The Rules, Part LXV

Photo Credit: vldd || Relative to a complete bridge, what’s the value of a bridge that will never be completed?

Here’s number 65 in this irregular series:

The second-best plan that you can execute is better than the best plan that you can’t execute.

Rule LXV

It takes more than the right ideas to be an investor. It also takes the courage to make the hard decisions at the time when it hurts to do so.

Will you make more money if you allocate at least 80% of your assets to stocks and other risk assets? Yes. How will you hold on during a gut-wrenching bear market that gives you the feeling that you are losing everything?

You could just refuse to look at your statements, or listen to financial media. But most people will bump into that randomly during a bear market, because the level of chatter goes up so much. It may be better to take a second-best solution and reduce the portion of risky assets to 50-60%, and simply sleep better at night. Reduce until you won’t be nervous, and preferably, make this adjustment during the bull market.

Do you have a nifty trading strategy that you are tempted to overrule because it generates trades that you think don’t make sense, or come at times that seem too painful? Perhaps you need to abandon the strategy, or lower the size of the trades done. Maybe do half of what the strategy would tell you to do.

If you use the Kelly Criterion to size your trades, and the volatility drives you nuts, maybe size your trades to “half Kelly.”

Am I offering an opiate for underachievement? Well, no… maybe… yes… Look, personalities are not fixed, much as some say that they cannot change. If you have sufficient motivation, you can come up with ways to change your personality to be able to deal with more risk, or, conclude that you will do better if you take less risk.

Writing out a set of rules can useful, as is testing them to make sure they actually work. In general fewer rules are better.

An example of this in my life was when I was a corporate bond manager, I made an effort to forget prior prices of a bond, thus forcing me to be forward-looking in my management. When I was younger, I told myself that there would be losses, and they were a price of getting the gains on average.

But if you can’t make your personality change, then you have to adapt your investment strategy to let you be happy while still achieving most of your goals. As an example, if you like to sell stocks short, it would be wise to have some sort of limit as to how much you are willing to lose before closing out a trade — this applies more to shorting, as losses are unlimited as prices rise, but gains are capped.

Ordinarily, if a person or institution is close to even-keeled with respect to risk, the time horizon and uncertainty of the cash flows from the assets should be the main criteria for asset allocation. But when a person is overly timid or bold, that will become the dominant criterion for their asset allocation.

It is important not to be of two minds here. Admit your weaknesses, and either fix them, or live with them. The trouble comes when you think you are strong, but then give in when a bad event happens that was beyond your capacity to handle.

It’s also important to understand that the market can be more vicious than at any prior point in history. Yes, there are historical highs and lows for every variable — but both can be exceeded… the speed of the current bear market is an excellent reminder of that. Try to understand that there will be as Donald Rumsfeld once said “unknown unknowns.” Have you left enough slack in your strategy for some really bad scenarios? Have you considered that it’s not impossible to have a second Great Depression event, despite the best efforts of politicians, regulators and economists? Have you considered that it is possible to eclipse the valuation highs achieved in 2000?

And consider the phrase from my disclaimer “The market always has a new way to make a fool out of you.” Have you considered what scenario would be poison for what you currently do? Unlikely as it may be, can you live with that scenario? If not, scale down your strategy until you can live with it. Or, figure out what your coping strategy would be.

The first life insurer that I worked for had the strategy that if things went wrong with their investing, they would sell policies more aggressively and invest the proceeds to grow their way out of the problem. They ended up being the largest life insurance insolvency of the 1980s, as their worst case scenario arrived, and their capital was depleted. They would have done better to grow more slowly, and more soundly. The same would apply to Enron and other companies that try to grow too fast. This is another case where the second best is achievable, but the “best” is not.

So, know yourself, and know the markets well. Leave some slack in your strategy… don’t play it to or past the absolute maximum that you can handle. Have some humility, and live in reality. For most investors, that will pay off in a big way.


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