buy more of the bonds and less of equities. This is where the Risk Management is Not Free rule kicks in: diversification is anti-momentum, a premier market anomaly. By diversifying and rebalancing, you are not maximizing your portfolio returns but minimizing volatility in a cost-effective way.
Remember, that in the end, we are all short volatility.
In the short run, market is a voting machine; in the long run, it’s a weighing machine. – Benjamin Graham
Price is a measure of Sentiment
Early last year, when it became clear that the China Virus had spread all over the world and was getting millions sick, overwhelming healthcare systems everywhere, the markets tanked. In USD terms, Indian stocks were down more than 40% and the S&P was down more than 30%.
Then, a miracle cure was discovered and the markets quickly recovered.
Just kidding!
Governments and Central Banks everywhere did whatever they could to lift sentiment. And markets quickly followed.
Sentiment remains one of the least understood but the most important factor in investing. All prices are eventually tied to how optimistic or pessimistic investors are feeling about the future.
While Graham’s weighing machine might arrive in time for tenured investments, like bonds, that have a fixed maturity date, perpetual securities like stocks are always at the mercy of the voting machine, i.e., sentiment.
The Market sets the Price
For stocks, Price = multiple x earnings
For prices to go up, you don’t need earnings to go up. It is enough if multiples do.
There are two pieces that drive returns… multiple expansion / contraction and the earnings themselves. It’s hard to predict the former (they’ve gone opposite their expectation of normalization), but they completely whiffed on the fundamentals. US companies have crushed.
Russell 1000 Growth Price to Book Grew from 5.2 to 12.4 in 5 Years…Russell 1000 Value 1.5 to 1.6 in Same Time Frame … forward P/E has doubled for growth and flat for value over past 5 years. h/t TOPLEY'S TOP 10 via @MarketWatchpic.twitter.com/0zj1DlkIjz
The market doesn’t care why you are transacting. Only that you are. It doesn’t matter what your investment horizon is or the type of investor you are, all transactions take place in the market at a price set by it.
As an investor, you can be right about the company (direction of earnings) but wrong about the sentiment (direction of multiple) and can end up with a stock that goes nowhere in price for years and exit with no rewards for your effort.
No such thing as Buy-and-Hold Forever
It is the end of a “long-term” for a subset of investors everyday.
Investors usually save with a specific goal in mind. These goals tend to be time bound: retirement, kid’s education, etc. While their horizons can be “long” at the outset, it gradually shortens as the D-day arrives. Equities (and other high-risk securities) are constantly being sold and rotated into bonds (and other low-risk securities) set by a glide-path.
As much as professionals like to fantasize about long-term investing, the investors in their funds have bounded horizons. This is especially true for open-end funds.
Sentiment + Finite Holding Periods = Volatility
Finite holding periods create the need to transact. This makes it impossible to ignore sentiment. The two combine to create volatility.
It is easy to blame investor greed and fear for bad portfolio outcomes. We have all seen this sketch make the rounds:
However, even if an investor overcomes the call of greed and fear, it is impossible to ignore time. This makes sentiment the prime determinant of investment outcomes.
If you think investors having longer time-horizons can ignore volatility. Think again. As the chart above illustrates, volatility is an equal opportunity hater.
Embrace and Extinguish
Volatility clusters. You have reasonably long periods of calm, then suddenly a lot of things “go wrong.” Markets gyrate and you feel that all hell has broken lose.
This leads investors to assume that periods of calm are normal and volatility is abnormal. But in markets, the reverse is true. Sudden shocks, volatility and jolts to sentiment are the norm. Calm periods are the anomaly.
Sentiments wax-and-wane. Multiples expand and contract. Markets melt-up and melt-down for no good reason.
The only time-tested way of reducing volatility is asset allocation. Invest in a basket of different assets (make sure that at least a few of them a not financialized) and accept the market for what it is.
Embrace volatility and extinguish it.
Looking for a sensible way to invest? Here’s how to get started.
In Where Good Ideas Come From: The Natural History of Innovation (Amazon,) author Steven Johnson lays out a big-picture of how ideas are formed and how to setup an environment that fosters innovation.
Readers in a hurry can stick to the last chapter of the book. That’s pretty much where the meat of the book is.
Take-aways:
It is important to just get started solving a problem. And do it publicly if possible. You may not solve the problem you set out initially but along the way, you will find a solution to something else entirely.
Error often creates a path that leads you out of your comfortable assumptions. Being right keeps you in place. Being wrong forces you to explore. Some of the most important innovations in history have taken a long, messy torturous path.
Markets allow good ideas to erupt anywhere in the system. The decentralized pricing mechanism of the marketplace allows an entrepreneur to gauge the relative value of his or her innovation. If you come up with an interesting new contraption, you don’t need to persuade a government commission of its value. You just need to get someone to buy it.
Business Adventures (Amazon,) is a collection of stories written by longtime New Yorker contributor John Brooks that capture the zeitgeist of the late 60’s.
It is dated and most of the stories are quite boring. And the few interesting ones, like the Piggly Wiggly short squeeze or the Ford Edsel disaster, have been discussed ad infinitum.
Quotable:
Most nineteenth-century American fortunes were enlarged by, if they were not actually founded on, the practice of insider trading. Not until 1910 did anyone publicly question the morality of corporate officers, directors, and employees trading in the shares of their own companies, not until the nineteen twenties did it come to be widely thought of as outrageous that such persons should be permitted to play the market game with what amounts to a stacked deck, and not until 1934 did Congress pass legislation intended to restore equity.
