Staying Rational in an Irrational World

By Michal Emory on January 11, 2019

Can we all agree this world can be irrational?  How else do you explain the popularity of the Kardashians, Justin Bieber, or 70’s fashion?

I don’t know what that is, but I am glad it is no longer “in” fashion. There are plenty of fashions today that leave me scratching my head. The finance world has some head scratchers too.  

As humans, we can be prone to succumbing to irrational behavior.  One way is through the Availability bias which is the phenomenon where people judge the likelihood of an event by the ease of which similar events come to mind.  Studies have shown that people are less likely to go into the ocean after news of a shark attack.  Yet, the chances of dying by a shark attack are 1 in 3.7 million according to the National Geographic.

Investors display this same phenomenon.  After the Tech Bubble, a big stock market move meant that we were in a bubble destined for another burst.  Or since the Financial Crisis, every rough patch meant that another cataclysmic fall was happening.  This is caused by the freshness of the pain and wounds in investors’ minds.  

We are currently (perhaps it is over?) in our third bear market since the Financial Crisis.

  The first was in the summer and fall of 2011.  The second started in August of 2015 and lasted until February of 2016.  During the first two, the S&P 500 may not have closed down over 20% from the previous high but they had the markings of a bear market.  And in each bear market, pundits were sure to forecast our impending doom.

The memos from Howard Marks of Oaktree Investments are some of my favorite pieces to read.  I make sure to read each one as soon as it is out.  A few years ago, he touched on a topic finally putting to words a concept that I have used when creating portfolios.  He called it second-level thinking.

To be a rational investor, it is critical to engage in second-level thinking.  Second-level thinking engages at a deeper level than what is easily seen at the surface.  Here are some simple examples of the difference.  

First-level thinking says, “This is a good company; I should buy its stock.”  Second-level thinking asks, “Everyone already knows this is a good company; what factors could drive its stock price higher or lower than people’s expectations?”  

First-level thinking says, “There is a lot of negative news; I should sell.”  Second-level thinking says, “There is a lot of negative news, but the market is pricing in too much negativity.  I should buy.”

First-level thinking says, “Trade wars and/or rising interest rates could be bad for the economy. Volatility has been up and stocks down. I should sell my stocks.”  Second-level thinking says, “The outlook could be bad because of trade wars and rising interest, but everyone is selling in a panic.  Where are the great bargains I can buy?”

Since the answer is rarely an absolute, we look at the probability of different.  What is the most probable outcome?  What outcomes have a reasonable probability?  What outcome is the market pricing in?  What outcome presents an attractive opportunity?


This doesn’t mean we will always get it right.  And sometimes “getting it right” means experiencing short-term loss.  2018 was a tough year.  The market turned violently in October.  Then the S&P 500 closed the year with its worst month since February 2009.  There has been no shortage of pundits talking about how a recession is right around the corner and the party is over for the stock market.  We think this is first-level thinking, and this bear market has mostly priced- in the current market risks.  

At The Trust Company, how do we stay rational in this irrational world?

1) Engage in Second-Level Thinking.  We look below the surface level when we build your portfolio both in the asset allocation and the security selection.  

  • Listen to the Data—Is the data telling the same story as the current perception of investors?  
  • Remain Unemotional— Whether at the economic level or down to the individual asset level, has the market’s current greed or fear topic du jour been priced in?  
  • Find the Value—Where are the attractive opportunities?

 
2) Rigorous Investment Process. There are many facets to this.  Each is designed to build portfolios that will outperform in the long-term, though will underperform sometimes in the short-term.

  • Diversify—Create a mix of investments that best suits your investment needs.  These can be return generators or risk mitigators that keep the portfolio volatility in-line with what is appropriate for each Risk Level.
  • Utilize Historically Significant Factors—Historically, certain investment characteristics like Value, Quality, and Momentum outperform over time. We look for investments that show value, are high quality, and exhibit positive momentum.
  • Continuous Research for the Best Ideas—We pride ourselves on being product agnostic.  This enables us to build portfolios that are dynamic and flexible for a variety of needs.  This can entail taking an active or passive (or both) approach with security selection.  


3) Disciplined Portfolio Approach—We all have financial goals and aspirations.  A disciplined approach is a key ingredient in the success of those goals and aspirations.

  • Appropriate Risk Level—In volatile markets like 2018, we see how critical it is to be in a portfolio that answers two questions.  How much risk can you afford to take?  How much risk are you willing to take?
  • Rebalancing—Rebalancing creates a disciplined process of controlling risk. It creates a framework for buying investments that show value, while capturing gains from investments that have been outperforming.
  • Tactical Asset Allocation—This works in two ways. One: where are opportunities within an Asset Class, Sector, or Stock that can be exploited?  Two: has a particular market experienced a fundamental shift that would cause us to take some risk off the table?


It is true that there are a high number of risks right now and we do not know how they will play out.  But we believe these risks are being priced in.  This begs the second-level question, “If the market is pricing in these risks, then where are the opportunities?”

As Mark likes to say, “not all our friends are necessarily clients, but all our clients are  friends.”  That is a saying that we have all adopted and consider it a privilege to be a part of your life.  We wish you a successful 2019, wherever the year may lead you.

 

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