When the Rules Change

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In the 1990’s competitive swimmers got very serious about swimming large distances underwater at the start of races. This culminated most famously in Russian Denis Pankratov winning the 100m butterfly at the Atlanta olympics by swimming more than half of the first length underwater and breaking the world record. Swimming’s governing body, FINA, decided understandably enough that people don’t watch swimming to see people kicking along underwater and limited the distance to 15m in 1998 (in backstroke this had been limited to 10m from 1991, later changed to 15m). The game changed, Pankratov was no-longer as dominant as he had been, placing 7th at the Sydney olympics in 2000. His world record was broken later too of course. Progress doesn’t stop. Nowadays it’s normal to see pretty much every swimmer in a top level field going to almost exactly the 15m mark underwater before surfacing.

Unfortunately when it comes to investing there is no committee that meets to determine the rules, no-one sends you a rulebook. No-one tells you when you can kick out to 15m rather than 10. Perhaps a better metaphor is evolution, as Morgan Housel wrote in a recent piece that in investing – as in evolution – there are no permanent advantages, no rules that can always be assumed to work –

Evolution is the study of advantages. Van Valen’s idea is simply that there are no permanent advantages. David Jablonski of University of Chicago described it: “Everyone is madly scrambling, getting better all the time, but no one is gaining ground. A species can’t get far enough ahead of the pack such that it would be extinction-proof.”

Morgan Housel

A lot of the basic lessons of finance and investing seem to have been turned on their head right now – negative interest rates, central banks funding governments, buying corporate bonds. What should investors take from this? Does the standard finance and investing thinking still apply, or have the rules changed in a world of negative interest rates and unlimited support.

Ray Dalio has gone as far as saying that the financial markets are no longer “free markets” in the traditional sense, and that the credit cycles that used to be a natural feature of markets, no longer apply.

So what rules can we rely on investing for the next decade?

Ten things I think I know –

  1. Prepare to be surprised (but don’t just prepare for the last disaster)

To state the obvious, the world is surprising , that’s the correct lesson to learnt from surprises (as Daniel Kahneman said). But there’s a deeper lesson behind this apparent truism. We do tend to learn lessons but we learn an overly-specific lesson rather than the general. Don’t buy airline stocks in a pandemic as opposed to stocks are risky and can fall 30%.

Some really silly things are going to happen over the next decade or so. You probably won’t understand all of them and many won’t make sense, but that’s ok. But spending too much buying specific hedges against the last disaster, or excluding particular sectors from your portfolio for specific reasons is probably not going to be a good strategy.

2. Risk still matters

Markets can and will fall fast and far, in a world where investors are pushed further out on the yield spectrum sentiment driven boom and bust could be the norm. There’s no magic here but you can manage your risks by diversifying, hedging, and most importantly giving yourself resiliency / margin of safety (for example by having ready access to cash), but, crucuially, don’t get triggered into loss aversion or paying up too much to remove risk. Investing is still about taking and even embracing risk.

Be Skeptical, but willing to take risk. It is dangerous for investors to assume they will always be bailed out, but equally dangerous to put tin-hats on and hold out for a massive crash while invested into cash or gold.

3. Avoid all-in all-out and resist market timing

It is so easy to get caught in false dichotomies – stark choices between two alternatives – by the framing of a question. A good example would be a UK investor looking to potentially diversify say half of their equity holdings from the UK to the US. It is easy to get trapped in a debate about relative valuation and which market will perform the best, and are we SURE the US market is a better proposition. But that’s the wrong debate. It’s always a question of degrees – avoid all-in all-out thinking and pinning everything on one simple narrative. It might sound good but will probably be wrong. Dollar cost average into and out of allocations in order to get yourself in motion without waiting for the perfect opportunity to move which may never come.

4. Understand your “why”

Without an objective you really aren’t going anywhere in the best of times (and these are not the best of times). You need to know what game you’re playing and have a metric for understanding when you’ve “won” the game (so you can take risk off the table), as well as to avoid wasting time and effort making the wrong performance comparisons.

This equally applies to each component of your portfolio (asset class, mandate or fund)- you need to know exactly why it is there. There are bound to be some tough times where performance is hard to explain, if you don’t know clearly why something is there, this will be very hard to manage through because you won’t have a clear sense of what you expect that allocation to do in a certain environment. Having weak ties to, and only a loose understanding of an underperforming strategy is a recipe for round-in-circles conversations and regret risk.

5. Avoid getting carried away by stories.

Don’t be a fed hater, a FANG hater a perma-bear or a gold bug. When no-one knows what the future holds but everyone has a good story to tell, it might be a good time to assume we know very little. my best answer is just be skeptical and just diversify.

6. Sharpen up your process

Get ready to be nimble: quick investors with liquidity were rewarded in March/April. Opportunities to enter markets and good valuations won’t hang around. In the “good old days” bear markets had the decency to hang around for a few years at least, which might have been painful but also gave plenty of opportunities for investors to average in at lower levels or buy the dip. We may have to get used to things happening faster now, as central banks react fast with strong support. Even more reason to get clear on your why and your strategy upfront so you can have the confidence to move quickly

7. Don’t bet on mean reversion

Don’t pin your hopes on interest rates reverting. Central banks are signalling as loud as they can do that rates are not going to rise, and demonstating their ability to follow through on that. You might not think it’s right, but there are much easier battles to win, fight those.

8. Be global to avoid FOMO

Getting backed too heavily into one country’s market (because it “looks” attractive) means you could be dependent on particular sectors eg oil, or styles like value could mean you miss out on rallies in tech or healthcare. Dont get too cute on market or sector allocations. What looks smart may not be rewarded, when you don’t know any better, just own everything.

This is particularly true for UK investors. There are a lot of reasons to want to diversify investments outside the UK right now, with several layers of uncertainty around the recovering from covid as well as Brexit, but of course UK stocks look “cheap” on all sorts of metrics. Having assets held in overseas currencies has proven to be a nice tail-risk hedge during recent market events.

9. Put your valuation metrics away

I’m not saying value is dead, just that we have a decade of evidence that it might not currently be the best framework for asset allocation. Assume we don’t know and just diversify, which will include buying some markets, and sectors, that look “expensive”. Find a way of doing it. Don’t exclude yourself from areas of the market just because they look expensive on particular metrics. It is easy to forget that most valuation metrics do not allow for the level of interest rates.

As Ben Carlson recently wrote: “If you’re waiting for valuations to revert back to some magical 15x average CAPE ratio from 1871 you may be waiting for a long time if the low yield environment is here for some time…. valuation is not useless but it does require context”

10. If you must, sin a little

With acknowledgement to Cliff Asness for this one. Doing a little bit of valuation-based allocation, betting on specific sectors or even market timing isn’t the end of the world but the key is “a little”. If this comes to dominate your overall strategy then you are setting yourself up for potential disappointment and regret. Keep it modest, and don’t expect to be rewarded quickly, or at all for your sins.

Is it really different this time?

A big problem here is the moral authority of the statement “the most dangerous words are – this time it’s different”, usually intoned slowly and earnestly by someone who has seen one more bear market than you. Frankly it’s a trump-all excuse for a lazy status quo bias, a false comfort that we don’t need to think about how we may need to actually change, and an excuse to avoiding the tricky reality that every time is different, and sometimes things do fundamentally change. It might not make sense, but we have to get to grips with the world as it is, not how it was or how we’d like it to be.

And four big questions I would love to know the answer to, but don’t …

Should investors use more leverage?

Should gold, commodities (and even bitcoin) be considered as strategic alloctions?

Can investors take more risk with a “Fed put”?

Is BTFD always the right thing to do?

More on these questions here.


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