You and I Both Know These Things…
Before we get into our main topic for the day, I recently appeared on a podcast with two people I sincerely respect: Alec Crawford (My first boss as Head of Risk Management during the Financial Crisis) and Olivia Albrecht (A business counterpart of mine at PIMCO for a number of years).
The topic of the conversation, you ask. ESG investing and the rise of AI. If you’ve been on a long vacation without access to the internet (It seems nice; I wish I could have come along), let me fill you in: ESG stands for Environmental, Social, and Governance; AI stands for Artificial Intelligence.
OK, before I lose half of you guys on the principle of the thing alone, let me try and lose everyone right here right now. My main message about ESG investing was simple. We know close to nothing about what the investment implications of ESG investing are. That’s neither good nor bad; it just is. How could we know much of anything about the investment implications of cutting carbon from our portfolios, for instance, given that all the data we have about things like the stock market are from an era where carbon was just not a consideration (and therefore not a unit of analysis)?
As a recovering quant, I tend to be skeptical whenever someone points to historical data to “prove” that this or that strategy should do well in the future (We’ll return to that in a minute), but in this case, there is simply no relevant long-range historical data to squeeze even a timid answer out of.
Let me be clear, this is not pro ESG or anti ESG. Sorry everyone, but sometimes being out with the things that we don’t know can be liberating. I hope you’ll listen. It was a good, no-dogma conversation from where I sat. The podcast is accessible here: https://www.treussard.com/newsletter/treussard-stay-crawford-albrecht.
Now, let’s dig into things that I think we know. And the more I think about investing, the more I get to a simple punchline: This stuff is really not that hard and this stuff is really, really hard. Hard or not hard, though, it’s all too easy to get turned around. So let’s keep a few things straight.
Past Performance is No Indication of Future Performance
(Logic: Not Hard; Psychology: Hard)
This is more than a regulatory disclaimer that you’ve seen a million times. This is just a simple reality based on the fact that human systems (including financial markets) are tuned up by competition over the long haul and are subject to external shocks, which makes the whole edifice constantly shifting. As a result, the winners of yesterday may or may not be the winners of tomorrow.
Now there are good characteristics and bad characteristics that may set up certain countries, companies, or individuals for more or less potential success in the future. That’s why the expression “I would buy stock in this kid if I could” exists. Maybe it’s a dogged work ethic (for a person), creative problem solving (for a company), or adherence to the rule of law (for a country, so that everyone knows how the game is played and can be out there competing fairly), and often all of these coming together. Maybe it’s even just a built-in advantage (like military technology might for a country or monopoly power for an industry), but every advantage can be outplayed or taken for granted. How did Blackberry screw up so badly? Where is the Ottoman Empire? How did the Brits lose their global advantage over the course of the 20th century (Here is one example)? Under bad characteristics, file in bold red Sharpie: “ethics and character.” A snake-oil salesman is a snake-oil salesman…. Fool me once, shame on me, fool me twice, and maybe it’s November 2024. But we digress…
More to the point, next time someone uses the present tense after describing a historical fact about investing (as in “US equities outperform International equities”) to project it forward, you call me. I have a few words for that person. Projecting past results forward with unwarranted conviction is a cardinal sin in my world, even though people find near-term comfort in it. Extrapolate at your own risk.
The Structure of Investment “Things”
(Not Hard)
Things like stocks, bonds, or currencies are human creations. They are engineered to achieve specific economic functions and sort risk and reward efficiently among different types of people based on their circumstances and preferences. If you don’t know what I mean, have you ever heard someone say, “I like certainty in my investments, which is why I love stocks?” No, you haven’t.
Think of every investment type as being built to bend, built to break, or a weird polymer in the middle.
Equities (stocks) were built to bend. Simply put, when you have equity in anything, its value can explore the full range from zero to infinity — though infinity is never an actual outcome. It’s an adventure, it’s always been. Ask the people who bought the first stock certificates issued by the Dutch East India Company in 1602 (when you meet them).
Bonds are built to deliver certainty and structure, which means when too much pressure is placed on that structure, the thing breaks. That’s what default is, whether we are talking about junk bonds, mortgage-backed securities, or US Treasuries. The size of the ‘ouchy’ after something breaks is a function of how much we were reliant on it not breaking. Junk bonds, no problem. Treasuries, big problem.
Then there are weird things in the middle. Currencies are a good example. Currencies are meant to be stable (to facilitate economic activity) but they bend based on things like relative interest rates across nations — this is why the US dollar is strong today, and the Yen is weak. But despite some relative flexibility, currencies tend to be ‘stationary’ over time. They don’t go to zero and they don’t go to infinity. You get into weird, confusing conversations with people when they take positions that require ‘currencies’ to go to zero or infinity (Crypto, he sighs).
The Asset Management Industry’s Obsession with Funds (and Mean-Variance Optimization)
(Two-fer: One Not Hard, One Hard)
I just told you there is structure in investments. Now I am going to tell you about a large-scale effort to take apart that innate structure in everyday investing. Mutual funds, ETFs — you name it — every asset class is being shoved into a fund structure, whether it has structure to start or not. Why? Scale. Asset management is a scale business. If you can sell one bond fund to millions of people, that’s an order of magnitude more efficient (read: profitable) for the asset manager. Are you surprised that everything in your financial diet is being packaged into funds?
Now, let me be very clear. There is no question that funds can be valuable in giving investors the benefit of scale. A diversified, low-cost equity ETF is the poster child for this. And to some degree, this is true of bond funds. Small investors may not be able to buy single bonds like larger investors can. So at least you can get exposure to the risk factors of bonds. But a bond fund explicitly strips structure (like a bond’s maturity) from the underlying thing itself. Again, that’s just an ‘is,’ not good or bad, just something you should know. (Extra credit: trading bonds is hard work. Most people are happy to make it someone else’s problem, even if it means losing structure in the process).
Now, mean-variance optimization. It’s a simple math-y way to combine investments based on risk and return statistics — all too often historical statistics, which takes us back to point #1. Out of the last 75 years or so of academic research in finance, it’s basically the one thing in the whole field that’s been adopted at scale. It’s a little bit like someone invented penicillin and the whole medical world went, “That’s it, we did it! Good job, everyone. Happy retirement.” My educated guess about the investment industry’s embrace of mean-variance optimization is that it’s a fabulous sales tool for mutual funds. Shove a new fund into the mean-variance meat grinder and it'll give it a weight in something conveniently called an ‘optimal’ portfolio. Then you turn around and say, “The Optimizer says you should own some of this.” Who’s to argue with The Optimizer? Do you think you’re smarter than The Optimizer? Let me be clear, I believe in diversification and all forms of risk management… a lot! But the selective adoption of scientific knowledge in investing is hard to dismiss as just a silly oversight.
Losing Stings a Lot More than Winning Tickles
(Not Hard)
This needs no explanation. We’ve all lost, and we’ve all won. Nearly universally, the sting from losing is unsettling and lasting. Winning is a quick high that only resets the bar higher. This means that, along the way, we should keep an eye to the downside to avoid being surprised with the ways in which we can lose (there always are ways to lose). Equally importantly, we should aim to avoid doing things that have a tendency to turn everyday losing into permanent self-defeat. In other words, let’s not snatch defeat from the jaws of (eventual) victory. Only you can do that for yourself. This means avoiding what investors call “permanent loss of capital,” which comes from selling at the wrong time or buying loads of things that can go to zero under reasonable scenarios. That’s permanent defeat. In stochastic calculus — the type of math that is required to price options — we call that an “absorbing state:” A stock at zero is an absorbing state. A decent person at zero is an opportunity to bounce back.
Complexity Jockeys vs. Simplicity Nihilists
(Not Hard)
At first approximation, you can place wealth management “practices” into one of two buckets, at the risk of slight caricature:
The complexity jockeys slowly complicate things under the guise of necessity and sophistication. Before you know it, you have ten accounts with the same firm, hundreds of holdings, and you don’t know what’s what. You end up with ‘strategic obfuscation,’ where the complexity is overwhelming, and surely you can’t do this without the guy who created this tangled web in the first place.
At the other extreme, you have the simplicity nihilists. They tell you that basically nothing matters, nothing you can do will make any difference in your future, and that markets are unknowable beasts that you can ride but should not dare explore further. These ‘minimalists’ argue that one-stop-shop solutions are fine and that the only frontier to conquer is your own psyche while you ride the wild beast (See this for an example from my youth).
The real world operates in the middle, the grey. Some complexity does nothing for you (except create a prison and higher fees), but there is such a thing as too much ‘minimalism.’ Striking the right balance is a challenging task, one that requires clear thinking and the right incentives.
Investing is a Means to an End
(Easy, but you decide)
When you take the final tally on your life, I doubt “How did I do as an investor?” will rise very high up the list. Even if you did better than everyone else at moving chips around the table, if the rest of your life sucked and your kids aren’t talking to you, I don’t think it’ll get you very far. Imagine how crummy you’ll feel if, despite being obsessive about it, you did badly at investing too (which is easy to do). This is a fundamental thing that both you and I know. Get the big things right, get most of the small things right too, and accept the occasional rainstorm. That’s how rainbows are created.