Archive for July, 2010

Johnny Carson as Carnac the Magnificent

In investing discussions you will frequently get some debate about this or that asset. Will prices go higher? Will the prices crash? Someone gives a good narrative for why the asset must continue to go up and someone counters with an equally convincing narrative against. Both sound reasonable and, depending on what narrative most matches your own feelings, you respond positively or negatively.

Here’s my take: Market narratives may provide the emotional framework people want to see in life to explain events, but they mean nothing (a point made very clear in Nassim Taleb’s book The Black Swan). The future is not predictable no matter how plausible someone’s narrative about it may sound.

We hear this stuff all the time in the news. Some market guru says that such-and-such must happen because of some inevitable series of events that will take place. Well there’s an old saying I like that sums up my feelings on this:

“No matter how thin you slice it, it’s still baloney.”

I don’t listen to or care what a single financial guru has to say on anything about the direction of the economy or the markets. I don’t care what degrees they hold, what awards they’ve gotten, what books they’ve written, or what they predicted in the past. The future is just not knowable and it doesn’t matter who is predicting it. In fact, it has proven to be a consistently profitable maneuver to ignore every single prediction about the market I hear and hold a balanced and diversified portfolio instead.

There’s another saying I really like as well about investing:

“Never confuse the unlikely with the impossible.”

For instance, not a single mainstream financial guru I know of was talking about deflation in early 2008. In fact, many thought it simply couldn’t happen here due to our modern banking system. This is the meaning of confusing the unlikely with the impossible.

Yet here’s what I said when the question of deflation came up in March 2008 on an investing forum:

http://www.bogleheads.org/foru….ary#176337

The one thing I’ll say is I’ve read analyses that have made convincing cases for inflation and those that made convincing cases for deflation. Someone will be right and someone will be wrong, but that’s how markets work.

Inflation and deflation are opposite sides of the same coin. Conditions that cause high inflation can lead to deflation as bankers attempt to control the problem and vice versa. The markets are too unpredictable to rule out any possibility, even those that seem unlikely right now.

The Japanese are certainly not inept and if it can happen there it can happen here (again). The market is one big social psychology experiment and can’t be modeled or predicted. Solutions that economists say should work may not work depending on how people feel collectively. So I’m not predicting deflation will or won’t happen. I’m simply saying that I don’t know (and neither does anyone else) and structure my portfolio accordingly.

I don’t say this as a way to bolster my ego. Simply that this represents the correct attitude of “I don’t know and neither do you.” This is the attitude you need as an investor.

Now, that was written over two years ago and what happened since?

In Spring 2008 TIPS were predicting high inflation as they went negative in yields. In fact, there were many market narratives about inflation roaring in. Yet, by December 2008 interest rates collapsed due to deflation and Long Term bonds (which do very poorly under inflation) posted 30%+ gains and even gold posted 5% gains. TIPS funds by the way posted around -10% losses for the year. No guru saw that one coming. In fact, many gurus were telling people to stay out of the market in 2009 with frightening sounding bear market narratives about it going lower. What happened? The total stock market posted around 30% gains that year.

What’s the lesson? Simple: The markets are not predictable and we simply don’t know how people are going to react to future events.

So if you’re going to listen to narratives, make sure it is in a fiction novel and not with your investments.