Reducing the Risks from Your Brain

“Knowledge alone isn’t enough. Even though we know it’s a bad idea to buy high and sell low, spend more than we earn, or invest in only one stock, we still repeat these mistakes… So ignoring what we’ve learned in the past makes it difficult to benefit from that knowledge. And pretending that there’s no consequence in the future for the decisions we make today creates a similar conflict.”

 The above sums up what I found to be a quick, insightful article in the New York Times.  It touches on the most overlooked issue in personal finance – the psychological barriers to making sound financial decisions. 

We take great pride in trying to educate our clients, often using the phrase “a great client is an educated one.”   However, as the article indicates information alone may have limitations when rubber meets the road as the client may convince him or herself otherwise using the “this time is different” or “we can make up for it down the road” or anything really as a reason.

The article mentions “by recognizing the impact our [psychological issues] may have, we stand a greater chance of turning that knowledge into good behavior”, but does little mention ideas to help with the recognition.  We understand that human nature won’t change and thus those issues will never go away.  Thus, we have taken steps to minimize their impact and proactively prevent them:

• Build a financial roadmap so clients have a clear understanding of how a financial decision will affect their long-term goals and objectives and balance sheet/cash flow trends.
• On top of client education, we take time to answer all client questions thoroughly so they will understand our plan to alleviate their concern.
• Transparency in our process helps understand the how and why of our recommendations.
• Reducing risk as market movements indicate a higher probability or large loss in the future in order to keep them from selling at the bottom.
• Meeting clients in the middle.  For example, putting a % of what they were going to invest in a private investment instead of the original amount

Of course, these methods are not perfect and we constantly evolve to find new and better ways to mitigate the psychological risks.  Still, the above are good first steps to recognizing the deficiencies we have and taking steps to avoid the pitfalls the deficiencies can bring.  

Please see the important disclosures that apply to this commentary HERE. 

Time for Active to Shine?

Picking active managers isn't easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

For at least a decade now passive management (managers who attempt to mimic an index) has been all the rage.  Originally passive management advocates were only on posters in Tiger Beat, but now they are on the cover of Vanity Fair.  More and more we get research, white papers, even client calls extolling the virtue of passive management over their active counterparts (managers who attempt to beat an index).  The trend continues to move more and more toward passive managers.  Will this ever change?

No, at least not forever, and I am a big advocate of passive management.  The reason was highlighted to me in the article.*  Thesis: the trend will continue to move as millennials, who are skeptical of active management, migrate to passive managers and the older active managers, who make up the bulk of active management, retire leaving new managers with little track record.

But the reason the trend will eventually reverse is the same reason why the money ultimately started flowing that way – returns:

1. Active management became popular in the 80s as ways to get diversified* market exposure and good rates of return
2. As it gained in more popularity, more managers entered the field = lower % of managers beating their respective index as quality erodes. 
3. Many of these managers raised their fees given the increased demand, lessening their chance to beat the benchmark
4. So here comes passive managers, cheaper and better performing than active managers
5. Repeat steps 2 and 3 AND lower quality active managers leave the field as dollars move to passive AND if everyone is buying an index stocks will naturally become over and undervalued, creating a nice situation for active managers AND creates a self-reinforcing problem - during a market selloff who is buying if everyone is passive?  This is where we are at.
6. The small pool of high quality active managers who were probably in cash before the sell-off and may now be well positioned to outperform over the full market cycle
7. Start over again

The debate of for academics, but why does this trend matter to retail investors?  Opportunity.  With everyone moving towards passive management, quality active managers should be better situated to beat an index over a full market cycle.  Picking active managers isn’t easy, but for those who are disciplined and know what they are looking for this could be the right time to go active.

Please see the important disclosures that apply to this commentary HERE.  See important definition on diversification at the same link.

The LeBron Trade

Huge upside and a downside that doesn’t cripple you may be an investment worth making

NBA Free Agency is the ultimate reality show.  Rumors, innuendo, last minute game changes, etc.  Quite fascinating really.  The winner gets LeBron James, the loser, a set of steak knives …

Well not really a set of steak knives for the Cavs.  They have a young, talented roster they can continue building with or without LeBron, though would certainly be better with him.  The Heat on the other hand would pretty much be destitute.

Regardless, it’s really a binary outcome – you either get him or you don’t.  The former obviously puts you in a substantially better situation.

But diverting resources to get LeBron hampers your ability to sign other free agents, who would improve your team.  The opportunity cost of chasing LeBron is enormous where you can’t really do anything until he signs.  For example, the Cavs lost out on Gordon Hayward as they have dedicated themselves to trying to get LeBron back on the team.

Thus, the argument could be made are you better off going after lower level free agents who you have a better chance of signing and will still improve your team?    To illustrate, let’s say the Cavs have a 10% chance of signing LeBron and 75% chance of signing free agent ABC.  Free agent ABC makes the Cavs a playoff team, maybe even a high seed in the East.  LeBron however makes you an instant title contender and a possible free agent destination, not to mention makes you increasingly more relevant.

Point being the upside is so great with LeBron that the opportunity cost of losing other free agents is totally irrelevant and thus the argument of using your resources to target more likely lower free agents moot.   The Cavs need to and have make this LeBron trade.

I do need to attempt to tie this back to investing.  And I think I can.  If you can find an investment, whether in the market or private or a startup, with huge upside and a downside that doesn’t cripple you it may be an investment worth making.  This may be true even if the likelihood of success is low and the opportunity cost is marginally high.  Good look finding your LeBron trade…

Please see the important disclosures that apply to this commentary HERE.

Use LeBron to Assist Your Portfolio Plan

LeBron will probably stay with the Heat; how I came to that conclusion can apply to portfolio management.

In all likelihood the best player in the NBA isn’t leaving the Heat.  As someone who likes the Cavs, I am a tad bummed; however, the Cavs and Heat should both be very entertaining.

On the surface this has little to do with your portfolio, but let’s use this as an example:

1. What I did in the above picture is list reasons why he would stay on the Heat and why he would leave. 
2. Everything in the above picture I deem as signals, items that indicate the direction of the ultimate outcome. 
3. Items above the red are why I think he stays, and below why he might leave (though those are more mixed).
4. Anything else I hear about LeBron I deem as noise, distortions that cause a loss of focus on what is the likely outcome.  For example: his kids are enrolled at school ABC, his wife wants to move back to Akron, he wants to play with Carmelo, etc.
5. Thus, given the signals as I read them the evidence is overwhelming he stays.

In short, I ignore the noise and read the signals to formulate that thesis.  But in practice it isn’t that simple: maybe some of the noise were actually a signals OR vice versa OR one of the mixed signals comes to fruition OR I missed something entirely OR maybe I am looking for confirmation bias.  Despite the sound process in theory, it certainly isn’t infallible given the highly subjective nature.

When it comes to portfolio management, I apply the same decision making process – look for signals (e.g. + likelihood of solid economic growth, + loose Fed, - uncertainty of QE unwind, +/- above average valuation) and ignore the noise (e.g. whatever is going on in Ukraine, endless Fed comments) to formulate a thesis (e.g. the background for stocks should be positive though with some headwinds).

Much like my LeBron thesis, the above can ultimately prove to be untrue as my assessment of the signals is subjective.  However, unlike like the LeBron thesis there are more objective signals from the market I can incorporate into portfolio management in the event my thesis fails.  It’s these objective signals that help hedge against the “OR” mistakes listed above, a luxury that wasn’t available when I formulated my assessment on LeBron.

So while in portfolio management it’s imperative to ignore noise and pay great attention to signals when going through the process, it’s equally imperative to have measures in place to guard against making the wrong decision.  The latter may not help figuring out where LeBron will land, but it could help minimize your drawdowns when the market corrects.

Please see the important disclosures that apply to this commentary HERE.