I’ve previously written a blog post about the key tenets of my investing philosophy that were more about the actual practice. In contrast this post is a collection of more fundamental views.
On the human condition in investing and its axiom
First of all, the human condition as it pertains to investing is that we can never be sure of future returns. The typical investing time horizon and the nature of returns is such that we have one life to live and the return will only be known at the end by which time it’s too late to change anything. Given the stage of my life, I’m obsessed with maximizing retirement date certainty. I spend much time thinking about two approaches to taming the (downside) volatility without compromising return potential: asset class diversification and market timing done correctly.
“Buy low sell high” is the only axiom of investing, everything else is derived from, therefore subordinate to, it. There are heuristics or rules of thumb that are derived from experience. But no matter how much experience it’s based on, or how authoritative a figure it comes from, a heuristic can never over-rule the axiom. For example, I invest in PMs and cryptocurrencies with the goal to “buy low sell high” even though they don’t conform to someone’s notion of productive assets. The word speculate as opposed to invest is used to describe, often derogatorily, such activities by some. To me, the word speculate carries no negative connotation. As a matter of fact, I believe successful speculation requires above-average understanding of human psychology and macroeconomics, as well as superior mental discipline. So no, I don’t mind being called a “speculator” at all.
On diversification, market timing and bubbles
The benefits of diversification with uncorrelated assets is mathematically derivable. It does not derive its validity from backtesting, although backtesting confirms it works. I consider that a first level corollary to the axiom of investing. There aren’t that many of those either — “costs matter” is another. Early literature of “Modern” Portfolio Theory which was developed in the 50’s focused on the two-asset universe of stocks and bonds. For a long time they were the only options available to individual investors; however, in this day and age, it’s sad to see how much of the investing public is still operating with this now self-imposed limitation. I’ve grown used to the resistance to alternative assets displayed on forums like Bogleheads and MMM. These days I click on threads about gold and cryptocurrency with the anticipation of a spectator at a UFC event. I’m usually not disappointed.
I’m an avowed market-timer, one that’s primarily interested in cycles of years duration or longer. The combination of market-timing and freedom to speculate allows me to take advantage of asset bubbles. The mainstream views bubbles as unavoidable evils of the free market, and the ability to hold through them with clenched teeth and unwavering asset allocation the ultimate financial virtue. I’d like to offer a different point of view. We know that bubbles appear with some regularity: PMs in early 80’s, Japanese stock and RE in early 90’s, dot com bubble of 2000, the housing bubble of ’07; and depending on who you ask on-going and near future: bond, cryptocurrency, Nasdaq and PMs. Given the length (build up, blow-off, collapse) and magnitude of these bubbles there is a possible variant perception: that the bubbles are the main acts, and the supposedly normal markets merely a chorus in the background on this financial stage of ours. According this view, a portion of our portfolio should be expressly directed towards taking advantage of bubbles, while the rest under the traditional asset allocation geared towards the “normal” market that are the plateau from which the bubble peaks rise. It takes great skill to ride a bubble due to the great emotion and hype invariably accompany each and that no two bubbles are alike. But successfully negotiating even just one could set one up for life, or at the minimum build a significant base from which compounding with a traditional allocation will ensure a comfortable retirement. For additional thoughts on riding asset bubbles see here.
On passive vs. active
Hardly a week goes by without encountering an article on the active to passive transition. I personally use them both for strategy diversification. Index funds are a great invention: for someone not inclined to put in the time and effort there is no better investment vehicle. In all likelihood the trend of active funds to passive will continue, especially in a bull market where hedging degrades performance. I believe that in so far as passive investing puts more money in the pockets of the public, more capital may be attracted into equities than would otherwise, further perpetuating equity bubbles. I also believe it’s possible for passive to become too big: market orders can be market distorting when passive is the only game in town.
I could probably go all indexing in the equity portion of my portfolio — my goal for actively picked stocks is to match the return of SPY anyway. One reason for staying with individual stocks is that it affords greater opportunities to write options, at the least when the goal is to have them expire OTM. Another reason is that even though I’m a lousy stock picker now, there’s always a chance that I’ll improve, and I’d like some incentives for doing so. Somewhere inside there is a voice reminding me too much of even a good thing can be problematic. Nothing has manifested yet but I have been thinking about how index funds may distort the market and how vulnerable they can be:
- Index funds take money away from high shareholder yield (dividend + buyback) companies to distribute among the entire index, assuming the majority re-invests distributions. This will create a disincentive for shareholder yield.
- Suppose a hedge fund builds up a large position in an index member. It can use artificial trades to increase the price before dumping it to index funds.
- It behooves to ask, in the example above, how a hedge fund could build up a large position in the first place. Index funds won’t be selling unless there is wide panic. But to generate wide panic just to load up on a stock may be too much to ask, although there may be specific external events in certain sectors that can create opportunities. Other possibilities include an index member acquiring a non-index member by issuing stock, or a particularly large buy-back that creates forced buy/sell conditions for the index funds can be taken advantage of. The most likely scenario remains when there is deterioration in the fundamentals of an index member, and a hedge fund can dump its existing position or simply go short after artificially elevating the price.
- The issue of stock-based acquisition requires further scrutiny. Recall that was a game CSCO played masterfully during the dot com era when using its high P/E stocks to buy low P/E companies provided an instantaneous boost to its numbers. Will we see them again (a large cross-border deal should do the trick) when index funds gladly foot the bill?
- Lastly, there is a danger of net capital flows out of index funds as baby-boomers retire.
Let’s be clear: these are not things that are happening now but what could happen when index funds become dominant. Various people has put the line at 90%. Personally I see it as a question of when, not if. That’s why I intend to maintain an active component lest getting swept away when the tide comes back in.
So there you go, some disjointed ramblings that should give better context to my investment decisions. I hope you find them somewhat thought-provoking.