PLAYING IT SAFE? - 29 JULY 2012
Arizona Memorial - Pearl Harbor, Hawaii
I’m reading one of Malcolm Gladwell’s books, “What the Dog Saw”. Like all his others such as Tipping Point or Outliers, this book brings up ideas I probably never would have considered by myself. What Mr. Gladwell seems eminently capable of doing is making the reader re-address what they might take for granted. While that sounds easy and all, it’s an especially difficult process if you have people invested in a certain point of view. Let me give you a couple of examples.
I used to hate running. I discovered the wonderment of running after years of cajoling by my running sister and after I read the book “Born to Run”. I bought my first pair of minimalist shoes--Vibram Five Fingers--and took to running, actually enjoying running. The point of the book was to turn the athletic shoe industry on its head by making a case that not only did the very expensive and highly touted high technology shoes not help you, they likely were hurting you. I took this and ran with it. What I mean is if I was so invested in something I assumed was right every single day of the week what else could I question that was assumed to be correct.
Today's blog is about what we do with risk. What I'm referring to is how we accept somethings and might totally disregard other types of risk, even with the inevitability of it.
- THE SLOW GAIN AND SPECTACULAR FAIL
Mr. Gladwell introduces two stock market investors in this book I’m reading. The first is a classic investor that’s singularly successful at picking stocks that win. Over the years, even taking the odds into consideration, this investor just seemed to achieve that success any one of us would want. And, he used a strategy that seemed quite reasonable--i.e. buy stocks that seems under valued and sell them when they reach higher value.
Here’s the problem with that strategy. The problem is for people like me I seem to always buy high and sell low. I am constantly at risk of losing my money through the variations of the stock market--btw, this applies to normal mutual funds as well. That’s because my whole portfolio is exposed to the market while I'm hoping the stocks I picked increase in value.
When I buy, I see stocks that seem to be exciting and buy them. Unfortunately, I seem to always buy them when they’re on their way up just prior to them actually taking that nose dive. Seemingly, the strategy is to buy under-valued stocks. That means you buy them at bargains then when they’re discovered and everyone else buys them, your stock prices go up.
Apple is a tremendous example of an under-performing stock that has risen like gang-busters. Back when the company was almost bankrupt in the early 90’s, if you bought their stock instead of a computer the value of that stock would’ve risen to the hundreds of thousands of dollars. Sure, the stock had its ups and down since then. Still, what was only 10 dollars back in 1992 is now worth over $650 dollars. I computer I long ago retired would've now been worth $100k or more today in Apple stock.
The normal strategy is to find those stocks. It’s to find the stock that’s under valued and hang with it. As we all know, this is incredibly difficult to do.
Here’s the core problem with that process. Even if you’re the best at doing this kind of thing, eventually you’re going to have a bad day. Someday due to circumstances beyond your control something is going to take hold of the stock market and make it crash. Someday, you’re steadily winning strategy will eventually have a very very bad day. This is inevitable and it’s well documented. There are stock market crashes all throughout history. It is a sure thing. It will happen. Yet, we all continue to invest in this strategy that eventually leads to a terrible loss.
Even if you're the type to successfully pick the winners, by staying in the market you're constantly exposed to the inevitable crash. This is a sure thing. And, despite the skills we might have with diversifying, all of your stock portfolio is exposed until you take very special care.
Okay, if you’re a buy and hold kind of guy, the loss is only figurative in that the loss is only realized when you actually sell. You’re the type of guy that should weather the storm if you’re disciplined enough to hang with the bad news. That means controlling every urge you might have to cut your losses and get out while you can when everyone else is selling in a stock market crash.
Of course, not everyone is like that. Most of us, maybe all of us, revel in the enjoyment of seeing our portfolio increase steadily over the years. Then, when the bad news happens, many of us panic which only makes matters worse--imagine runs on banks, as an example.
- THE SLOW PAIN AND SPECTACULAR GAIN
The next investment guy Mr. Gladwell introduces us to doesn’t like that strategy. He thinks the strategy is steeped in hidden failure that inevitably will cause your investments to fail and fail spectacularly. This investor takes a different approach. He invests in sure thing, slowly increasing but guaranteed investments. Then, he slowly uses some of that money to put options on stocks.
What’s an option in stock market lingo? I’m not the best at this by far but here’s the deal. An option is a contract for the option to buy a stock at a given price within a given time-period. If the price increases above the option price, you’re making money right away. If it doesn’t rise above the price then you don’t buy. Here’s the catch, there’s a fee to setup this option. Essentially, you pay a fee to establish this contract. If it works out, you make money. If it doesn’t you don’t.
Okay, you’re wondering what’s the deal here. Well, what you’re doing is keeping your portfolio only in high reliable assets--US Federal Government T-bills as an example. Then, you only buy the option to buy when it’s profitable. The expense is the amount of money to pay for all these options you don’t take. Some might call it insurance as in you’re insuring yourself against the loss.
This approach is entirely counter to the tactic of having your money exposed to the variations of the market. And, you’re constantly paying money by buying options that don’t work out. What that means is your cash flow is constantly moving outward and rarely moving inward. But, when it moves inward, it moves in big.
- THE COMPARISON
These two investors are really a comparison in two different core risk strategies. The first is to slowly see a gain and be exposed to a spectacular fail at any uncontrollable moment. The second is to see a slow reduction but be fully exposed to a spectacular gain that you might have guessed correctly.
The difference really is what type of person are you verses which one do you think you want to be. The problem with the slowly gaining guy that’s constantly exposed to risk is the spectacular fail is almost un-plan-able. As in, you don’t think of that worse case scenario only because it’s so unthinkable in the context of all the prudent decisions you make with everything else. This contrasts with the other guy that does pay to position himself for that spectacular opportunity. The challenge with this guy is the power of conviction. Without it, he may waiver and not stay the course in a steadily decreasing cash amount and want to change strategies mid-stream just like his friends would if the stock market crashed.
LOOK AT THIS ANOTHER WAY
We constantly look for an easier way to do things. Some might call it "more efficient" ways to do things. It is our human nature. Without too much of a stretch of the imagination, you might say this has led to many of us driving everywhere when we used to walk to those same places. Having the car available is a big contributor to the tremendous neighborhoods in the US. What we’re seeing is the sprawl of suburbia or Urban Sprawl. We have that car because we think it's easier and more efficient to drive than to walk.
Obviously, there’s an impact to this. First and foremost is simply the lack of exercise we do. Our society is experiencing an epidemic in obesity. Our kids weigh more than they ever had in human history. Our bodies are getting larger. Everything is affected by this. Health insurance goes up because of complications related to being over-weight. Transportation costs go up because there are fewer spaces for people--each individual takes up more space. Even our daily stresses go up because people are simply suffering under their own weight. Despite all this, we know there is a limit to this growth--pun intended. We know there will come a time when our expanding waist line and associated effects will cause a terrible problem. While that terrible problem isn’t here now, but like the stock market crash, it’s inevitable that it will hit us. The straight-line growth of our waist line will eventually lead to a substantial unsustainable problem.
This article is not a debate on the why’s for this situation. It’s only my attempt at showing how the investment strategy problem is similar to what we do everyday on things that affect us like our waist line. In the investment strategy situation, the normal investor willingly collects a good feeling for moderate gains every single day. They’re happy being on that course. Yet, their portfolio is constantly exposed to the unexpected cliff. It’s all at risk yet they don’t mind as if the cliff didn’t exist. Despite what we think or tell ourselves, that cliff is there and it's inevitable.
Everyday we enjoy the benefit of life in a suburb. We enjoy our cars. We appreciate the food we eat. We take comfort in the luxury we’re experiencing everyday. It’s wonderful--like the gains we see in the stock market. Yet, there’s a problem. It’s a false gain in that eventually, sitting on our butts every day will lead to problems such as obesity, diabetes, lack of mobility, reduced quality of life, maybe unemployment, and perhaps death. The cost to this lifestyle of luxury isn’t hidden yet we persist.
I don’t believe there are any studies that wonder about our abilities to direct ourselves out of danger when we seemingly feel very safe yet see that cliff coming at us. If there were studies, I wonder what they would say.
The point of this article is to consider what risks you’re exposing yourself to. If you’re seemingly on a good slope with steadily increasing opportunity or revenue, is there a cliff on the horizon that needs to be accounted for? Are you seemingly in a good state yet, there's a bad taste in your mouth? Are you the realist that says “that cliff will hit us sometime, it’s inevitable”, in that case you take a more painful route to avoid the cliff. But, at the same time you position yourself with some investment to take opportunity when it shows.
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