A couple days ago I listened to one of the worst investment pitches I have ever heard. Its manifest awfulness had nothing to do with the investment strategy on offer and everything to do with the presenter.
My colleagues and I endured approximately half an hour of some guy literally shouting at us about how great this fund was and how the fund’s investments have averaged 24% IRRs. The presenter paced like a caged animal for the duration of his monologue, punctuating the pitch with exclamations of “got it, people?!” and “okay, people?!”
I imagine this is kind of what it was like listening to Mussolini speak publicly (if Mussolini had been a real estate guy, anyway). Browbeating prospects into submission was the cornerstone of this guy’s sales process. Not a good look.
Of the myriad varieties of aggressive salespeople, aggressive financial salespeople are probably the most hazardous to your wealth. They are almost always selling you something pro-cyclical and frequently there is financial leverage on top of the cyclicality. (Where do you think the 24% IRRs come from?) This is stuff with significant go-to-zero risk. Caveat emptor.
Nonetheless, I’m fascinated by the psychology of aggressive salespeople. They are okay at making money but in my personal experience at least pretty lousy at hanging on to it. I think that has to do with pro-cyclicality, willingness to take on lots of leverage and a general predisposition toward gambling. These guys live like Thanksgiving turkeys.
Early in my career I had a number of colleagues who spent time in subprime lending. One of them described how at the peak of the cycle the reps would all be driving sports cars. Then when the cycle rolled over tow trucks would show up to repo the cars as the reps defaulted on their auto loans, same as their customers. You would think people in the subprime lending business would have a better grasp of the credit cycle. But you would be wrong.
To me this is further anecdotal evidence that pro-cyclicality and herd behavior are hard-wired into human nature. But it doesn’t make listening to obnoxious salespeople any easier.
Unwillingness to define a circle of competence = “Dumb”
Inability to define a circle of competence = “Dumb”
Overestimating your own intelligence = “Dumb”
Overestimating the impact of intelligence on outcomes = “Dumb”
Believing intelligence translates into control of outcomes = “Dumb”
There are many dimensions to intelligence. Yet we tend to talk about intelligence in a reductive way. As if it is somehow straightforward to separate the world into the “smart” and the “dumb.” By the standard of raw IQs the folks on Wall Street responsible for creating synthetic CDOs circa 2006 were frighteningly intelligent. Look what they wrought.
People with low IQs tend not create really bad outcomes. At least not at the level of society at large. People with low IQs are rarely put in a position where they have that much power and influence.
Really bad outcomes result from “smart” people overestimating their intelligence. They result from “smart” people mistakenly believing being “smart” allows them to control outcomes in complex systems. And they result from “smart” people being coerced into doing dumb things by warped incentive systems.
[W]e rarely recognize that most investment debates – debates that literally make markets – are just a reflection of people making different decisions not because they disagree with each other, but because they view investing with a different set of priorities.
If you’re trying to maximize risk-adjusted returns you have no idea why someone would buy a 10-year Treasury bond with a 2% interest rate. But the investment probably makes perfect sense to Daniel Kahneman. Paying off your mortgage with a 3% tax-deductible interest rate is probably crazy on a spreadsheet but might be the right move if it helps you sleep at night. Trading 3X leveraged inverse ETFs is financial suicide for some and a cool game for others. Long-term investors who criticize day traders bet on football games because it’s fun. People who scream at you for over-allocating into REITS buy six-bathroom homes for their four-person family. The flip side of Daniel Kahneman is the billionaire who risks his valuable reputation to gain money he doesn’t need. Have you been on Twitter? People see the world differently.
Two rational people the same age with the same finances may come to totally different conclusions about what’s right for them, just as two people with the same cancer can pick radically different treatments. And just as medical textbooks can’t summarize those decisions, finance textbooks can’t either.
This isn’t just about differences in risk tolerance.
People who work in finance underestimate that watching markets go up and down isn’t intellectually stimulating for most regular people. It’s a burden. And even if they can technically stomach investment risk, the added complexity robs bandwidth from other stuff they’d rather be doing. The opposite is true. Claiming your investment product is entertaining is usually the refuge of those who can’t point to performance. But it’s crazy to assume that many people don’t find investing incredibly entertaining – so much so that they rationally do nutty stuff regardless of what it does to their returns.
Everyone giving investing advice – or even just sharing investing opinions – should keep top of mind how emotional money is and how different people are. If the appropriate path of cancer treatments isn’t universal, man, don’t pretend like your bond strategy is appropriate for everyone, even when it aligns with their time horizon and net worth.
Here are some areas where I think personal values and priorities will play a significant role in your view of optimal portfolio construction:
Definition of risk. Do you define risk as volatility (“prices going up and down a lot”), or as permanent impairment of capital (“realizing losses in real dollar terms”)?
Definition of performance. Are you focused on absolute performance (“I want to compound my capital at 10% annually”) or performance relative to a benchmark index (“I want to outperform the S&P 500”)?
Tax sensitivity. Are you someone who will spend $1.05 to save $1.00 in taxes based on “the principle of the thing?” Or are taxes just something you have to deal with if you want to make money?
People who use volatility as their risk measure, focus on relative performance and are extremely tax sensitive tend to gravitate toward passive investing strategies. Those who define risk as permanent impairment of capital, focus on absolute performance and are less tax sensitive might favor a more active approach.
Really think about it. My gut response used to be, “to replace my future income,” as I’ve discussed here. However, this response was incomplete. I say incomplete because it seemed too cold and mathematical. It was not based on my personal values. Investing without considering your values is like having the fastest boat in the middle of the Pacific Ocean with no set destination — no matter how fast you go, you will always feel lost. Chasing riches without knowing why you truly want them is a surefire path to lifelong misery.
You might be skeptical, but think of the countless investors who have lost their fortunes, their families, and their freedom pursuing money without purpose. Don’t get me wrong, some of these individuals may have valued the idea of having the most money, but I would guess that they are actually trying to fill a deeper psychological need (i.e. being respected intellectually) instead.
Read the whole thing. This is a foundational issue and will have a dramatic impact on how you view the markets and various investment strategies. I spend a ton of time (arguably too much time) thinking about this.
Why I Invest
#1 – To attain financial independence. Financial independence is a tricky thing to define. For some people that is hanging out and playing a lot of golf. For me, financial independence boils down to “F*** You Money.” That is, having the flexibility to choose when, how and for how much money I am willing to work. I live a pretty minimalist lifestyle and am not located in a high cost of living part of the country. Based on my current budget I think I could live off $36,000/year without substantially compromising my lifestyle. Throw in a couple kids and maybe that moves up somewhat. So I view attaining financial independence as a reasonable goal.
#2 – I love the game. That is, I love investing as a purist. I love doing research, and combining that research with strategy and tactics based on what is going on in the markets. I love that the risk/reward tradeoffs in the markets are always shifting, and that the game is always changing. To me, investing is basically the greatest strategy game ever devised.
Reason #2 is why I write this blog. Reason #2 is also why much of what I write here pokes fun at the investment management business and the financial advice complex.
What passes for “investing” in those contexts is often really just an exercise in “getting market exposure.” If all you are really doing at the end of the day is getting market exposure, you should make sure you are doing it in a cost effective and tax efficient manner. From there you are welcome to run in endless circles debating whether this one particular guy happened to be lucky or skilled in beating the market over a particular trailing 15-year period.
Hence why I find the active versus passive debate so tedious. As my career progresses and my values come into focus I am less and less interested in that discussion. Ultimately, if you are providing financial advice, the “best” thing to do mostly comes down to the specific client you are working with, and that client’s goals and values.
If I know someone’s goals and values, it is easy to go to my investing toolbox and say:
“Well, you are a 22-year old with no debt who inherited $10,000, and you have no particular interest in investing other than ‘putting the money to work’ in an abstract sense, and you are modestly concerned about the price going down ‘a lot.’ Given the circumstances something cheap and simple fits the bill. Here is [an index fund or a low cost, diversified active fund]. Let’s touch base again in a year to see if your circumstances have changed. Life comes at you fast in your 20s.”
“Oh, so you are very high net worth, former C-Level executive, and would like to earmark 20% of your portfolio to generate extraordinary capital appreciation. You are hyper-aggressive as an investor and your net worth is such that you’re not going to destroy your legacy if some of this stuff blows up. By the way, it can ALWAYS blow up. There are no guarantees in this world. And going this route will incur higher management and due diligence costs. All that said, to have a snowball’s chance in hell of generating that level of capital appreciation we need to look at private equity, single manager hedge fund investments, maybe a very highly concentrated portfolio of individual stocks.”
Why It Matters
Where you run into real problems is when you build a portfolio out of sync with your values. What happens is that you start doing stupid things as you attempt to “tweak” things to your liking. If you are an advisor and you have a client in the wrong portfolio, the client will eventually fire you. The CFA Level III Curriculum actually teaches a couple of mental models for dealing with this issue.
The first model involves classifying investors into Behavioral Investor Types. There are four main types. Obviously most people share some characteristics of different types but I bet if you are honest with yourself you can sort yourself into one of the four:
Passive Preservers: These are individuals who accumulated wealth primarily through diligent saving, and not through risk taking. A significant portion of their overall net worth may be in the form of defined benefit pensions or social security. Passive Preservers are characterized by risk aversion and low levels of investing knowledge. My mom is a textbook Passive Preserver. The biggest risk for a Passive Preserver like my mom is that she will not take enough risk in her portfolio, and that inflation will erode her wealth in real terms over time.
Friendly Followers: Friendly Followers chase fads (and thus performance). They tend to buy high and sell low, and rationalize those decisions in hindsight. The main risk to a Friendly Follower is that he whipsaws his net worth into oblivion over time by constantly buying high and selling low. Friendly Followers often display acute Fear of Missing Out (FOMO).
Independent Individualists: If you are reading this blog, I suspect you are an independent individualist (or at least have that streak running through you). Great! We share the same behavioral investor type. I hardly need to tell you that for us, making up our own minds is paramount. If someone tries to force feed us instructions, we will push back. Our greatest asset as investors is our predisposition toward contrarian thinking. However, as a fellow Independent Individualist I will tell you our greatest weakness is confirmation bias. Once we make up our minds, we tend to seek out information confirming our views and spend less time and energy considering evidence that may contradict them. This can lead us to overlook or downplay certain risks.
Active Accumulators: Active Accumulators have generated significant wealth via risk taking. These individuals tend to be entrepreneurs, business owners and senior executives. They are extremely aggressive and confident investors (their confidence is rooted in their past business successes). Active Accumulators tend to take too much risk, in too concentrated fashion. They also tend to discount the impact of randomness on investment outcomes. The biggest risk for an Active Accumulator is that he (yes, they tend to be men) blows up his portfolio with a concentrated bet. On the flipside, their risk tolerance can also allow them to win big when they are right.
Now when you think about these types, you can probably get an idea of who is more suited to passive investing versus active. The CFA Institute material has a nice diagram that ties it all together:
The trick is to tailor your investment program to your behavioral type. Now, on occasion you will have a situation where someone’s biased preferences cause him to do things that put his standard of living at significant risk. In that situation you have to evaluate the level of risk to decide whether to attempt to moderate the behavioral bias or simply adapt the portfolio to the bias. Which leads to the second model:
The more emotionally driven your behavior, and the lower your standard of living risk, the more flexibility you have to adapt the investment strategy to your behavioral type.
Of course, understanding your values and behavioral type also helps in the selection of a financial advisor if you go that route. Different behavioral types need different things out of an advisor:
Passive Preservers need a counselor.
Friendly Followers need a teacher.
Independent Individualists need a sounding board and/or devil’s advocate.
Active Accumulators need a sparring partner and/or punching bag.
Q: Because you have been so successful, let me ask you this: What is the secret to success?
Bogle: People often ask me what the secret to success is, and I say, “I absolutely have no idea.” In fact, I don’t use the word success. But I think it has something to do with working a little harder and a little longer than everyone else on whatever job you are given or task you are doing. Do a better job on it than everyone else, and the rewards will come. From this perspective, at least, the secrets to success are not very mysterious.
Some people will never have passion for anything because that is the type of person they are. Being yourself is very important. This is true whether you are dealing with your associates or your clients because people can spot a phony a mile away.
Figure out who you are, and try to follow a career that fits with who you are. Woodrow Wilson wrote a book titled When a Man Comes to Himself. I came into myself, to be honest, when I was probably 11 years old. I figured out who I was and what I wanted to do in life very early–too early, you could argue. Most people start to get a good sense of who they are probably in their early 20s, some in their 30s or 40s, and some never. Some people never get to know who they are.
People need to ask themselves, “Am I the kind of person I want to be? Am I filling a role in life, in the community, and in society that I want to fill? Am I comfortable in my own skin? Where does being a good spouse and parent fit in with a career?” People should consider all those kinds of things.
There is a neat post on Redfin’s blog. It is the CEO’s “IPO diary.” Read the whole thing for a fascinating look at the process from the inside. A couple of sections really resonated with me:
Masters of the Universe
In other ways too, the roadshow had the feel of a bygone era. For example, almost everyone on the buy-side we met that week was a man: in one group lunch, all 24 of the portfolio managers in attendance were male. We may have met more portfolio managers who were Israeli special forces veterans than women. I asked our bankers how long it would take the first one to kill me with his bare hands.
Almost all of them took notes on tablets. Some of them tried to look up as you spoke, but with their eyes focused on nothing except the numbers in their head. They weren’t just capturing the highlights of a meeting; it was a nearly verbatim transcription of what we’d said, so we could be held accountable for it later. Information in every form is the currency of Wall Street, and drops of it never seem to fall on the floor.
Chess with Bobby Fischer
Most of the fund managers were exotically, obviously smart. Except for one person who fell asleep in a meeting, none of the fund managers we met was anyone I’d want to be on the other side of a trade with, buying what he sold, or selling what he bought. This is what I realized I had been doing my whole life as an E-Trade stock-picker; it had been like challenging Bobby Fischer to a game of chess. I spent a long time that first week trying to judge whether it made sense to have so many brilliant people decide where our society allocates capital, as opposed to making cars or software or hospitals.
The Last Ideology-Free Realm
What impressed me most about these people was their willingness to change their minds. No one in our society seems to change her mind about Donald Trump or Hillary Clinton based on a new fact, but a fund manager on the wrong side of a bad trade has to change her mind in a moment or lose her job. This is why investing is the world’s last ideology-free realm. It would be easier to accept the premise that our society can’t agree on one version of the truth anymore, about whether temperatures are rising or the economy is growing, except that’s exactly what happens when every public company reports its earnings every quarter. You can believe what you want to believe, but not with a million dollars on the line.
And, perhaps most interesting to me:
The Last, Best Order
One of my favorite meetings was with a Scottish fund manager in San Francisco. His firm was known for buying only a few stocks, and holding each for as long as a decade. In a hotel meeting room with enough prospectuses, pitchbooks, cookies, fruit, cheeses, crackers and popcorn for 30 people, he came in alone. And rather than rattling through twenty or thirty questions about our metrics, he just asked me why I ran the company.
I found myself talking about my older brother, who had died just before I became Redfin’s CEO, and the feeling I had then that my life so far hadn’t made the world a much better place. He asked me about whether Redfin’s sense of mission would survive our public offering. He didn’t write much down. His order was one of the last, and the best, to come in.
My aspiration as an investor is to be that “last, best order.” There’s a reason I classified this post under Finance, Investing, Learning and Values. There is some real insight here.
They say there is nothing new under the sun and so when I started thinking more deeply about philosophy, The Meaning of Life, etc. a few years ago I should not have been surprised to find myself drawn to a philosophy developed over 2000 years ago!
Today I encountered this quote from the philosopher Epictetus:
Don’t let the force of an impression when it first hit you knock you off your feet; just say to it: hold on a moment; let me see who you are and what you represent. Let me put you to the test.
This is something to meditate on as an investor as well as an individual. As you go about your day, think of all the people and ideas you dismiss out of hand.
Are you dismissive about these people and ideas based on reasoned thinking? Or are you just making snap decisions for convenience?
How many people and ideas do you write off each day for no reason other than that they offend your preconceived notions of how the world works?
When you think about things this way, you will quickly discover surprisingly little of what you believe is reasoned from first principles. This isn’t something to be ashamed of! In fact it is intensely liberating. It means that life is not a test you pass or fail. Rather it is unknown territory for exploration. Life is an adventure, and you are the hero! What is more exciting than that?
I am a fan of parsimony, in both financial modeling and life. In the spirit of parsimony, I think I can distill my core values down to three quotes from Marcus Aurelius’s Meditations:
Be like a rocky promontory against which the restless surf continually pounds; it stands fast while the churning sea is lulled to sleep at its feet. I hear you say, “How unlucky that this should happen to me!” Not at all! Say instead, “How lucky that I am not broken by what has happened and am not afraid of what is about to happen. The same blow might have struck anyone, but not many would have absorbed it without capitulation or complaint.”
When you wake up in the morning, tell yourself: The people I deal with today will be meddling, ungrateful, arrogant, dishonest, jealous, and surly. They are like this because they can’t tell good from evil. But I have seen the beauty of good, and the ugliness of evil, and have recognized that the wrongdoer has a nature related to my own—not of the same blood or birth, but the same mind, and possessing a share of the divine.
Words that everyone once used are now obsolete, and so are the men whose names were once on everyone’s lips: Camillus, Caeso, Volesus, Dentatus, and to a lesser degree Scipio and Cato, and yes, even Augustus, Hadrian, and Antoninus are less spoken of now than they were in their own days. For all things fade away, become the stuff of legend, and are soon buried in oblivion. Mind you, this is true only for those who blazed once like bright stars in the firmament, but for the rest, as soon as a few clods of earth cover their corpses, they are ‘out of sight, out of mind.’ In the end, what would you gain from everlasting remembrance? Absolutely nothing. So what is left worth living for? This alone: justice in thought, goodness in action, speech that cannot deceive, and a disposition glad of whatever comes, welcoming it as necessary, as familiar, as flowing from the same source and fountain as yourself.
Here is how I read and apply these as core principles for living:
Quote #1: Strive to stand strong in the face of the chaos and tumult life inevitably brings. This striving creates meaning, and allows you to shape your sense of self.
Quote #2: All human beings are worthy of dignity and respect. At the extreme, even those who seem “bad” or “evil” share many of our traits. On a less extreme level, those we disagree with generally have good reasons for believing the things they do. Strive to empathize and understand a person’s reasoning before rushing to judgement. In doing so you will develop a richer understanding of the world and the people around you.
Quote #3: Wealth, power and status are at best impermanent. It is nice to have them, but they do not create meaning in and of themselves. Wealth, power and status are all subject to the wheel of fortune. They are impermanent. Ask yourself: in a post-apocalyptic hellscape, where wealth and status are irrelevant, how would I create meaning? (see also: The Road by Corman McCarthy)
I have come to look at life as a game. Not that game. More like Settlers of Catan. In life, as in Catan, everyone starts in a certain position. That position is partly determined by chance. As a result, initially everyone has access to different resources.* Strong players do not use their starting position as a crutch. They find creative ways of gaining access to resources over time. Trade and relationship building are key.
In my experience, the majority of players in life are weak ones. That’s not to say they are weak people. Just weak players. There are lots of ways to explore this distinction but because of this blog’s theme, let’s start with money.
I have met many individuals who are slaves to their money. For these people money is always a limiting factor. There is never “enough” money for X, Y, or Z. Note that this is independent of income. You would be surprised how many hedge fund managers are slaves to their money, even with net worth figures in the hundreds of millions of dollars. Weak players do not realize that income and spending are not external forces acting on otherwise hapless human beings. Money is a resource. It is a raw material you use to design and build a meaningful life.
The use of the indefinite article “a” versus the definite article “the” is quite intentional here. Money is hardly the only raw material required to build a meaningful life. Other materials include empathy, creativity, compassion–the amount of each required to build out a meaningful life will vary with the individual.
The key to becoming a strong player in The Game of Life is to locate control within yourself. You are the architect and head contractor on the project of living. Yes, external forces can have a dramatic impact. But a surprising amount of the game lies within your locus of control.
Thus, strong players tend to do the following:
Make investments with convex return profiles. I am not just talking about money here. This can be any decision to improve your education, skills, or health. When you invest in yourself, the benefits tend to compound over time. If you are interested in a deeper discussion of this, listen to this interview with Chris Cole: http://investorfieldguide.com/cole/.
Selflessly invest in others. Again, I am not talking about financial investments. Doing simple things like taking a few minutes to do an informational interview with a job seeker, or helping a co-worker with a project in an area of your expertise, also has a convex return profile. Not only does it feel good to help other people, but it also helps build a stronger relationships and a solid reputation. You never know who someone else might know, and it is relationships that make the world go round. And for the umpteenth time, I am not just talking business! John Wathen is a powerful example.
Practice optimism. It is difficult to build anything, let alone a worthwhile life, if you only ever see the worst in everything. A moderate dose of cynicism will not put you down. However, chronic pessimism is an incredibly destructive thought pattern. Pessimists tend to focus on external forces they can’t control, versus aspects of their daily lives they control completely. You have definitely met chronic pessimists. These are the people who spend their lives hurtling from one crisis to the next. They are chronically ill. They are constantly distracted by relationship problems. There is never enough money and it is always someone else’s fault.
Minimize/eliminate the role of chronic pessimists in life. As a natural consequence of their unpleasant disposition, chronic pessimists are not enjoyable people to spend time around. They drain your energy. If you have the misfortune to work on a team with one you will quickly realize they are shirkers, ever-reluctant to pull their weight. Unless you have a special gift for coaching and leadership, the most efficient way to deal with chronic pessimists is to cut them out of your personal life and workplace.
Above all else, however, strong players in the game of life act with intention. They think through the consequences of their actions ahead of time. They think strategically about how they should deploy their time and financial resources in pursuit of their goals. They are mindful of their thoughts and emotions and how those may influence perception and behavior. They understand that to a great extent, people create their own realities. There is probably plenty more to be added to this list, but the way I see it these are the essentials.
* If you are curious, I believe the role of government in society is to promote equality of access to opportunities.
If you haven’t picked up on it in other posts, I have a moderate interest in eastern philosophy and religion (Taoism, Buddhism, etc.). I also enjoy listening to Wu-Tang Clan. So when my girlfriend bought me The Tao of Wu by the RZA for Christmas I read it in about two hours.
The RZA’s life journey has been truly extraordinary, taking him from the projects of Staten Island to Manhattan sound studios and even Hollywood (among his producer credits is the soundtrack for Kill Bill: Vol. 1). The Tao of Wu describeshis spiritual journey.
The Tao of Wu is structured as an autobiography, with occasional digressions into areas as diverse as the theology of the Nation of Islam and its various derivatives, the interpretation of Buddhist koans and chess strategy. To the casual observer this might seem like a gimmick, but I found many of the anecdotes to be thought provoking and evocative of the cyclicality emphasized in Buddhism and Taoism.
Early on there is an anecdote about how, when RZA was young, his family moved into a new home and was almost immediately robbed. The robbery was devastating. However, there was some consolation in that the move allowed RZA to make a great friend–an older neighbor boy. After a couple of years of friendship came a surprising revelation:
‘When y’all first moved in, I robbed your house maaan. I never knew you was going to be a cool family.’ When he told me, there wasn’t much I could do about it, and by then he was my best friend–or as they say in the hood nowadays, my big homie–so in a way it was cool.
That’s just one lesson: Your allies can arrive as enemies, blessings as a curse.
Each chapter of the memoir is devoted to a particular “pillar of wisdom.” These are followed by brief meditations or words of wisdom. At the end of the first chapter, for example, comes a passage discussing the importance of solitude.
“I advise everyone to find an island in this life,” RZA writes. “Find a place where this culture can’t take energy from you, sap your will and originality.”
Who Should Read This Book
Literally everyone. Obviously Wu-Tang fans should read it, and it’s worth a look by anyone interested in eastern philosophy and religion. But beyond those obvious audiences the subject matter is accessible to everyone. If you read fast, you can take a first pass through the book in two or three hours. Given its meditative tone, The Tao of Wu is also worth keeping on the shelf to revisit from time to time.