Time Horizon Alignment

In a previous post I discussed the idea of time dilation. Time is not absolute. This idea comes to us from physics, which is a fairly exacting and mathematical discipline. The measurement depends on the relative velocity of the observer and whatever it is she is observing. It’s relative. Hence, “relativity.”

Likewise with portfolio management, the velocity of activity in your portfolio will tend to reflect your investing time horizon. Someone managing money trying to think about what a business will look like in a decade may go entire years without placing a single trade. However, this is unlikely to be the case for someone operating on a one to three year time horizon. Especially if that person is managing other people’s money. And doubly so if the other people whose money is being managed are evaluating performance on a quarterly or annual basis.

The tendency among institutional investors these days is to track performance on shorter and shorter intervals. I follow hedge funds that provide weekly performance estimates. This despite offering quarterly liquidity or less! I haven’t the slightest idea what someone is supposed to do with that information. It’s random noise. (Someday I mean to do a piece on the collective delusions of institutional investment committees)

I am convinced the way you should deal with this is to scale your input data to your time horizon. So for example if you are trying to puzzle out what a business might look like in five or ten years you probably should limit your focus to annual reports and proxy statements (at least once your initial due diligence is done). Even quarterly results are likely to introduce a lot of unwelcome noise into the picture.

What if something material changes halfway through the year?

Well, you can still risk manage the portfolio on more frequent intervals (an underlying assumption here is that you are thesis-driven versus trading on technicals). If something nasty, unexpected and material happens to a stock halfway through the year you are going to see it sell off sharply. That’s the trigger to dig in further to see if the investment is impaired. If you own a good business with a strong balance sheet it is going to decline over a period of years, not months. You will have time to get out before things get catastrophically bad.

Now, this only works with high quality businesses. It doesn’t work with classical value investing. It doesn’t work with merger-arb type special situations. It definitely doesn’t work with distressed investing. I watch value investments much more closely. Also cyclicals. Particularly if there is leverage involved. Levered cyclicals (think banks) can deteriorate very rapidly, and fatally.

So it’s not that a long time horizon is always superior.

It’s that mismatches create problems.

Oh, and if anyone happens to know what those weekly performance estimates are good for, drop me a line in the comments.

Investing vs. “Getting Market Exposure”

Like “financial advisor” and “hedge fund,” the word “investing” is probably one of the most abused terms in our financial lexicon. These days many people use the word “investing” when what they are really talking about is “getting market exposure.”

For fun I googled the definition of investing:

Source: Google

I also re-read this post from Cullen Roche where he discusses “allocating savings” (what I would call “getting market exposure”).

It’s funny how “investors” abuse the term “investing”. What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all. It’s just an allocation of savings. Investing, in a very technical sense, is spending for future production. So, if you build a factory and spend money to do so then you’re investing. But when companies issue shares to raise money they’re simply issuing those shares so they can invest. And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production. You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion. After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts. That is, they’re not really these sexy get rich quick vehicles. Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful. But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production. Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss. It’s not a place for gambling or getting rich quick. In fact, it’s much the opposite. It’s a nuanced view, but one I feel is tremendously important to financial success.

I have promised myself I will stop using “investing,” “getting market exposure” and “allocating savings” interchangeably.

For me, the semantic line between investing and “getting market exposure” is a little different from what Cullen proposes. For me it’s this: as an investor you are looking to compound capital at a rate exceeding your cost of capital (opportunity cost), while avoiding permanent impairment of capital.

Yes, “extraordinary” is a fuzzy term. To me, pretty much anything above 10%, net of expenses, is extraordinary. That will give you nearly a 7x return over 20 years. If you can do 15% (an extraordinary achievement, btw), that multiple jumps to over 16x.

Some of you are no doubt thinking you can net 10% annually forever in an S&P 500 index fund. And maybe you are right. In my view the odds are stacked against you over the next 10 years. In fact, I would gladly take the other side of that bet over next 10 years. But beyond the next decade or so it is hard to tell.

The reason is broad market returns measured over long time periods are sensitive to starting valuations. If you ask the average equity analyst he will probably tell you the market is “fairly valued” today based on the one-year forward price/earnings multiple. Which is another way of saying “meh.” By other measures, such as the Shiller CAPE, the US market is extremely expensive. But if you are allocating your savings based on one-year forward earnings multiples you’ve got bigger problems than parsing the nuances of various valuation multiples.

Source: JP Morgan

Also, analysts kind of suck at forecasting earnings growth. So the forward price/earnings multiple is a flawed input at best.

Source: Business Insider

Anyway, if none of this stuff interests you, you aren’t thinking like an investor. The whole point of investing is to seek out asymmetric risk/reward propositions. That’s very different from “simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.”

Netflix Levers Up (again)

From Dow Jones Newswires (emphasis mine):

Netflix Inc. (NFLX) said Monday it is planning to tap the high-yield bond market with a $1.5 billion deal. The company said it will use the proceeds for general corporate purposes, including content acquisition, production and development, capex, investments, working capital and potential acquisitions and strategic deals. The company’s most active bonds, the 4.875% notes that mature in April of 2028, last traded at 96.50 cents on the dollar to yield 5.332%, or at a yield spread of 239 basis points over Treasurys, according to trading platform MarketAxess.

I’m not going to belabor the point here. You can decide for yourself whether 5.332% is appropriate compensation for lending on a 10-year term to a company management says will burn $3bn to $4bn of free cash in 2018.

Disclosure: No position.

Different Priorities, Different Portfolios

So I pushed out my big behavioral finance/investing values post last week only to discover today that Morgan Housel is riffing on the same themes. He writes:

[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.

The Relative Performance Game

I wrote in a previous post that much of what passes for “investing” is in fact just an exercise in “getting market exposure.” In writing that post, and in the course of many conversations, I have come to realize the investing public is generally ignorant of the game many asset managers are playing (not what they tell you they are doing but what is really going on under the hood). In this post, I want to elaborate on this.

Broadly speaking, there are two types of return objective for an investment portfolio:

Absolute return. For example: “I want to compound capital at a rate of 10% or greater, net of fees.”

Relative return. For example: “I want to outperform the S&P 500.” Or: “I want to outperform the S&P 500, with tracking error of 1-3%.”

We will look at each in turn.

 How Absolute Return Investors Play The Game

The true absolute return investor is concerned only with outperforming his established return hurdle. The return hurdle is his benchmark. When he underwrites an investment, he had better damn well be underwriting it for an IRR well in excess of  the hurdle rate (build in some margin of safety as some stuff will inevitably hit the fan). He will be conscious of sector exposures for risk management purposes but he is not checking himself against the sector weights of any particular index.

I emphasize “true absolute return investor” above because there are a lot of phonies out there. These people claim to be absolute return investors but still market their products funds to relative return oriented investors.

Guess what? The Golden Rule applies. If your investor base is relative return oriented, your fund will be relative return oriented. I don’t care what it says in your investor presentation.

How Relative Return Investors Play The Game

The relative return investor is concerned with outperforming a benchmark such as the S&P 500. Usually managers who cater to relative return investors also have to contend with being benchmarked against a peer group of their competitors. These evaluation criteria have a significant impact on how they play the game.

Say Amazon is 2.50% of the S&P 500 trading on 100x forward earnings and you’re running a long only (no shorting) fund benchmarked to the S&P 500. If you don’t like the stock because of the valuation, you can choose not to own it or you can choose to underweight it versus the benchmark (maybe you make it 2% of your portfolio).

In practice you will almost certainly own the stock. You may underweight it but you will own it at a not-insignificant weight and here’s why: it is a popular momentum stock that is going to drive a not-insignificant portion of the benchmark return in the near term. Many of your competitors will either overweight it (if they are reckless aggressive) or own it near the benchmark weight. Most of them will own it at or very near benchmark weight for the same reasons as you.

Sure, if you don’t own the stock and it sells off you may look like a hero. But if it rips upward you will look like a fool. And the last thing you want to be is the idiot PM defending himself to a bunch of retail channel financial advisors who “knew” Amazon was a winner all along.

The safe way to express your view is to own Amazon a little below the benchmark weight. You will do incrementally better if the name crashes and incrementally worse if the name rips upward but the effects will not be catastrophic. When you are ranked against peers you will be less likely to fall into the dreaded third or (god forbid) fourth quartile of performance.

This is the relative performance game.

Note that the underlying merits of the stock as a business or a long-term investment get little attention. The relative performance game is about maximizing incremental return per unit of career risk (“career risk” meaning “the magnitude of relative underperformance a client will tolerate before shitcanning you”).

If you are thinking, “gee, this is kind of a prisoner’s dilemma scenario” I couldn’t agree more. In the relative performance world, you are playing a game that is rigged against you. You are handcuffed to a benchmark that has no transaction costs or management expenses. And clients expect consistent outperformance. Good luck with that.

I am absolutely not arguing that anyone who manages a strategy geared to relative return investors is a charlatan. In fact I use these types of strategies to get broad market exposure in my own portfolio.

I do, however, argue that the appropriate expectation for such strategies is broad market returns +/-, that the +/- is likely to be statistically indistinguishable from random noise over the long run*, and that this has a lot to do with the popularity of market cap weighted index funds.


Corollary: Don’t Be An Idiot

If you are one of those high net worth individuals who likes to run “horse races” between investment managers based on their absolute performance, the corollary to this is that you are an idiot.

The guys at Ritholtz Wealth Management (see my Recommended Reading page) have written and spoken extensively about the problems with such an incentive system. It is nonetheless worth re-hashing the idiocy inherent in such a system to close out this discussion. It will further illustrate how economic incentives impact portfolio construction.

If you say to three guys, “I will give each of you 33% of my net worth and whoever has the best performance one year from now gets all the money to manage,” you will end up with a big winner, a big loser and one middle of the road performer. You will choose the the big winner who will go on to be a loser in a year or two. Except the losses will be extra painful because now he is managing all your money.

Here’s why. You have created an incentive system that encourages the prospective managers to bet as aggressively as possible. This is exacerbated by the fact that your selection process is biased toward aggressive managers to begin with. No self-respecting fiduciary would waste his time with you. People like you make for terrible clients and anyway a self-respecting fiduciary’s portfolio is not likely to win your ill-conceived contest. Your prospect pool will self-select for gamblers and charlatans.

In Closing

Incentive systems matter. Knowing what game you are playing matters. There is a name for people who play games without really understanding the nature of the games.

They’re called suckers.


*Yes, I know it is trivial to cherry pick someone ex post who has generated statistically significant levels of alpha. I can point to plenty of examples of this myself. Whether it is possible to do this reliably ex ante is what I care about and I have yet to see evidence such a thing is possible. Also defining an appropriate threshold for “statistical significance” is a dicey proposition at best. If you feel differently, please email me as I would love to compare notes.

Case Study: Embraer Investment Post Mortem

One of the most vexing problems in the world of investing is that of distinguishing luck from skill (spoiler alert: it is nigh on impossible). This is an issue of paramount importance. It is, in a sense, the whole ball game. Morgan Housel calls luck “the flip side of risk:”

[E]xperiencing risk makes you recognize that some stuff is out of your control, which is accurate feedback that helps you adjust your strategy. Experiencing luck doesn’t. It generates the opposite feedback: A false feeling that you are in control, because you did something and then got the outcome you wanted. Which is terrible feedback if you’re trying to make good, repeatable long-term decisions.

In investing, a huge amount of effort goes into identifying and managing risk. But so little effort goes into doing the same for luck. Investors hire risk managers; no one wants a luck consultant. Companies are required to disclose risks in their annual reports; they’re not required to disclose lucky breaks that may have led to previous success. There are risk-adjusted returns, never luck-adjusted returns.

As someone who evaluates investment managers for a living, I am acutely aware of this issue. Particularly as it relates to repeatable, long-term decisions. The hedge fund graveyard is littered with the remains of dudes who got one big bet right then proceeded to nuke their fund with the next one.

The way I deal with this in my personal portfolio is to keep an investing journal. The purpose of the investing journal is to document key decisions and conclusions: research; trade and position sizing rationales; emotional triggers and strategies for dealing with them. All this is documented for later review so I can at least attempt to understand the role of luck and skill in the outcome.

You may recall my old post on trading Embraer (ERJ) using a mix of technicals and fundamentals. On 04/03 I sold the remnants of my ERJ position for a decent gain. Below is my investment post mortem. You will have to forgive me the rough edges as this is only lightly edited from the investing journal itself for grammar and clarity.

ERJ Investment Post Mortem

Below is my original model for ERJ. This would have been done in Fall 2017 (I am lazy about the dates). Obviously the numbers are rough. I am not one of those people who agonizes over precision in a DCF model where a couple basis points on the discount rate will move the valuation by $500 million. My format is blatantly ripped off of Professor Aswath Damodaran’s DCF template. Knowing his philosophy on teaching I trust he’ll take that as a compliment.

The point of the exercise is to get an idea of the upper and lower bounds on the business’s value so a position can be sized. ERJ is subject to a high degree of uncertainty due to the capital intensive and cyclical nature of the business. Even though the model produced a point estimate of the per share value I think of a range of possible outcomes. For ERJ playing around with the numbers led me to believe the base case business value would fall somewhere between $24 and $30 per share. So decent upside appeared to be on offer from an entry price in the mid-18s.

Source: Demonetized Calculations

My initial experience with the name is laid out in the trading post linked above. So we will pick up later in 2017. In 3Q17 I wrote:

The theme of the 3Q17 call could perhaps best be described as “under promise and over deliver.” See the above graphic from the presentation slide deck for all the summary you need. They are guiding down in 2018 due to all the factors highlighted in gray bubbles. This more or less holds 2017 results flat and has no impact on the investment thesis. In fact, today the shares traded down further.

The 190-E2 program looks to be on track with the first delivery set for April 2018. They expect about 10% of 2018 deliveries to be 190 E-2 jets.

Meanwhile order activity continues in the legacy book. 12 Super Tucanos were ordered (6 by the US for Afghanistan and 6 by an undisclosed customer). The Super Tucano also passed the initial qualifications required for the US OA-X light attack plane evaluation program. 45 E-175 jets were ordered by SkyWest which is a nice bridge order.

For the time being I like this as a 5% position. I would add opportunistically again below $18/share, assuming no fundamental challenges to the thesis. Need to keep an eye on the order book (they didn’t break out the order book in the presentation material).

On December 21, after ERJ-BA merger talks were announced, I wrote:

ERJ closed up about 22% of the day on the back of news that it and Boeing were in merger talks. This was confirmed by both companies a couple hours after WSJ broke the news. WSJ said the discussions involved a significant premium for ERJ but the sticking point is that the Brazilian government has to bless the deal.

This is a huge validation of the investment thesis and argues for sizing up the position. Considerations:

Analysts think the deal is likely to break. Of course, no one saw it coming anyway so not sure how good their read really is. Skepticism seems to center on the fact that Boeing had been dismissive of Airbus’s move with Bombardier’s regional jet business (although, when you think about it, why would Boeing give public props to its competitor?)

I actually think the deal makes more sense than the analysts. Airbus has clearly gone out of its way to validate the regional jet market. These deal talks do the same. Plus, Boeing and Embraer already have cooperation agreements in place related to the KC-390 tanker.

However, the Brazilian government is a total X factor and I have no desire to try and handicap its actions.

Given the uncertainty, I think it makes sense to hold at current levels and size up opportunistically. If the deal talks stall, ERJ will drift back down toward $18-20 and present an opportunity to add incrementally to the position. The validation of the deal talks clearly is a tremendous boost to the ERJ investment thesis. If the deal breaks, on the other hand, the price will fall quickly back to $18-$19.

I do not think it makes sense to sell out of the position now and bank gains. That would be a short-sighted trade versus what I am really trying to accomplish with core positions. I would rather have Boeing take me out at a higher price (I think this deal gets done between $25 and $35 if it goes through) OR size the position up after the talks collapse and wait for value creation according to the original investment thesis.

No trades placed today but need to keep a weather eye on ERJ’s price.

On 1/5/18 I trimmed the position:

Sold shares of ERJ today @ $26.17. This reduces the position to about 3.3% of the portfolio. The cash on cash return for these shares is about 30% with an IRR in excess of 70%.


Negotiations between Boeing and the Brazilian government are ongoing. Brazil doesn’t want to give up control. Boeing wants control. Allegedly Boeing will not settle for a JV (this process has been leaky and I suspect both sides are strategically leaking info in an attempt to enhance their negotiating position).

This is more or less impossible to handicap. The Brazilian government is not operating purely on economic considerations.

What changed today was that it was leaked that Boeing’s offer for Embraer was $28/share on an informal basis. This is smack in the middle of what I think the likely value of the equity is today (about $25-$30/share). At $26/share the risk-reward skew just isn’t that great anymore.

But why not sell the whole position?

It is possible a deal goes through at $28/share or even higher.

If a deal does not go through, it is possible the shares sell off but to a level well above cost. If this occurs, there is an option to accumulate a bigger position. I am not sold that Boeing won’t accept a JV if it is the only option. It seems stupid for them to walk away all together given the Airbus/Bombardier arrangement. A Boeing JV would be a tailwind for the business and in any event this arrangement validates the long-term investment thesis for Embraer which should enhance conviction.

If a deal does not go through, and there is no JV, the shares should sell off back to around $20 or so. In this case I would accumulate back to a 5-6% position and add opportunistically over time. With 2018 a transition year there is a good chance for an earnings or guidance disappointment that will create further opportunity to accumulate additional shares.

In sum, I feel good about this trade. It feels like a balance of offense and defense. This is a perfect example of why I like to retain the flexibility to actively size positions to  manage risk and return. The key is not to be “trading scared” based on loss aversion. The focus has to be on the business fundamentals and the risk/reward skew.

On 4/03/18 I closed out the position with the following rationale:

Sold the remainder of my ERJ position.

I had intended to wait longer to exit this position in hopes of eking out a little more performance. However, in reviewing the overall portfolio it seems clear there are better opportunities on offer.

This is the first example of me liquidating a position to redeploy the capital into a better idea. Really what appears to be on offer from ERJ in the shorter-term is a merger-arb type return–a fairly small bump (maybe another 10%) with deal break risk. As a residual position it just can’t contribute that much relative to what it would detract in a deal break scenario. This is more of a value pattern investment even though ERJ has a good track record of capital allocation. So ultimately in looking at the risk/reward seems prudent to take the win and move that capital into a better opportunity.

I used the proceeds from the ERJ sale to build my CBOE position above the 10% threshold to bring it to Core Weight.

What Worked

  • Modeling appears to have been validated by subsequent market action and alleged Boeing negotiating position.
  • Trading around this position worked well (85% IRR vs. 43.3% cash return).
  • Disciplined exit.

What Didn’t Work

  • Position was sized too small. However, I can’t really knock myself too hard for this as the Boeing takeout clearly surprised the entire market. I suppose it might have been possible to foresee a deal after Airbus and Bombardier announced their partnership. But that is subject to significant hindsight bias. And anyway, I don’t want to leave myself in a position where I am relying on someone else to take me out for an investment to work. These aren’t supposed to be merger-arb trades.

Luck vs. Skill

  • The Boeing merger talks served as a catalyst which was not underwritten at all in the original investment case. So I get no credit for that.
  • From a risk management POV I think I can take credit for prudent position sizing. Remember that at the time the Bombardier-Airbus partnership was seen as a significant threat. Also the business performance outlined in the 3Q17 presentation was in line with my expectations for a rocky transition to the E2 Series.
  • Luck did not “save me,” but it certainly got me paid on an accelerated time horizon.
  • I do give myself some credit for thinking of the whole portfolio and not just this name in deciding to exit the position.


  • Not too much to take away from this one. Looking back I don’t think there is anything I could have done different without the benefit of hindsight. Probably the biggest takeaway from this position is not to attribute the quick payday to my own analysis. The position was properly sized but my actual investment case did not play out (the investment was underwritten for a much different time horizon).
  • I will keep an eye on things with ERJ to see how they play out. For one thing it could make for a good investment again in the future. For another, it will allow me to compare my investment case to what actually plays out, and assess whether redeploying the capital into CBOE was really the right decision.


I hope you enjoy reading this. Feedback is always appreciated. I will share more of these in the future.


Why Do You Invest?

Nick Maggiulli at Of Dollars And Data asks: why do you invest?

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.”

Or, conversely:

“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:

Source: CFA Institute

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:

Source: CFA Institute; SLR stands for Standard of Living Risk

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.