Category Archives: Uncategorized

Acquired Optimism

Are you an optimist or a pessimist? Few questions are as basic or as revealing about our fundamental outlook on life and the world around us. Today I’d put myself in the “optimist” column albeit with some qualifications. To my family and friends that may come as a surprise. Indeed, my outlook has evolved over the years — today I’m an optimist by choice rather than disposition.

Happiness and Optimism

Culturally we tend to view those who warn us of impending doom as idiosyncratic thinkers, prescient iconoclasts, or even misunderstood geniuses — if not in those exact terms, at lease imbued with superior intellect. Consider this article, Are Happy People Dumb? from no less a paragon of thought leadership than the Harvard Business Review. Just in case the title equivocates, it opens thusly:

Happy people are not the smart people.

I felt the author dealt with happiness in a narrow sense of our immediate reaction to life circumstances. The article actually went on to make a different point (it’s worth a read so I won’t spoil it for you). But the sentiment reflected in its opening sentence is not uncommon. Happiness, some thought, is only reserved for the oblivious masses, the happy-go-lucky man-on-the-street, or worse yet, the dumb-as-a-door-knob brother-in-law. A person moderately read, traveled, and spent five minutes thinking about the future can see that wealth polarization is worsening, ideological differences are getting more entrenched, middle class is going nowhere, white collar jobs are being displaced by AI, our international allies are abandoning us, China is taking over the Pacific, war is brewing everywhere, OH MY FXXXING GOD THE WORLD IS COMING TO AN END!!! I was like that, a worrier by nature. I was taught to plan for the worst and hope for the best. But somehow I was preoccupied with the plan part and never allowed myself the hope part.

There have been claims of a “happiness gene”, although I find the evidence a little wanting. Certainly much of our immediate mental responses to external events are deeply rooted in our psyche, they’re called “gut reactions” for good reason. We know that when speedy decisions are needed, out mind apply certain heuristics, i.e. short-cuts borne from experience, rather than lengthy deliberation. As a result of our evolution, the heuristics tend to highlight signs of danger because of the risk/reward asymmetry — our ancestors were much better off assuming the rustling of leaves was from a mountain lion beneath than an errand gust. It’s quite possible for the tendencies of these heuristics have a genetic or neurochemical basis that also spills over to longer term decision making. Therefore, we need to overcome our innate dwelling on the negative, in order to make an accurate forecast by assessing the probabilities and consequences of potential outcomes; it may even be an acquired skill. The history of stock markets has shown optimism of this sort, a positive, thoughtful outlook on the future, to be by far the more profitable orientation.

Market and Economic Outlook

As a PM investor since 2002, I’ve lost count of the dire warnings I’ve read on websites like SafeHaven, DailyReckoning, FinancialSense, GoldSeek, Gold-Eagle, 321Gold, and last-but-not-least, ZeroHedge. Pessimism sells — I’m proof: fifteen years ago I bought into the doomsday thesis hook, line and sinker. I bought into, and lost money in, both David Tice’s and John Hussman’s funds. It took me a long time to come around to the other side which was an intellectual process. To start, there was one fatal flaw with the bearish thesis: it didn’t work for investors. Note I didn’t say it’s wrong because that’s a rabbit hole of theories about manipulation and what should have, would have happened. Instead, it’s an incontrovertible fact that the bearish thesis has made its believers poorer.

It’s a truism that the market goes up most of the time, but that is too simplistic an answer to why the bearish thesis did not panned out. I can think of two reasons why.

  1. One favorite line of attack on the “phoniness” of the stock market’s recovery is to point out that the recovery has left much of the middle and working class behind. Much of the gloomy picture is accurate, although I take issue with some interpretation of the data, such as the stagnant wage growth by noting that average wage is highly age dependent such that a typical worker is still getting more pay as his career advances. It’s undeniable that some are left behind by the digital divide, and unequal wealth distribution is both a humanitarian concern as well as a social ticking bomb. However, looking at it unemotionally, unequal wealth distribution is evidence for both the compounding effects of the knowledge economy and the diminishing economic footprint of the disaffected. Unevenness of recovery does not mean it’s false, but rather it’s early and has legs. Conversely, the top is not far away when everything everywhere is booming.
  2. The biggest mistake the bears made was to underestimate the resiliency of the system, by which I mean the policy tools the central bankers and governments around the world were willing to adopt. Sacred classic economic principles turned out to have its basic assumptions abrogated. Fore example, many was sure the expanding money supply was going to lead to inflation. Nine years later they say, oops the velocity of money collapsed. Oops indeed, that was one expensive mistake. I see the China bears making the same kind of mistakes again.

Like it or not, central bank and government intervention in the economy is likely to stay or even expand (see the recent Felix Zulauf interview). I choose to take advantage of the situation rather than make my portfolio a statement of what I believe things should be. As Keynes once said, “When the facts change, I change my mind. What do you do, Sir?” It was nice to have read Fredrick Hayek, Milton Friedman and Ayn Rand, but one can’t make money with Austrian economics and sound money principles. I too see nobility in the suffering of a starving artist — the operative word being “starving”.

Today I still have a substantial allocation to PMs based on their portfolio diversification characteristics, but I don’t expect a near or even medium-term monetary collapse. Readers are no doubt aware that my portfolio is currently leveraged long equities, from which some may surmise that I’m “optimistic” about the stock market. That’s not incorrect, but the whole picture is more nuanced. As always, the time frame plays a critical role.

  • As the title 1998 (relative to the dot com bubble) would suggest, my base case scenario doesn’t call for a top in the stock market until 2019.
  • The Next Bear market I anticipate to be a cyclical one within a secular bull market, for a decline of about 30% lasting 12-18 months.
  • Nonetheless, my 10-year equity return projection is under 4.3%. One way to get there is to round-trip in three years, then grow 6% for 7 years. That’s equivalent to 4.2% nominal for 10 years. In other words, I expect the current bubble to pull-forward a lot of the future returns. Based on this projection, the 4% rule for the Jan 2000 retiree is in jeopardy. Take a 70/30 initial allocation as an example, even if it were to make it to 2030, the portfolio would be too depleted to support the retiree much longer (see also).
  • I’m more hopeful after this next 10 years, and for the world as a whole. The technology trends of AI/ML etc. will take many decades to play out. Even if the US doesn’t grow as it did post WWII, the global economy just might.

I would consider this “tempered optimism”, no outright disaster, but the economic manipulation is not consequence-free either. What matters more, clearly, is what to do with this understanding.

Life in General

Looking back I believe I’ve made a case for not being an out-and-out pessimist, but probably not a strong one for being an optimist. For that we need to look outside the markets. In the larger picture, there is one and only one reason that makes me fundamentally optimistic about humanity: our knowledge is still expanding: in fact it’s being generated and disseminated at an unprecedented pace. Knowledge, once obtained, cannot be destroyed, but compounds for future generations. As long as humanity survives, and knowledge expands, there will be progress. Besides given me hope for humanity, this line of thinking has offered me clarity in the overall hierarchy of values.

On a more personal level, my optimism comes from my ability to think for myself, to adapt to change, and to raise a loving family. My active approach to investing as well as my appetite for risk are direct expressions of that optimism. I’d like to think that my path to where I’m today has not contradicted that belief. I have not always thought this way; I like this way much better.

May our future be brighter than the past.

None of the above is investment advice, the standard disclaimer applies.

Some Rambling Thoughts on Investing Philosophy

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.