“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II
Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.
And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.
Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.
So it is with the sell-side.
We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.
I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?
Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.
Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.
Sure, this stock trades rich, but our analysts can see a path higher from here.
How many times have you heard this stuff? Or stuff that rhymes with this?
Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.
That doesn’t mean you can’t go to lunch with the sell-side.
It doesn’t mean you can’t use research from the sell-side.
It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.
If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.
And it’ll cost you.
*The next recession is always at least a couple years away.
Money is a funny thing. As a unit of exchange it is the raw material for consumption (or, if you prefer, the deferral of consumption). We express who we are through our spending. It’s no surprise then that the answer to “how much is enough?” varies wildly from person to person. But really what it boils down to is an optimization problem.
Contrary to what people think, the hard thing about answering “how much is enough?” is not calculating a dollar amount. The hard thing is deciding what constraints to apply to optimization. Once you do that, the calculations pretty much fall into place on their own.
At a high level, we are looking at the following function (let’s call it the Enough Function):
Enough = Present Value of (Future Lifestyle Spending + Future Basic Needs Spending + Desired Margin of Safety)
Obviously you can disaggregate each component (Basic Needs Spending would break down into line items like “Housing” and “Essential Food”). For the purposes of this post I’ve opted for brevity.
In principle optimizing the Enough Function is pretty straightforward. In practice people find it difficult for a couple of reasons. For one, most people live like sheep. They follow the examples set by advertisers, movies, TV shows and the people around them.
We can partly blame evolution for this. A million years ago if you didn’t fit in with the rest of your tribe you would be ostracized and could look forward to dying cold, hungry and alone. We are a long way from those days and yet our evolutionary programming dies hard. Most people have not spent much time thinking what actually gives their lives meaning. So they look for meaning elsewhere.
On a more mundane level, quantifying a margin of safety can also be tricky. There is just no way to gain absolute certainty. Margin of safety is best addressed with scenario analysis, which is beyond the scope of this post. In fact, for people who are totally lost when it comes to this stuff, a good reason to hire a professional financial planner is to delegate the analytical work to someone with expertise.
I don’t have a position on whether it’s “better” to live frugally or not. If we’re looking at the continuum of spending patterns, with Mustachianism on the frugal end and Kardashian-esque conspicuous consumption on the other, I suspect most people plot somewhere in the muddy middle.
Personally, I tilt a little more toward the frugal end of the spectrum. The main reason for this is that most of the things I enjoy doing (reading, writing) are not particularly expensive pursuits. But do I think people who want to drive nice cars and live in big houses and spend lots of money on clothes and jewelry are “doing it wrong?” No. Their Enough Functions are just optimized for a different set of constraints.
The Root Of All Most Financial Problems
Financial problems result from mismatches in the optimization of the Enough Function and the financial resources at hand.
It is okay to make a ton of money and live the high life. It is not okay to make very little money and live the high life. Unless you are optimizing for a crushing debt load and eventual bankruptcy, of course. Fortunately, if you find yourself in this position there are a couple levers you can pull: spend less or make more money.
Like I wrote above, this stuff is really simple in principle. The challenge comes in the implementation, but it’s mostly a challenge of self-discipline (on the spending side) and hard work (on the income side).
I think of myself as a reasonably intelligent person. I like to imagine myself as an independent thinker who is reasonably well-read. So for a long time, it was nearly impossible for me to say “I don’t know.”
I think there were several contributing factors here. Youthful arrogance (it seems young people chronically overestimate their competency); ambition (“it is good for my development and career prospects to be seen as capable and intelligent”); anxiety (“if I cop to ‘not knowing’ I am admitting I am not as smart and well-read as I line to think”).
These days I try to make “I don’t know” my default answer.
Charlie Munger models this behavior well. I read a transcript of the most recent Daily Journal Meeting, and it’s littered with stuff like this:
Question 2: My question relates to BYD. Given that you’ve successfully invested in commodities in the past, how do you view investing in things such Cobalt, Lithium, and Helium as technologies of the future?
Charlie: Well I’m hardly an expert in commodity investing, but certainly cobalt is a very interesting metal. It’s up about 100% from the bottom. And it could get tighter, but that’s not my game. I don’t know much about…I haven’t invested in metals in my life much. I think I bought copper once with a few thousand dollars. I think that’s my only experience.
Question 8: Your thoughts on the valuation of software companies like Apple, Facebook, Google, Amazon, Alibaba. Are they over-valued, potentially under-valued, too early to tell?
Charlie: Well my answer is I don’t know. (laughter) Next question. (laughter)
There are a couple of important benefits that come with a willingness to say “I don’t know.”
The first is that it helps combat conformation bias. Of all the behavioral biases, the one I suffer most from is confirmation bias: a tendency to seek out only information that confirms my (usually contrarian) view. Openly admitting “I don’t know” helps me maintain a more open mindset, and to loosen my grip on my ideas. If you get too entrenched in a position you risk developing what Dealbreaker jokingly refers to as “Ackmania.” Or some new strain of it, anyway.
Also, when you say “I don’t know” in conversation with someone else, you leave them an opening to teach you something new. No only that, but you are likely to develop a deeper relationship with that person. People love to talk about themselves and their areas of expertise.
Now, I am still more than willing to hypothesize about different things. Sometimes, for entertainment purposes, I even frame these hypotheses as statements of facts. But in my mind they are still just hypotheses.
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.