FIRST: Correlation and Causation are not the same
Flipping a coin and landing heads ten times will surely increase the chance to return tails the eleventh time, right? If you answered “yes”, you are assuming your coin has some kind of built-in memory, which of course is a fallacy. I know it is not easy to admit, but jumping to conclusions characterizes many of us. We see countless relationships that have no validation whatsoever.
Current headlines link the stock market movements directly to the oil price. It happened ten months on a row, so the eleventh will be the same, right? Boy, do we love mental shortcuts and follow these mental leaders down endless correlation rabbit holes. As presented in the above graphs by Tyler Vigen, one can come up with some very interesting correlations, while there is no causal relation at all. Caveat emptor.
I had to smile when I saw Ben Bernanke (the ex-FED chairman) try to explore the correlation between oil and the stock market in his recent blog. Very current affairs and a pleasant effort coming from him, but not so helpful for long term investors. At least, he came to the right conclusion in his blog and we now understand what he spent his time doing at the FED, apart from lowering our interest rates.
A more worrisome correlation and causation can be found on page 25 of the latest Berkshire Hathaway shareholder letter written by Warren Buffett. Yes, you will have to read the original, because page 25 seems to have gotten little attention from Wall Street commentators. I quote loosely: “there is a small likelihood of a “successful” (as defined by the aggressor) cyber, biological, nuclear or chemical attack on the United States. Nevertheless, what’s a small probability in a short period, approaches certainty in the longer run (If there is only one chance in thirty of an event occurring in a given year, the likelihood of it occurring at least once in a century is 96.6%). Aggressor’s means of doing so have increased exponentially during my lifetime. “Innovation” has its dark side”.
Increased innovation and inflicting terror are highly correlated. Causation lies in the fact there are enough people willing to use new dark technologies on a large scale and chance dictates they will be successful at one point. I am an optimist, but realize that often what you don’t see or read will dictate your investment results significantly. It pays to buy protection against sigma six events. Unfortunately, they will occur with great certainty.
SECOND: Uncertainty is certain
As I write this blog, the world markets are doing their thing on my screens. One day the market mood seems to be on Prozac, only to have run out of pills the next day. Headlines scream of volatility, increased uncertainty, risk-on, risk-off, negative rates, imploding China, oil to $10 and even recession. Everybody has an opinion about why the market is doing what it does best, being unpredictable, not in the least Christine Lagarde. She heads the IMF and seems to be releasing a perpetual stream of warnings of doom during her extended reign. I could be forgiven not to mention the martial law under which I live while writing this article. Yes it is a tough life: I am in France and the baguettes are still as good as ever.
You see: it will only be in hindsight that we will be able to conclude with a high degree of certainty, why the markets are currently acting so erratically. Before the future turns into history, it will remain uncertain how all the moving parts will play out and the un-exact science lends itself to many explanations. Not even the smartest investors and/or quant-modeled algorithms can play out all the possible outcomes and make winning bets all the time. Daily market predictions have an entertainment value, but mean nothing as a fundamental long-term guidance tool for investments.
Luckily we can decrease uncertainty by focusing on events, which are more predictable than others or shall I say less uncertain. Take demand for fresh baguettes in France or an increasing older population in Western Europe, the USA and Japan: there is nothing more predictable than census figures moving along the timeline. We are all getting older. The greying population by itself will undoubtedly create much more demand for all kinds of healthcare related services and products in the years to come. When investing, it pays to focus on the most predictable outcomes and to keep an open mind when elements change, simply because change is a constant.
THIRD: Perception of control is an illusion
Most of us like to be in control of our lives. We are surprised when our lives are changed by events we never had control over in the first place. This perception of control causes happiness, stability and reduced stress, but it is an illusion. We create many bubbles for ourselves and tend to resist, as well as love to ignore outside forces that may impact our perceived sense of control. With investing, this can have major implications, as seen with the epic blow-up of Long-Term Capital Management (LTCM), a hedge fund, which employed two Nobel Prize economists, PHD-designed trading strategies based on low returns per dollar invested, amplified by an enormous amount of leverage (30 to 1 debt to equity). Have you ever tried to leverage approximately $5 Billion of equity 30-1? This makes $150 Billion, which combined with derivatives, resulted in more than a Trillion in market exposure. Don’t try this at home…
LTCM thought their trading strategies had an extreme low possibility of failing and their financial algorithms gave them a very high degree of perceived control. In other words, their bubble could not burst, no way! We know the rest of the story. Hindsight is easy; the 1998 financial crisis in Southeast Asia was amplified by Russia devaluating its currency and stopping payments on its debt. This spurred a fright-flight to safety and increased liquidity, an instrument LTCM was short of; the illusion of control ruptured. LTCM had to be bailed-out, because its positions threatened to take down the financial system. Not that we learnt anything, since the same scenario repeated itself in 2008, a mere 10 years after the LTCM fallout had occurred. Wearing a seatbelt will not be of any help when driving off a steep cliff.
FOURTH: Bad habits are best changed in small steps
Unless you have tried everything else and are forced to operate a radical change, it is probably wise to try altering bad behavior with small steps. While new laws about banning electric teakettles and toasters are being discussed by 751 well-paid legislators from the EU parliament, the pressure on the EU as an institution has reached an all-time high: there are no less than four pending referendums challenging the very existence of the EU as we know it. This makes me wonder if Europe would not have done better building itself slower, in small steps, fighting sovereign narcissism, complacency and too much bureaucracy. Bad habits, small or big will most likely result in a disappointing outcome.
A lot of behaviors we display in life are semi-automatic and we don’t even blink when we act them out. Investing by regularly switching to the latest best performing fund has been proven unwise. Today’s top performing funds have a high chance of being tomorrow’s losers and following this bad habit will evidently negatively impact your investment performance. Paying high banking fees to get cash from an ATM is another bad habit. We mostly don’t care because the absolute number seems insignificant to us. But, did you know that in the USA the average ATM fees are 2.88%? Over a 5-year period this would accumulate to a negative 15.25% performance over your cash. Dieting is another goal-oriented activity better not done through shock therapy: small changes aimed towards an improved diet and a workout schedule have proven to be much more sustainable.
Carpe Diem is cool but has no value in relation to your investments. Try to slowly expand your time-horizon from short to long term. Try thinking in blocks of two years and then practice blocks of five. Changing your outlook will enhance your investment results tremendously: you will care less about the daily gyrations of your portfolio and more importantly will be less inclined to sell or buy at the wrong moment. Sticking to one strategy and process is remarkably effective over time.
These are only a few important items to consider when you invest and there are of course many more. Your money deserves and needs attention. If neglected it will be very easy for your assets to die of a hundred small cuts.