The Investment Scientist

Longtime readers of my newsletter know that I am an advocate of comparing your portfolio to your wardrobe. When the market offers you a discount, you shouldn’t see your wardrobe/portfolio as losing value. Instead, you should see this as an opportunity to add to your collection of clothing items/investments.

I also like to explain that in your retirement, your well-being will depend not on past prices, but on the number of durable assets you own. Some of you might ask: 

What is a durable asset?

In my mind, a durable asset is an asset that grows with humanity, independent of technology and politics. 

A prime example of this is the global stock index fund. It includes nearly all traded stocks in both the US and international markets. It represents the total business value of humanity. As long as humanity exists and demands higher living standards, the total business value of humanity will increase. 

Is an outstanding stock like AAPL a durable asset?

It happened when she still lived in China. One day she telephoned me, saying that a friend from her church told her about a fantastic investment opportunity. A brother in Christ had an ingenious business idea; he would buy water ponds, set them up for fish farming and sell his daily yield to restaurants for profit. He promised great returns. To get it going, he needed to borrow money with an annual interest rate of 36% (or 3% monthly.) He also wanted to keep this lucrative opportunity exclusively for fellow believers. My mom’s friend further testified to her that she had invested $10k and had already received her monthly interest, which she promptly invested back into the enterprise upon advice of this fellow Christian. 

I told my mother to stay away from such a scheme since it made neither economic sense nor incentive sense – see my previous article. 

My mom countered with these arguments:

Three weeks ago, in the middle of the Silicon Valley Bank saga, some of my clients got really panicky because they read predictions that we would soon see a total banking system collapse. 

At the time, I advised sitting tight and, if indeed the market should fall, using this chance to buy durable assets at a discount. I know full well how messed up the system is, but I also know that as long as the US dollar remains the world currency, there is unlimited ammunition to deal with the problem. We are not Zimbabwe or Argentina. 

And that is exactly what happened (see the Fed balance sheet here.) In the three weeks since the SVB collapse, the Fed has printed nearly $400B of new money, reversing 2/3 of the tightening we have seen since March of 2022. In other words, since the Fed decided to fight inflation in March of 2022, about $600B has been unprinted (this compared to $5T that was printed after the Pandemic.) However, in just a short three-week time, $400B was printed to rescue weak banks.  

In a previous article, I argued that for folks in the wealth accumulation phase, market discounts like we are getting now, between 22% of the S&P 500 and 33% of the Nasdaq, are actually good news. The same amount of money can now buy more enduring assets. And yes, owning more enduring assets in retirement is absolutely better than owning fewer! In the future, I shall write another article about what constitutes enduring assets (#). But back to the current topic.

I got an email from a retired client of mine, who asked: “What about me? I am past the accumulation phase. I need to draw a fixed income from my portfolio, and I just saw it shrink by nearly 20%.” We did a review of his portfolio, afterward, he felt much more reassured.

Did I do some kind of magic trick? No, I simply showed him what was hidden in his portfolio statements. I compared not just the value of his portfolio, but also his projected yearly portfolio income between August of last year to this August. Here is the comparison table. 

I gained a lot from my Oxford experience. Some of the gains are for me personally, some of the gains are for my business, and yet others can help me better serve my clients. I would count the latter as my clients’ gains.

The biggest gain undoubtedly came from Professor Sussman’s macroeconomics class. There I learned all the intricacies of macroeconomics, including how monetary policy is conducted. The class helped me understand a language called “Fed speak.” For instance, in March last year, when the entire stock market was in a tailspin, the Fed came out with an announcement of “unlimited” QE. The me without the Oxford education would have not understood what that meant. But alas, after the macroeconomics class, I knew exactly what the Fed was planning to do and understood its implications for the market. Thus in the depth of market despair, I was confidently rebalancing my clients’ money into stocks. Sure enough, the market snapped back quickly and has been rising ever since. 

Back then I wrote a newsletter article where I informed you:

This is an article I wrote fourteen years ago almost to the exact day. Here I repost it without changing one word. I do make a few additional comments with red letters.

On July 17th, the S&P 500 reached its peak after breaking a string of records. In a two week time however, both the S&P 500 and the Nasdaq Composite have lost 7.7%. The index that represents smaller stocks suffered a bigger loss of more than 10%. Are you feeling any pain and anxiety? I know I am.

The market is breaking new highs, but it can turn on a dime. Understanding how you will feel in a falling market is very important.

Before I talk about how I deal with the pain and anxiety arising out of the market tumble, I’d like to first talk about Equity Premium Puzzle and Myopic Loss Aversion. These are weighty academic terms, but they would help us understand our psychology and how it could drive us to do stupid things.

I wrote this article in 2007. It’s every bit as valid today as 14 years ago.

I am an amateur pilot. I remember vividly an episode that happened during my training a few years ago. That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by crosswinds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.

My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulence. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.”

Berkeley professor Terry Odean published an interesting paper in the Quarterly Journal of Economics in 2001 about how men and women invest differently. It was an empirical study based on stock transaction data in tens of thousands of accounts over a seven year period provided by a brokerage firm.

These investment accounts were either opened by a man or a woman, and were single or joint accounts. Thus there were four account types. An interesting phenomenon emerged from the study: the more a man is in control of an account, the worse the performance. (See net return vs benchmark.)

Here the benchmark is not any composite index, it is simply the return that resulted from no trades being made throughout the whole year. 

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Allow me to indulge in a bit of fancy. I would love to be remembered as the person who invented the oxymoron “Intelligent Ignorance.” By the end of this essay, I hope to convince you that intelligent ignorance can make you a better investor.

Like the other oxymorons “jumbo shrimp”, “pet peeve”, “bloody awesome” etc., this one needs a story as well. It all started with Nobel Prize winner Daniel Kahneman’s discovery that we humans experience joy when making money and pain when losing money – Duh!  Hold on, keep on reading, there’s more. The pain is usually twice as intense as the joy even if the amount of money lost or gained is the same. This means that if you pay too close attention to a volatile market, it could be a hell of bad experience. Bad experiences lead to bad judgments and before long you are making bad trades.

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Allow me to ask you a seemingly unrelated question: what do you think the most common hair color in Ireland is? If you answered red, you are like the majority of people, but you are also wrong. The most common hair color in Ireland is dark brown (80%.) 

As you answered that question, what went through your mind? What mechanism caused you to arrive at the wrong answer? How is it relevant to stock market investing? I will answer these questions one by one in the space below.

If you answered red, you were using a mental shortcut called the representative heuristic to answer the question. What is the representative heuristic, exactly? It essentially says we humans tend to erroneously equate what is representative to what is likely. Indeed, red hair is representative of Irish people. Just under 10% of the Irish are redheads, compared to 1% of the rest of Europe. So the typical Irish in your head is a redhead, probably wearing green clothes and holding a pint of Guinness. Since you can easily recall a redhead Irish in your mind, you think therefore that the Irish are more likely to be redheads.

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