Financial Thinking

In our effort to understand the world around us, we observe, we form hypotheses and we test whether or not our explanations match reality. From there, we use models to test our understanding of natural systems. Since the early 20th century, we have tried to understand financial systems using this scientific form of reasoning. Practitioners and academics have used the tools available to them to explain the movements of financial markets and develop a model that reflects their understanding.

Practitioners (traders and investors) gain experience in the markets, which reflect reality. They are mostly able to perceive what has happened, even if they are not always able to assume why. They use their reasoning and common sense build on their experience. This type of knowledge is reflected in aphorisms and sayings that are passed back and forth between practitioners. Sayings like “sell in May and go away”, “don’t fight the tape”, or “buy the rumour, sell the news” reflect an accumulation of experiences that have shown these aphorisms to be helpful. The main drawback to this type of accumulated, popular wisdom is that people don’t always process their experiences rationally. Think, for example, of a gambler who “almost won”. Almost winning is exactly the same as losing, in reality, but it is experienced very differently. This type of experience could skew the perceptions that support popular wisdom.

Academics and models try to explain and reproduce reality. Because reality is complex, they simplify and they take shortcuts in an effort to reduce the complexity and develop a model that is easy to use. These models are then used to try to predict the future. As we have seen, our models are sometimes helpful, but are never failproof. (Take as an example the saying that “economists have predicted nine of the last five recessions.”) Contrast this with a physical, not social, science. Models in physics, chemistry or biology are able to exactly explain and predict outcomes with known variables. With social sciences, however, the greatest variable is human action. Economists tried to reduce this by inventing “homo economicus” or rational man, someone whose choices are logical and preferences are consistent. As behavioural economics has shown, that man doesn’t exist.

Because movements of financial markets are based on human behaviour, random fluctuations do not fit within the same realm of randomness as Brownian motion or other outcomes that can be described by the bell curve. The bell curve is a tool that academics use to reduce the potential outcomes of a random variable that can’t be known. If the distribution is normal, the validity of the outcome will not be affected and, although the answer is not known exactly, it will always fit within known parameters. If the random fluctuations, however, do not fit the bell curve, it cannot be used as a shortcut to describe the parameters of potential outcomes. This has, in fact, been shown to be the case in many ways. Just a couple are the market crash of 2008, which had a standard deviation of 12, meaning it should only happen less than once in the lifetime of the Earth; the fact that measured volatility is not consistent over time; and the fact that correlations change with circumstances.

Close enough may be okay for some things, but it’s not good enough for my money. I’d rather use no model at all, than a model that is known to be flawed. But this seems to not be the case for the financial industry. Instead of rejecting a flawed model, ever more complex measures and ratios have been developed, always based on the same assumptions, ie. normal distribution and rational decision making. When forecasts are wrong, excuses are made such as: the direction was right, but the magnitude was wrong; the movement was right, but the timing was wrong; or the prediction would have been correct, but the markets were manipulated by the government. Those are all ways of “almost winning”, which as we recall is exactly the same as not winning, especially when money is at stake.

Instead of trying to predict the future based on models that do not accurately represent reality, it is more robust to heed popular wisdom that is based on experience and keep in mind that the outcome could be vastly different. I don’t mind admitting that financial markets in specific and human behaviour in general are systems that we can’t model because we don’t understand them sufficiently. Facing this reality allows a practitioner to make decisions that are not based on erroneous assumptions.

The barbell investing strategy, or “core and explore”, works to reinforce the asymetric return expectations that we discussed earlier and it controls some of the costs of active investing. Today, we look at the reasons to own investments directly, some of which are similar. Directly holding equity and fixed-income investments improves transparency and accountability, while reducing costs and risk.

When investing, there is no shortage of people willing to help and become involved in the process. To be clear, I am not focused on advice. In my opinion, advice is valuable and co-exists with the actual investment process. When a person invests their capital, they can either directly purchase stocks, bonds, real estate, etc., or they can buy through middle-men or derivatives. Derivatives, in my mind, are things like options and futures, but also equity-linked GICs and principal protected notes. Any “synthetic” investment that derives its value from another investment can be considered a derivative and it removed by one step the investor from their investment. A middle-man might be a stock broker, but I intend to consider pools of money such as mutual funds and hedge funds, where the target investments are owned within a structure that obscures granular control and reporting.

Derivatives have two problems that potential investors should be aware of. First, they constitute a form of leverage, which increases risk. This is true in the case of options, where a nominal amount of money can be committed to control a proportionately large number of shares. The change in value of the underlying shares influences the value of the options, magnified. But there is also path dependency to beware. This means that the sequence of returns influences the final value, something that’s not true for “long” stock or bond investments. This can be seen particularly clearly with inverse ETFs. Their daily performance is the opposite of the index they track, but over a longer period of time, there will be a divergence between the index level and the inverse ETF value, with a possibility that both lose money.

Mutual funds have been the subject of increased discussion recently over the fees and costs they contain. Without entering into this particular debate, the costs of a mutual fund are a constant drag on performance that doesn’t necessarily exist in a stock or bond portfolio where the investments are owned directly. If the mutual fund’s net performance outpaces the market, the extra cost is unimportant, but it could cause the fund to lag in performance. On the other hand, it’s possible that an investor who isn’t comfortable choosing their own investments might have better performance hiring a professional money manager, whether via a mutual fund or owning the investments directly, with similar costs in either case. An additional benefit, then, of owning the investments directly is the additional accountability. Mutual funds announce their holdings two or four times a year, at which point it is possible to tell (assuming low turnover in the fund) that the manager remains consistent with their stated strategy. Direct investment holdings, by contrast, are visible at any time, to see that the strategy continues to be executed as agreed.

Hedge funds combine the worst of all the drawbacks mentioned above. That’s not to say hedge funds cannot be a good investment. They are much less robust, however. First, they are able to make use of leverage and derivatives to execute their strategy. Second, they impose additional costs, usually “two and twenty”, meaning a flat 2% per year plus 20% of returns in excess of a benchmark. If the manager wants to maximise their fees, they could even select a benchmark that’s easy to beat, such as 10 year T-bills. Finally, there are reduced reporting requirements, meaning that an investor may never know what investments are owned within the hedge fund and may be unable to assess whether or not the manager remains consistent in executing their strategy.

Whether an investor makes their own investment choices or hires a professional money manager, it is more robust to own the underlying investments directly. It usually costs less when a large (eg. mutual fund) company is not involved in bundling the underlying investment. It also yields more granular control in the case of buying or selling a position. The investor is able to maintain a better understanding of which investments are held and how they are each contributing to the overall performance of the portfolio. The improved visibility also makes it easier for a professional manager to be accountable for remaining consistent in their strategy.

Most people use a middle-of-the-road strategy. They want a narrow range of outcomes, because not losing is important. Reducing the possibility of losing money also reduces the possibility of making money. A strategy that provides similar certainty with a possibility of better returns is called a barbell strategy. It is also sometimes called core and explore. Using this strategy, the majority of the capital is invested in dependable assets, while the remainder is invested in high conviction investments with a greater potential return.

As an aside, I have been trying to conceive this approach in the context of robustness that I have been exploring through the last few articles.  This is in part due to the fact that a number of thinkers who also present ideas related to robustness have suggested this particular approach. It is not novel, but it is not commonly practiced. Upon further reflection, it seems to me that this approach is most suited to use with asymetric payoff expectations. It cannot, by itself, improve the robustness of a portfolio.

A barbell strategy combines high dependability with high payoff. I’ll explore how the barbell strategy might be applied to asset classes, then how it might apply to an investment portfolio. I’ve noticed a trend over the last few years of continually declaring new asset classes. I’m sticking with the traditional cash, bonds and stocks, since real estate doesn’t trade in a liquid market and other asset classes, even hedge funds (a strategy, not a class), are really a subset of the three I mentioned.

With bonds, a barbell would hold short-term government bonds on one side, with high yield, longer dated corporate bonds on the other side. The government bonds provide certainty, while the junk bonds provide the return. With equities, one side of the barbell might hold the bluest of blue chips, while the other side holds small cap growth stocks. Another approach might hold cash or equivalents on one hand with high payoff equity options on the other. This is where we can see the role of the asymetric payoffs most easily. While the cash provides guaranteed value, the portion dedicated to equity options has the potential to either lose value (to 0) or to gain value (double or more). This is where all the potential loss or return comes from, but the loss cannot exceed a certain percentage (that allocated to options), whereas the gain is not similarly restricted.

Both sides of the barbell need not be equally weighted. It might make sense to more heavily weight the low risk side of the barbell, taking advantage of the more granular control of risks afforded by this structure. Using a barbell strategy will probably not change the probable return much, but it has additional benefits. It allows an investor to spend time in finding and managing the growth assets, leaving the more dependable assets mostly alone. The is also the possibility of reducing the cost of investments. In a case where an investor were relying on professionally managed money, they could allocate the more passive side to lower cost investments (such as ETFs) while the more active side is allocated to costlier strategies (such as hedge funds).

A final idea that is related to the barbell strategy is to account for other forms of return in your personal financial picture. For example, an entrepreneur may consider their startup business to be the small-cap growth stock side of an equity barbell, and invest their remaining assets in more dependable blue chip companies. A tenured professor may account for their salary income as part of the safe bond portion of their investment strategy. Similarly, a landlord already has exposure to real estate.

In the end, the investment portfolio is likely to produce similar return and variability to a middle-of-the-road strategy. However, the barbell strategy allows an investor to take advantage of higher risk opportunities, especially with asymmetrical expectations. It can further save time and cost by depending on higher dependability investments for the majority of a portfolio, concentrating a portion in high conviction, well understood investments with a greater expectation of return.

Accepted wisdom says that no one cares more about your money than you. In the case of most of the people I work with, this is true. There are, however, a few people whom I feel take very little responsibility for their finances. Whether they have no interest or no capacity or simply find it distasteful, they benefit from having someone handle their investments on their behalf. The majority of people, however, do well to be involved in the decisions that are made about their finances. Read more