- Investment decisions are inevitably built on expectations. These expectations in turn are built on the available information. However, the constant flow of information is full of smoke and mirrors.
- There is one piece of knowledge an investor can always rely on: I may be wrong.
- This simple finding leads to the very basics of investing: Goals, investment horizon, contingency plans and not least self-knowledge.
- The examples of Warren Buffett’s approach to investing and Harry Browne’s Permanent Portfolio provide us with very different angles on these basics.
Investment decisions are always built on some sort of opinion about what the future holds. This opinion in turn is fuelled by the given information. There are hundreds of voices about the direction of stock prices in general, individual stocks, interest rates, commodity prices -- you name it. Much of that I consider as noise that I find not helpful and/or hard to trust. There are a number of reasons for my unease:
Financial markets and sports are probably the two top-ranking playgrounds for people who love data (unsurprisingly, at times these two playgrounds overlap). There are tons of ubiquitous data. Often this data is used to target emotions which provides a constant challenge to the individual investor's brain.
Slight changes to past data can produce very different conclusions. Adjustments for inflation or different currencies may be the most common examples.
The tons of data suggest calculability even when there is none. There are always unknowns that nobody can possibly think of in advance.
Most predictions come from market participants. Market participants are by no means neutral observers and therefore caution is warranted with regard to their comments. To be fair, it is close to impossible for them to signal credibility. If they have a skin in the game they are biased, if not, you wonder why they do not put their money where their mouth is.
If someone really had better knowledge about the future, why would he/she share it rather than taking advantage of this knowledge? Even the slightest edge over the other investors should translate into huge returns.
With all that said, there is no chance that the flow of forecasts will ever run dry. The reason may be that investors have difficulties to accept that markets are subject to erratic fluctuations. Therefore, we will always be looking for assurance that it is possible and rewarding to find and decrypt the hidden mechanisms that are behind the market movements.
The one piece of knowledge to rely on
So there is this dilemma: I need to build my investment plan on some sort of expectations about the future, but the market noise does not seem to give me any clues what I should be expecting. In this situation, I had to think of René Descartes and his quest for this one piece of knowledge that he could completely rely on. Of course, he famously concluded:
I think, therefore I am.
If I had to make a suggestion for what an equivalent truth in the world of investing could be, the best I could come up with would be:
I may be wrong.
(If you have better ideas, please share.)
Sorting the sources
At first glance, this finding probably fails to impress, but there is an immediate benefit to it: Since this is the one thing that I am entirely sure of, it helps me to separate the more credible market voices from the less credible ones. As Harry Browne put it:
The investment expert with the perfect record up to now will lose his touch as soon as you start acting on his advice.
[Harry Browne: Fail-Safe Investing]
As always, Warren Buffett sets a positive example. There are numerous quotes from him like this:
I have not [..] made my last mistake in purchasing either businesses or stocks. Not everything works out as planned.
[Warren Buffett: 2013 letter to shareholders]
You will also find that many contributors on Seeking Alpha are unafraid to offer a word of caution with regard to their own findings. I always appreciate that.
What is 'wrong'?
Before moving on, it makes sense to think about the exact meaning of 'being wrong' in our context. My definition would be as follows:
An investor has been wrong if he/she fails to reach his/her goals in the given investment horizon.
With that in mind, we can now spend some thoughts on the options that exist for not ending up in that category.
First of all, it is important to remember that there are different degrees of wrongness ranging from being 99.9% right to being 100% wrong. The former could result in working slightly longer than actually intended before retirement, whereas the latter would be the equivalent to going completely broke. In order to avoid the worst outcome, it looks like a good idea for the risk-conscious investor only to consider investment plans that have a second chance already built in.
There are two dimensions of second chances that can be favorably combined:
The first dimension is asset class/ stock diversification. If the investor is holding 20 positions and has to write off one, it is a blow, but hardly the end of the world.
The second dimension is called time diversification and means that the longer the holding period for stocks, the less risk the owner has to bear. Note that stocks offer the greatest upside in terms of time diversification. There is an interesting Morningstar research paper on that subject.
Our definition above points already to the aspect of time by referring to the 'investment horizon', but there is also another key word that can help us: 'goals'.
Two gentlemen who have been right
There are a number of potentially winning formulas for different levels of ambition. Let us get back to two of the gentlemen who I quoted earlier and review their successful strategies with regard to their potential 'wrongness factor' for the individual investor.
Warren Buffett's value approach to investing is well documented and researched. His track record speaks for itself.
The other example is Harry Browne's Permanent Portfolio. Harry Browne's advice to retail investors was to build a 'bulletproof portfolio' that offers protection 'no matter what the future brings'. You can find more information on his Permanent Portfolio e.g. here. The comparison with Berkshire Hathaway looks less brave than you may think when considering that even the Permanent Portfolio impresses by constant outperformance measured against its target.
The following table compares the two examples in terms of the variables discussed above:
Stock market outperformance
1. Wealth preservation
Portfolio of shareholdings
Portfolio of four asset classes
Margin of safety approach to stock picking and acquisitions
At least one asset class to prosper, no matter the economic environment
The only feature both approaches seem to have in common is the investment horizon. However, even in this respect there is an important distinction to be made: For Warren Buffett 'forever' seems to be both, a statement of confidence in the quality of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) holdings as well as a safety measure to take advantage of time diversification. The following paragraph from Berkshire's Owner's Manual covers both aspects:
Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.
By contrast, time diversification is close to irrelevant in a Permanent Portfolio compared to asset class diversification and the reduction of individual positions through rebalancing is part of the plan. 'Forever' means here, that the Portfolio as a whole will deliver irrespective the investment horizon, if required until eternity. One year of underperformance against its targets is the exception, two consecutive underperforming years are almost unthinkable.
The Berkshire-Portfolio in total, of course, is delivering on its more ambitious targets in most years as well and the catchphrase most investors feel attracted to is 'market outperformance'. Many of us enjoy a competitive environment and feel outperforming the market is just the right target. While I accept that this can be a tempting and even achievable goal, this article is called 'I May Be Wrong' for a reason. Expressions like 'winning formula' and 'margin of safety' can be misleading as they make it sound like it would be both, easy and safe, for other investors and even do-it-yourselfers to replicate the Buffett-approach. It is important to remember that Berkshire-type investing is based on active management that requires a very rare skill-set. Data and formulas are ubiquitous, skills are not. What is meant to become the replication of a winning strategy can easily turn into a chain of individual mistakes, if you do not have what Buffett calls 'Berkshire blood' in your veins. This is probably why even Warren Buffett advocated a simple S&P500 ETF in his 2013 letter.
The low-risk benchmark
At the same time I do not see any real downsides to the Permanent Portfolio which can be safely replicated even by inexperienced investors. The maximum of criticism that I could offer would be that the Permanent Portfolio is designed to produce second-best results which may cause investors to try and guess which asset class will outperform next. But this argument relates actually to the investor who then failed to get his/her goals right in the first place rather than to the concept.
It is also worth bearing in mind, that there are hundreds of ways to take on high risk without even coming close to the Permanent Portfolio's performance. This is why I like to use the Permanent Portfolio as a point of reference in portfolio construction similar to the risk-free interest rate of a treasury bond in the context of a DCF model. I track the performance of my own portfolio against a virtual Permanent Portfolio to see, if the extra risk that I am taking through higher exposure to equities in general and my individual stocks in particular is paying off.
What we can take from the above is that in order to minimize the risk of being wrong the following rules should help:
Know your goals - The more realistic your goals, the less you need to worry about being wrong. The more ambitious your goals, the more important your contingency plan.
Know your sources - The expert who is never wrong can be safely ignored.
Know your investment horizon - Time is on your side. If you are patient enough to take advantage of time diversification, you are in good company.
Know yourself - Risk is directly linked to the person behind the steering wheel. 'I may be wrong' applies not least to self-knowledge. Remember the average driver believes his/her driving skills are above average.
Make sure you are not taking the high-risk, low-reward route - By comparing the performance of your portfolio against an appropriate low-risk benchmark such as the Permanent Portfolio you can control if your approach is worth the risk you are taking. If not, switch to the benchmark. There is nothing wrong with that.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.