Embracing Uncertainty: Do Nothing and hope Nothing Happens but don’t make me Think

By Noah Solomon

Special to the Financial Independence Hub

One of my favourite quotes is attributable to the late, great economist John Maynard Keynes. During a high-profile government hearing, when a critic accused him of being inconsistent, Keynes responded, “When the facts change, I change my mind. What do you do, sir?”

Being uncertain of what to do and/or scared of being wrong can cause investors to cling to their existing strategies and portfolios regardless of changes in the economic backdrop or market environment.

Another cause of investor inertia lies with the wealth management industry, which generally espouses a “do nothing and hope nothing happens” approach to investing whereby clients are encouraged to adopt a static, buy-and-hold approach and refrain from making any significant changes to their portfolios, regardless of changes in the investment environment.

The behavioral explanation behind the abdication of action in favor of passivity is nicely summarized by the following quote:

“You see, Dr. Stadler, people don’t want to think. And the deeper they get into trouble, the less they want to think. But by some sort of instinct, they feel that they ought to and it makes them feel guilty. So they’ll bless and follow anyone who gives them a justification for not thinking.”

– Ayn Rand, Atlas Shrugged

Despite this tendency to cling to the status quo, the fact remains that refusing to change your portfolio in response to changing conditions has historically been one of the costliest mistakes in investing.

Sometimes It’s OK to Do Nothing (But it’s really hard to know when)

When asked what went through his mind when he listened to his own music, jazz legend Miles Davis responded, “I always listen for what I can leave out.” Davis meant that there are times when less is more: restraint can be more effective than action. As is the case with music, there are investment climates in which it’s best to do nothing.

The value of sound risk management varies depending on the market environment. The ability to manage risk has little value when conditions are favourable.  During a bull market that occurs against a backdrop of attractive valuations, low leverage, and a favourbale economic climate, risks are minimal and any move to take profits and reduce risk will likely make you worse off: just sit back and enjoy the proverbial ride. Conversely, there have been (and inevitably will be) times when risk management and flexibility can prevent a great deal of financial (not to mention emotional) pain.

So far so good: swing for the fences and make huge returns in favourable markets and apply the brakes to avoid losses when conditions turn hostile. But wait! To pull this off, you need to do the impossible and successfully predict exactly when markets will turn from favourable to hostile and vice-versa. In other words, you need to be consistently right … or do you?

It’s not just about Being Right. It’s also about What you Do when you’re Wrong

People put too much emphasis on being right. One explanation for this is that people get psychic income from being right:  taking profits on winning positions makes them feel good. Conversely, accepting a loss forces us to admit we were wrong, which can be psychologically challenging even for professional investors. The net result of these opposing reactions is that investors often strive to maximize their percentage of winning vs. losing positions. While this strategy seems like a good idea, it can lead to highly sub optimal results.

You don’t need a PhD in finance to know that, all else being equal, having more winning than losing positions is a good thing. However, the rub lies in the all else being equal part. Investment performance is not just about your percentage of winning vs. losing positions. It also depends (often much more so) on the average magnitude of your winners relative to that of your losers. People who put too much of a premium on being right and have trouble admitting defeat and liquidating losing positions can (and often do) win the battle yet lose the war. Their many yet relatively small winning positions are more than offset by a small number of losers which dwarf their winners in terms of magnitude. This type of investing is like picking up pennies in front of a steamroller.

Embracing Uncertainty: The Assumption of Wrongness

“It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring.” – Carl Sagan

We are not nihilists. That being said, we believe that neither us nor anyone else will ever have a complete understanding of anything. Nobody can consistently and accurately predict future prices. There are too many mixed signals, resulting in too much uncertainty. The very fact that bear markets have plagued investors throughout history speaks volumes: if historical bear markets had been expected, then they would not have occurred. If this isn’t sufficient proof that trying to be consistently right is an exercise in futility, just look at the forecasting track record of Wall Street strategists! Moreover, it can be very expensive to convince the markets that you are right.

There is a Chinese proverb that states, “To be uncertain is to be uncomfortable, but to be certain is ridiculous.” In our view, it is far more reasonable to embrace uncertainty and use it to your advantage. As is the case in many spheres of life, prudence entails hoping for the best and planning for the worst. Being wrong is a not a matter of if, but rather of when: it is unavoidable. Instead of getting caught unprepared and suffering severe losses when the inevitable happens, it makes sense to build an assumption of wrongness into your strategy: assume that occasional failure is inevitable and have a pre-determined (rather than spontaneous) process to mitigate losses. This is the essence of risk management: it is the very thing that can prevent tolerable losses from becoming “there goes my house” losses when markets turn sour.

Kenny Rogers vs. The Machine:

You’ve got to know when to hold ‘em
Know when to fold ‘em
Know when to walk away
And know when to run

• Kenny Rogers, The Gambler

Without a doubt, Rogers’ eloquent description of chance and the role of human intuition is far more romantic and engaging than statistics and algorithms (what isn’t?). However, the simple fact is that the latter are more useful with respect to investing. Countless studies spanning several decades have clearly demonstrated that data-driven, rules-based systems tend to yield better results than human judgement and intuition. Not only can algorithmically driven systems analyze far more data than humans, but they are also utterly devoid of the cognitive biases and emotional baggage that often result in poor decisions.

We strongly believe that all investment decisions should be based on what can be measured rather than what can be predicted or felt. We never do anything based on our opinions, unless they pertain to mathematical phenomena and statistical distributions as opposed to Fed policy. The fact that other investors think that they can predict the future presents our machine learning-based strategies with the opportunity to produce superior risk-adjusted returns over the long-term. By quantifying the circumstances under which key investment decisions are made, the Outcome mandates offer investors a consistent approach to markets, unswayed by judgemental bias.