Miss-Conceptions

  "Don't let schooling interfere with your education" ~ Mark Twain

I have had quite a few people tell me that some of my early posts are too technical and are difficult to follow. After some reflection, I would like to try again. This time I will try to focus on the big picture of what I am doing. Hopefully this will give more clarity and understanding and alleviate confusion.

I will start with what I believe is the key to good investing.

Valuation:

Value is what something is worth and investing is "betting" that the value will change in a way that makes you better off. My father challenged me to have a very difficult question in mind as I went through my collegiate education. This was to help keep me motivated on school and learning.

My question was "What is the 'true value' of an asset?". What I learned is that the value of things change constantly and there is no "true value" to anything. Yet the whole goal of investing is buying things that will be valued higher in the future, so I have had to come up with some sort of way to think about valuations.

Differentiation:

My solution has been to look at macro economic variables in the market place and figure out if they are predictive of future asset valuations. I have found a few that are. Even more interesting, they predict opposite movements in different assets. i.e. when high they predict good things for one type of asset and bad for another and vice versa. This led to my asset allocation model (which emphasizes the asset which is most likely to do the best over the next 12 months).

As I have gone through the process of learning these things I have uncovered a number of miss-conceptions in the investment world. I call these things counter-intuitive wisdom. My model seeks to take advantage of some of these miss-conceptions. I will highlight three examples.

1)  The first miss-conception is that the market includes all information in its price. I have found that the market is biased towards the recent past. Information more than 5 years old is forgotten or heavily discounted. If a stock has gone up recently, we believe it will continue to go up and vice versa. I de-link from the recent past by looking at long periods (and treating all the data equally). I focus on how prices (valuations) have reacted after various market environments going back over a hundred years in some cases (where the data is available). It is interesting that the things I focus on have worked for so many years.

2) The second miss-conception is that markets "revert to the mean" (or average). When markets get too expensive or too cheap they will move back to some sort of average valuation. This is not an accurate model of how they really move. They actually oscillate between over and undervaluation. This understanding helps me avoid getting out of positions too early. 

3) The last misconception for today is that you should only buy "cheap" things. It seems reasonable that you would only want to buy cheap assets if your goal is to have them appreciate. In reality some cheap assets are cheap for a reason and some expensive assets are expensive for good reason. In looking at the next year of returns, stock markets actually do very well when they are most expensive (last year [2017] is a great example - and we have been fully invested in stocks). This is a tough one for me, because at heart I am a value investor but I have found that some markets have their best performance when they are expensive.

Most investors do not understand this and therefore miss out on a lot of good returns at these high valuation levels. One has to be cognizant that things will break at some point, there are usually signs, and it usually takes a full year for a bear market to cycle through. The key is recognizing and adjusting early in the bear market cycle.  

Big Picture:

At a conceptual level I differ from most because I am trying to capture as much of the upside as I can, while also trying to avoid some of the downside. Many tactical allocation models focus on avoiding all of the downside while getting some of the upside. They often also trade much more often than I do. I am very long term oriented and make allocations focused on a longer term outlook. These may seem like small distinctions but they have a real impact on costs and outcomes. I hope to prove that out with this blog's allocation portion being my proof statement.