Saturday, January 16, 2016

Mortal and Venial Sins in Investing

Financial markets have been roiled in 2016 on fears that China's economy continues to slow, and that the Fed will pursue a more hawkish tightening path than anticipated (the two are related, indirectly by the Fed's status as a monetary superpower, and directly by the RMB's link to the dollar). It has once again been a time to reflect on the challenges a fundamental investor faces. Macroeconomic concerns are hard to weigh when you're considering places like the US, and considerably more so when you're trying to assess an opaque economy in transition like China. So should an investor simply throw his hands up in the air?

I see a few potential strategies.

1. Learn all you can about macro. In his outstanding paper "Investing in the Unknown and Unknowable", Richard Zeckhauser notes the outsize returns to investors who can marshal complementary skills. Being a sophisticated macro observer has always seemed to me one such complementary skill. Some of the greatest trades of all time incorporate macro elements, whether intended or not. But I suggest with this a fair amount of trepidation. First, much of macro is unpredictable, and the product of a complex adaptive system, so it seems like a poor use of time trying to analyze it. Second, even where macro knowledge is helpful, there is a trade-off of time spent on macro analysis vs. asset-level analysis (such as knowing more about a company whose stock you own). Third, an excessive focus on macro fluctuations can lead to distraction from long-term trends, and prevent fundamental investors from appreciating the positive outlook for assets. So, perhaps the best idea is to focus on understanding the long-term drivers of economic growth, and to avoid being swept up by emotion during cyclical booms and busts. 

2. Invest in assets that are relatively insensitive to economic fluctuations. There are two variants of this strategy. The first is to invest in assets whose prices are relatively stable. This will likely lead an investor into low return strategies like investing in government bonds. For obvious reasons, I don't recommend this, even if it will help you sleep better at night! The second variant is to look for assets whose prospects are relatively bounded in a variety of economic scenarios (note there is often a great deal of overlap between these two variants: it is precisely their occasional divergence that is worth exploiting). The traditional version of this is to invest in various types of utilities. But there are obviously many high quality businesses out there who are resilient to most economic downturns, through a combination of competitive positioning and financial strength. These businesses generally trade at premium valuations (i.e. with low implied returns) for that reason, so when they go on sale, it's best to be prepared to act swiftly.

3. Be realistic. Understand that there will be ups and downs in any portfolio. Just as important, one has to differentiate between forgivable and unforgivable mistakes. Or, to draw a parallel to Roman Catholicism, we should differentiate between venial and mortal sins in investing. Charlie Munger has a great quote: "I like people admitting they were complete stupid horses' asses. I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn." But there's a limit to how harsh we should be with ourselves. I'm constantly wary of being a pattern-seeking, story-telling animal. It's okay not to know whether Chinese growth will be 3% or 6%. It is much less okay to lose money on a company that is modestly cheap if Chinese growth is 6% and in dire straits if growth is 3%. 

If I had to highlight one unforgivable sin in investing, it is getting swept up by emotion at market tops or bottoms (only identifiable in retrospect, unfortunately). But what's worse is that we have a tendency to compound these errors. It is really, really not okay to lose sight of the long-term prospects of a wonderful business, sell one's stake in that business, and compound that error by refusing to buy at a higher price. So, if you make a mistake, so be it - wipe the slate clean, lest a venial sin turn into a mortal one.

I wish all readers a happy, productive and - just maybe - sin-free 2016.

P.S. John Huber has an excellent post touching on some similar themes. 

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