The New Face of Failure

Built by Irishmen

Folks are pretty quick to take credit for success, and there’s no shortage of people who will accept credit for strong investment returns in 2013. Just like the people sailing on the Titanic’s maiden voyage when it left Southhampton were proud of it, though they didn’t build it. A rising stock market fosters the illusion of insight. This bestows investors with overconfidence in their abilities, which can sink their portfolios.

As self-perceived investment geniuses, they will be tempted to trust their gut instead of a risk management strategy. This type of overconfidence usually doesn’t last any longer than the bull market, but it can, and does, cause harm. People who fall victim to this delusion rationalize passing on basic portfolio management tenants such as rebalancing. They end up taking more risk than they should at exactly the wrong moment. Everyone knows that they should buy low and sell high, but it’s contrary to human nature. Our instincts tell us to hold on to the investments that are performing well and they discourage us from putting money into those which have performed poorly - but that’s exactly what buying low and selling high looks like. Confidence is better placed in the process and the strategy rather than the perennial performance of any asset class or our personal investment genius. The irony is that those who focus on the process rather than recent performance typically end up with better long-term performance. If basic maritime protocol was focused on more than the unsinkability of the Titanic you may have had a far less dramatic story but a better ending.

Sunk by an Englishman

Gaudy equity returns make people forget that the market can also go down, and, in fact, a healthy market does not move in a linear fashion. Bubbles and crashes are linear movements, but healthy markets are like the ocean - rhythmic waves with occasional choppiness. The current context makes it easy to dismiss risk management for how it diminishes return. Diversification? What good is that? Why would anyone want to hold investments like bonds or emerging markets equity that are going down? Why, for that matter, would anyone even want to hold investments like alternatives that are going up, but not as fast as the market? In rising markets, investors quickly forget the need for any kind of loss protection. Why bother with lifeboats on an unsinkable ship? They would just block the view from the First Class Promenade.

Investors should not resent risk management because it does not provide direct benefits when things are going well. To dismiss risk management in any market – even a rising market - is hubris. A rapidly rising market is precisely the time when you need to pay close attention to your risk management because that’s when you have the most to lose. That’s when the growing part of the portfolio gets furthest from the target allocation and creates the greatest risk exposure. The higher the market valuations rise, the more the asymmetric risk profile tips towards the downside. It is easy to get awed by current returns but valuations will be a better predictor of your future returns.

She was alright when she left here

Conviction is necessary, but investors should not be so foolish as to believe that nothing could possibly go wrong or that they’ll recognize and respond to the warnings when hazards appear. That’s the wrong view. The warning light is always on. Risk is not flat, but there is always risk. Confidence crosses the line to overconfidence when we forget that lurking peril.

You can’t guarantee an 8% return nor can you make it happen. The most you can do is design a portfolio that, over the long term, is likely to average an 8% return. That doesn’t mean it will get an 8% return every year. It doesn’t even mean that it will get an 8% return in any year. There will be years with lower returns - some much lower. We must learn to take the bad years with grace and patience and rely on our risk management to prevent irrecoverable disasters. There will be years with higher returns, too – some much higher. When the market is up 32% we see investors with an 8% target return dissatisfied with a 25% return. Sounds crazy, but some folks need to learn to take the good years with grace and patience.

It seems counterintuitive, but behavioral studies tell us that people take greater risks to avoid losses rather than to pursue additional gains. So why would anyone with a 25% return want more risk if risk is to avoid loss? It’s because the perception of loss or gain depends on the determination of the default state. A 25% return looks great when framed by an 8% target return, but it looks like a loss when the presumption is an index return of 32%. Perhaps the perspective, and not the portfolio, needs the adjustment.

The new face of failure

The new face of failure looks a lot like the old one: over exuberance. Nearly every decade will have a big year to fill investors with hubris. It draws their focus to the index return and makes them think that strategy, risk management and valuations are for people who do not know better - the suckers. This game of index chasing post-rally never ends well. It’s why valuations are more predictive of future returns than recent past returns. From a practitioner standpoint it is also misaligned with the client needs. Strategy should be built around the clients’ goals rather than index envy. There are no investors with the same investment objective and time horizon as an index. Using the index return as a benchmark is not prudent, and can be dangerous. That false contest goads investors to take ridiculous risks. Full speed ahead all the time can make you a little quicker in stages, but it’s more important to arrive safely at your final destination.

Those who do not learn from history will repeat it; that’s why the new face of failure and old face of failure look the same. The failure is the allure of an index return and losing sight of the process. They must diagnose their needs and examine pitfalls and opportunities using a disciplined process that doesn’t include feelings about last year’s return. Investors must resist the temptations to give themselves credit they didn’t earn, dismiss risk management in rising markets, and to covet the returns of more aggressive investors. These are all symptoms of perilous overconfidence which has sunk many investors in the past and will again in the future. There are no new mistakes, just new people making them. Just like a new ship running into an old problem – there’s nothing new about icebergs in the North Atlantic.

As always, we are proud to be your partners in stewardship without compromise and crank reminders of process.

Best Regards,

The Team

Galway Investment Strategy

[email protected]

© Galway Investment Strategy

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