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Can Investing Be A Simple Task?

Investing on autopilot

When we think of our life or just talk about what we have been doing lately with a friend, we tend to focus on big events. If we have just taken a trip, the details will be recounted. If a baby has been born or we've been to a wedding, the event dominates our conversations. Similarly in the news, an uprising in Iraq or the World Cup can consume the headlines and color what we think is occurring around us.

But really, life is more often concerned with simple tasks, with everyday activities. We walk to the mailbox. We drive to the store. We eat our meals at pre-determined times. We sleep.

Behavioral scientists or psychologists tell us that these actions are controlled by what Nobel laureate, Daniel Kahneman, calls System 1. System 1 is our subconscious, automatic response system that takes us pretty smoothly through each day without a lot of conscious thought about how we do it.

Unless you are six months to a year old, you don't give much thought to the mechanics of how you get up on two feet and walk. Unless you are a student in drivers ed, driving is fairly effortless. And don't get me started on how easy it is to eat! Now sleeping - it seems the older you get, the more effort it takes, but generally, if you get tired enough, you just fall asleep.

Buy and hold investing has the allure of the System 1 tasks that so dominate our lives. You invest once, you allocate among asset classes to diversify away risk, and, other than an occasional quarterly or annual tweak back to that allocation, that's it. The markets take care of the rest.

System 1 is very efficient. It handles most tasks … most of the time. But what about reason, logic, responsiveness, don't they come into play? That's the job, in Kahneman's view, of the mind's System 2. It steps in to use those faculties only when System 1 needs its help.

You're walking along and the sidewalk ends. What do you do? You just can't keep following System 1 and keep automatically walking, can you? You might be lakeside or worse still, on the edge of a cliff. A decision has to be made.

You're driving your car, suddenly a big diamond-shaped orange sign appears on your right hand side - "Detour", abruptly you need more than just an automatic pressure on the accelerator, hand(s) on the steering wheel and brake at the ready - you need to think about what to do next.

This even happens while eating. You're automatically eating your salad. Fork to lettuce, fork to mouth, chew, repeat.

Then, soup comes. You prepare to repeat the process - but now with a spoon. You pick up the spoon, dip it in the soup, and bring it to your mouth. All this without a single conscious thought. The soup touches your tongue - you recoil - it's too hot! Do you really want to keep consuming it right then? You have to think about it.

Finally, sleeping seems automatic. What could be more passive? You just have to lay there, right? But that's an illusion. You have a bad dream, doesn't System 2 have to convince you that that's all it is? A crack of lightening awakes you. A summer storm has sprung up in the middle of the night. "Do I have to close the windows?" There's a noise downstairs, the dogs start barking, you awake. Is a trip downstairs to investigate necessary?

These are all simple tasks and we spend most of our lives automatically carrying them out without even thinking about them … most of the time. But they have one other characteristic: they are all responsive to change.

In every case these simple tasks still require a contingency plan. They must be ready to respond to the environment around them … especially surprises!

Kahneman tells us that "The main function of System 1 is to maintain and update a model of your personal world, which represents what is normal in it. The model is constructed by associations that link ideas of circumstances, events, actions, and outcomes … As these links are formed and strengthened, the pattern of associated ideas comes to represent the structure of events in your life …" Yet, he also tells us that "A capacity for surprise is an essential aspect of our mental life …"

As I write this article, I've been trying to think of an ordinary activity, some simple task we do, that does not require that we also have the capacity to deal with a surprise while we are carrying it out. (Let me know if you think of one. I haven't.)

Still, most of the investment world seems to be forever trying to convince us that investing is somehow different. The buy-and-hold mantra is chanted on the financial shows and printed repeatedly in both the financial and non-financial press.

I guess they would respond, "But investing isn't a simple task." And that is true. But does that lead to the conclusion that the way to deal with a non-simple task is to abandon the use of System 2 when a surprise occurs?

Of course, the buy and holders, the advocates of passive investing, would respond that they employ System 2 before they invest. But isn't that the same as thinking about where you are going and what you are going to wear before you leave on your walk, but then automatically proceeding into the lake when the sidewalk unexpectedly ends? That leaves you being all wet, doesn't it?

In contrast with passive investing, active investing always has a plan to deal with contingencies. Active investing is generally responsive investing. It is designed to adapt to its surroundings, and plans for surprises.

While I could write a separate letter on what constitutes a surprise, I know from the behaviorists that in addition to exposure to repeated occurrences of associated events, surprises often shape our view of what is normal. Usually these dual experiences serve us well. I fear, however, that now is not one of those times for most older investors that have seen many different markets come and go.

This year, and for most of last year, for that matter, we have seen stocks march steadily higher, with only an occasional 5% or less retracement. Many investors new to the market think this is the norm and, thus, are fully participating in the stock market's advance. Eventually they will be surprised.

Source: Bespoke Investment Group

Experienced investors are more hesitant. And many, perhaps most, have not enjoyed much of the stock market recovery that has been going on since 2009.

This is because the basis for what they perceive as normal is very different from that of novice investors. Longer-term investors have experienced two bear markets in which the S&P tumbled more than 50% and their portfolios, which they expected to live on the rest of their lives, were severely reduced. Their view of "normal" is now very different than it was at the height of the bull market at the end of 1999.

It's like this week in the World Cup games. Going into the competition even the US team coach did not give them much of a chance. Then the surprise occurred, they beat Ghana, the very team that had kept them from advancing in two past efforts.

The surprise changed perceptions. When the team played Portugal this weekend, expectations were different. Although the US was playing a team that is a perennial favorite, with the world's number one soccer player, many expected a victory, especially when we were up 2 to 1 with 20 seconds to go.

When Varela scored and the US had to settle for a tie, the same fans that had so little expectation of success at the beginning of the competition were now disappointed. Yet, we are still in the thick of the competition, when we were not expected to be here. Surprises can indeed change expectations.

So yes, long-time investors see the market advancing daily. They hear the repeated reports of new index highs - 22 such reports this year alone, right on pace with the 45 recorded in 2013.

Source: Bespoke Investment Group

But the dual bear market memories from the last decade just won't let these investors pull the trigger. They don't want to be burned again.

The problem is that this "old normal" of theirs is conflicting with the "new normal" and the resulting indecision is burning them once again, just in a different way - the opportunity being lost.

Perhaps, if those of you in my generation and the one that immediately succeeded it will think back to their bear market experiences; they will recall what many remember. They either tried to invest themselves and fell victim to being carried away by their emotions - the overconfidence/capitulation cycle, or they followed the buy and hold advice of most financial advisors and took some sizeable losses.

Make this time different. Give disciplined, quantitative active management a try. It's true, actively managed portfolios have not traditionally generated returns as great as a stock index when it's rallying - but generally they get more returns during these times than investors that avoid stocks because they were once (or twice) burned. And if active management's loss avoidance design can provide you with the confidence to participate in these gains, isn't that a better place than you are in right now?

I know if you are trying to watch the markets yourself, and make your own investing decisions, you have to be conflicted right now. You've missed so much of the advance.

But bull markets often last much longer than expected and indexes can go much higher than expected. On a price-earnings basis we are at the bull market average, but still have a ways to go to reach the average at bull market tops. And while the S&P and Dow flirt with daily new all-time highs, the NASDAQ and the Russell 2000 are quite a bit below their high-water marks (I believe the bull will not end until these levels are surpassed).

Of course, there will be corrections along the way. Just as there were corrections over the course of the current rally, and with the S&P up six days in a row, and a positive Fed report that usually means a flat or down week after, I would not be surprised to see stocks fall or regroup this week. But as I opined as this year began for investors to expect a 10% correction, such times are a time to invest not to shrink away.

We did get a 10% correction in the NASDAQ this spring, but now we have recovered and stand ready to make new highs.

Source: Bespoke Investment Group

The NASDAQ Index currently stands just 15% from its all-time high made way back in March, 2000. While a buy-and-hold approach still has a ways to go to get back to the breakeven point created by its top fourteen years ago, dynamic, risk managed investing models using active management are designed to better that long-term performance. They seek to accomplish that by emulating, not rejecting, our everyday experience with life's simple tasks - let System 1 carry you along for most of the time and engage System 2 when surprises surface.

All the best,