Steady, average, middling – these are dirty words in the investment community. Instead the narrative expounds the wonder of ‘excess returns’, ‘beating the market’ and ‘being the best’. This narrative leaves out much, particularly the elements of time and availability. Actually it doesn’t, it assumes we shall deliver these returns in all accepted time frames (that is to say the time frames arbitrarily delineated as accepted). And that we can choose to be one of the chosen who through skill and hard work can realise these outsize returns.
It seems unbefitting of such noble ideals for reality to intrude. That clumsy interloper flinging off muddy shoes, wafting smelly feet and squishing our carefully arranged cushions as they flop on the sofa. Reality, and I say this with deep sadness, has little respect for our ideals.
In the world of investing, most of us offered an unpalatable truth: that it is insanely difficult to outperform consistently over longer periods and multiples more to do so on multiple time frames. Sorry.
But how about person x or fund y we counter, they do it? If them why not us? And with these exemplars we relegate reality and end up with the following de facto profile: striving for market beating returns with a hope of avoiding the larger losses that are more likely with that territory.
There is a balancing act here which doesn’t work for me.
Base rates (and the zero sum nature of the system) tell us few are good enough to pull this off through skill. This may well be you but if so you are an outlier. If it isn’t then ‘beating the market’ becomes predicated on luck. (think of this as a distribution with widening variance the further from market returns our desired returns).
What then to do? My desired returns (over the long term) may in excess of market returns but my skills, knowledge and tools are middle of the road. If I go with the default structure the only chance I have of achieving excess returns with consistency is if a) I improve a lot or (more likely) b) hit on a rich and long lasting seam of luck.
One is slow, intensive and uncertain and the other is out of my hands.(read the part about Andy Zaky in this post if you want a bit more)
There is an unglamorous alternative. Take a look at the returns of two investors below. Which of the two does better after 5 years?
They both average 12.8% per year but it is investor B who makes the best returns.
She is the greater success even though it is investor A who would garner all the plaudits. This example is over-the-top as the large losses incurred by investor A would raise eyebrows, but the point is made.
At the end of the five years when investor B shows excellent returns everyone may coo with admiration at their achievement. But over the course of the journey their eyes would have been on the magic dust of investor A.
Such are the differences between arithmetic and geometric means. Arithmetic means are useful for ‘advertising’. Geometric shows us the money.
This is a handy blueprint for how I structure my investment practice: if I avoid large losing periods then I need not care about ‘beating the market’ in good times. In fact in any time period I need achieve slightly above mediocre returns.
This is rather profound. And less susceptible to arbitrage.
This way of going about the business of investment is not an interesting or exciting profile.Being middle of the pack will not get us noticed. For the most part the industry is structurally incentivised to do better than average (not of just the market but also benchmarks).
This sets up a potential contradiction. In previous posts I have written about the structural value on offer from not being concerned about shorter term volatility (here for starters). In this piece I say I want to limit downside volatility. The answer is in levels – on a trading program level I do what the system demands volatility or not. At an aggregate level the intent is that each program balances the others. Operations are structured to round off the sharp edges and curtail portfolio level losses.
There are numerous methods of smoothing downside volatility – diversification, timing filters, arbitrage, position sizing or other risk mitigation methods for starters. Few of these schemes are poor if used well. Where they fail is when we take 2+2 and get 22. Charlie Munger warns:
It is easier to make a mistake with a good idea because a bad idea is quickly rejected
There is no free lunch. There is a strong incentive to supercharge what works. Wiser heads try and maintain perspective by considering a world including counter-factuals.
That being said the investment game is incredibly forgiving.
We need only be ok at all this to come out well ahead.
The caveat, and isn’t there always a caveat, is that the durability of your methodology is determined by the weakest element. And that weakest element is almost always the same. The one in the mirror, that clump of electrical pulses, chemicals and tissue known as us.
Here is another example for you. Consider carefully the fact that without ever achieving over 15% investor B trumps investor A. Naturally if investor A could curtail those losing years their results would be spectacular BUT as we move up the returns curve we introduce a larger element of noise and luck. There are areas such as HFT and arbitrage where this is less so but their challenge differs in that the predictability of their returns renders them liable to be dissipated as new entrants feed off the carcass.