Author: shyam

Is it rational to be irrational?

Not losing is winning.

“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do.” – Charlie Munger

In 2002, Daniel Kahneman won the Nobel prize in economics for his groundbreaking work in applying psychological insights to economic theory, particularly in the areas of judgment and decision-making under uncertainty. In 2017, the Nobel prize in economics went to his long-time collaborator, Richard Thaler, for exploring the biases and cognitive shortcuts that affect how people absorb and process information. Their books, Nudge, Misbehaving, Thinking, Fast and Slow, went on to become best sellers and hugely influential.

When it comes to investing, their biggest observation is that people prefer to avoid losing compared to gaining the equivalent amount.

This leads to poor investment outcomes because investors use their “lizard brain,” ignoring probabilities and expected returns.

Context matters

Imagine, you are asked to spend a month in a deserted island that has no food. You are allowed to fill a sack with anything you want and take it with you. What will you fill it with?

The “rational” answer is potatoes. It is one of the most nutritious vegetables known to us. It is a good source of many vitamins and minerals, such as potassium and vitamin C. Aside from being high in water when fresh, potatoes are primarily composed of carbs and contain moderate amounts of protein and fiber. (Potatoes 101)

Now, what if you are allowed to take 7 sacks? A normal person would probably still fill one sack with potatoes but go on to fill the other 6 with different types of food. After all, who, in their right mind, would like to eat potatoes every day for 30 days? Economists, however, would label this person “irrational” because he did not take 7 full sacks of potatoes with him.

Rationality is context dependent. By viewing all decisions from within a context-independent model, an economist might arrive at the conclusion that people are irrational. But, so what?

Prospect in Theory but not Prosperous in Practice

Prospect theory, summarized in the chart above, simply states that carriers of value are changes in wealth or welfare – rather than final outcomes. In theory, a smart investor should be able to exploit this irrationality, along with a million other behavioral weaknesses, and make bank. But in practice, the theory has been a bit of a let down in that area.

Thaler is a principal in Fuller & Thaler Asset Management Inc. that runs $6.1 billion in the small-cap Undiscovered Managers Behavioral Value Fund and $261 million in the Fuller & Thaler Behavioral Small-Cap Equity Fund.

After 5 years, these funds haven’t beaten a simple market-cap weighted small-cap ETF.

Fat-tails and Geometric Compounding

In the markets, it is entirely possible to lose years of returns in a single month. Low probability events with high severity can wipe out even the smartest investor.

Combine this with geometric compounding – a 50% loss requires a 100% gain from the bottom to bring the investor to break-even – and the preference to avoid losses doesn’t look that “irrational.”

The model, silly!

Perhaps, the problem is not with people but with the model being used to judge them. There is a big difference between tossing a hundred coins simultaneously and tossing them one after another. Behavioral economics uses a flawed model that treats them the same and labels us “irrational.” But, if you look at the world through the lens of non-ergodicity, actual investor behavior is not too far off the mark.

To make an economic decision, I want to know how my personal fortune grows or shrinks under different scenarios, not how the average person’s fortune grows or shrinks.

I don’t care that the average person “wins” at Russian Roulette, I care about what happens to me if I keep playing over time. Taylor Pearson

Conclusion

While the field of behavioral economics is interesting and it’s a good insight to how people behave in business and investing, one should ask themselves that if bad behavior is so pervasive, then (a) how come investing using that model has been a failure, and (b) if the model labels everything it sees as bad, then perhaps the model itself is wrong?

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Fat Tails, an Introduction

Benjamin Graham described Mr. Market as a manic-depressive, randomly swinging from bouts of optimism to moods of pessimism. While equities and markets exist in perpetuity and can create wealth in the long-term, most investors don’t have the luxury of remaining invested forever. We have extensively discussed the problem of sequence-of-returns risk for investors who have finite investment horizons in our Free Float newsletters (Intro.)

A bigger problem than sequence, is the severity of low-probability events. Also called fat-tails or black-swans.

NIFTY 50 Monthly Returns
NIFTY MIDCAP Monthly Returns
NIFTY 10-year government bond Monthly Returns

While an investor can mitigate an unfortunate sequence of returns through diversification, a market tsunami can hit all assets at the same time.

US/India Equity and Bonds during the Corona Panic

The charts show how years of returns can get wiped out in a month in the markets. While investors mostly focus on the average, the tails end up dictating their actual returns.

While using traditional statistical tools like average, std-deviation, correlation, etc. makes sense 99% of the time, they breakdown during that 1% of the time where an investor needs them to hold. This is the main motivation behind studying tail-risk events.

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Static vs. Tactical Allocation

What makes sense and for whom.

Our first post discussed one of the biggest risk that investors face: sequence-of-returns risk. One way to mitigate this is through asset allocation. You can just put half your investments in equities and half in bonds to reduce your over-all risk. An alternative is tactical allocation. In tactical allocation, you use a signal, like an SMA (Simple Moving Average) or equity valuations to switch between equities and bonds. Here, at any given point in time, you are fully invested in one asset class.

So, which one is “better?”

The answer is, “it depends!”

It depends on the investor’s tax slab and whether it is going to be a lump-sum investment or a SIP. For lump-sums, investors are better off with a tactical approach (bonus if you are in a lower tax slab.) For SIP investors, static allocation makes more sense because you can maintain proportions without selling the over-allocated asset. And, surprisingly, the frequency of re-balance did not matter for static allocation.

Re-balance Frequency for Static Allocation

Our back-test shows that there is no difference to overall returns between monthly and annual re-balance frequencies. Focus on the black line on the following charts.

Monthly re-balance:

Annual re-balance:

Static vs. Tactical – Rolling 10-year Returns

Static allocation returns have been converging with those of the tactical strategy.

Green: static 50/50 allocation, monthly re-balance

Red dot: static 50/50 allocation, annual re-balance

Brown: 50-day SMA, weekly sampling

The above chart reinforces a couple of points we made earlier:

  1. Sequence-of-returns risk is real.

  2. Large impact of when you start and stop your investments (“luck” factor,) is real.

  3. Excess returns in a back-test could be because of high transaction costs or lack of liquidity. In such cases, expect excess returns to diminish as those factors improve.

  4. Barring a couple of instances, annually re-balanced returns were within the range of those that were re-balanced monthly.

Tax impact

If you do a worst-case tax impact analysis on both static vs tactical (SMA) strategies, over the long-arch of time, tactical wins. In the chart below, static allocation is the ALLOC.NET-ST (green) line and tactical is the SMA.NET-ST (red) line.

However, if you are a SIP investor, then you don’t need to sell the over-allocated asset under a static-allocation setup – you could just buy the under-allocated one till it falls back in line. So, if you plot the after-tax returns of tactical allocation with pre-tax returns of static allocation by year:

Years 2011 through now, there is hardly any difference between them. They both turn in annualized gains in the low 7% range – adding about 1.25% over an all equity portfolio.

Summary

  1. For lump-sums, choose tactical. For SIP choose static allocation.

  2. Don’t ignore bonds. There are periods where a bulk of the returns are driven them.

  3. Don’t ignore the role of taxes in DIY. For example, a mutual fund that wraps the SMA strategy would enjoy a 2+ % boost in annualized returns.

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Tactical Allocation, An Introduction, Part II

We introduced tactical allocation in our Free Float newsletter last week. We saw how, by using a simple moving average to toggle between equities and bonds, one can reduce drawdowns in their portfolios. In the ensuing discussion, we mentioned how excess-returns found during back-tests could be an artifact of illiquidity and high transaction costs of the markets in the past. It is not like people who traded markets before us were dumb (or somehow, we suddenly added 50 IQ points in the last 20 years.) There has to be a reason why the money was left on the table.

Indian markets have seen significant changes over time. It has got more deeper and wider with better liquidity, lower transaction costs and higher levels of automation. One way to gauge the efficacy of strategies is to use a metric like Sharpe or Information Ratio over rolling-windows through time. Also, the drivers of total returns in allocation strategies will be different across different time-horizons leading to different tax liabilities. It is useful to decompose returns to handicap them from a tax angle.

200-day Tactical Strategy
50-day Tactical Strategy
  • There are quite a few time-periods where tactical allocations will under-perform buy-and-hold equities.
  • Over a 10-year horizon, on an annualized basis, bonds have contributed about 1-4% to over-all returns.
  • Sharpes have been falling through time. One should expect this strategy to attenuate further.
  • Bonds have a bigger say in determining over-all returns in low equity return environments. So, use both assets!
  • Bond returns have been less volatile that those of equities’. However, that doesn’t mean that have been constant through time.
With and without bonds

In high equity-returns environments, bonds are usually an after-thought. However, running these strategies “equities-only” is ill-advised. In the chart above, returns in the recent 10-year periods have been palatable only because of the returns contributed by bonds.

Our personal experience has been that when equities drawdown, investors switch over to tactical strategies, only to abandon them once stocks recover. Thus, leaving their downsides exposed during the next drawdown; ensuring that they end up with the worst of both worlds.

Excess returns aside, SMA strategies are also useful in managing risk. With lower risk, one can employ a bit of leverage to boost returns. We have done deep-dives into variations of these strategies in the past. Interested readers can have a look at our SMA Collection.

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Book Review: This Is Not Propaganda

In This Is Not Propaganda: Adventures in the War Against Reality (Amazon,) Peter Pomerantsev lays out how the very tools that “democratize” information has been turned against democracy itself.

We live in a post-fact world where we are caught in a social-media driven doom-loop:

Social media is a sort of mini-narcissism engine that can never quite be satisfied, leading us to take up more radical positions to get more attention. It really doesn’t matter if stories are accurate or not, let alone impartial: you’re not looking to win an argument in a public space with a neutral audience; you just want to get the most attention possible from like-minded people.

It’s a lamentable loop: social media drives more polarised behaviour, which leads to demands for more sensationalised content, or plain lies. ‘Fake news’ is a symptom of the way social media is designed.

Social media technology, combined with a world view in which all information is part of war and impartiality is impossible, has helped to undermine the sacrosanctity of facts.

Peter Pomerantsev in This Is Not Propaganda

The book came out in 2019 and my personal experience has been that things have become worse. We now have WhatsApp groups where people self-select to receive the version of truth they desire. Political parties have setup up hundreds of such groups to make sure that we always hear what we want to hear.

While it is easy to blame social-media and messaging apps for the current state of polarization, traditional media has also embraced the post-fact world.

About The New York Times, for example:

Under Sulzberger, “there has been a heavy investment in the growth of opinion at the Times,” the journalist continued, noting that Bennet is a friend. “That was something that A.G. wanted and approved, because it drives their subscription strategy. New York Times readers like to read opinions—especially opinions that align with their own—and they increasingly don’t like to read opinions that don’t align with their own.”

The Daily Beast

We often don’t appreciate what we have and take the current state of the world as granted. However, democracy, freedom and progress are all recent occurrences. For the the vast majority of human history, monarchy, serfdom and stagnation was the norm. If we can’t even be bothered to be informed, do our choices mean anything? Before we know it, we’ll be back to the dark-ages.

Recommendation: Worth a read.

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