Since I’ve been venting about topics like Tapas, I may as well keep the ball rolling on another topic I really can’t stand: Charts. Specifically, investing charts. Even more specifically, investing charts going back decades that ignore history and make gross assumptions about the future.

Here are the big problems with investing charts that I often see:

The Problem of Induction

This is partially the idea that what you see around you is bound to continue on into the future as it did in the past. Big mistake. A line on a chart may not always continue going up for instance even though a chartist may think it will. I feel sorry for people that just don’t seem to get this idea. Risk is real and can show up at any time. We need to consider how unknown risks may affect our investing strategy instead of looking at what a chart is suggesting. The line on the chart you see dragging out into the future may suddenly go straight down tomorrow. Investors that use charts to read into the future are going to be bitten by the problem of induction eventually.

Assuming Monetary Policy Explains Everything

I also dislike when people try to attach simple monetary policy explanations to complicated problems, or even worse, to obviously wrong applications. For instance, someone will show a chart that covers a tumultuous period like WWII along with interest rates, GDP, etc. The chartist reads into monetary policy and tries to discern the trend and reasons for the market performance. They seem to not consider that the monetary policy is probably a fallout of the historical situation and not what was causing that situation.

For instance, when I see a chart covering something like WWII do you know what I read into it as the cause? Not interest rates from the central bank that’s for sure! How about cities being bombed into the ground, low unemployment because you are shipping citizens into war, price controls affecting commodity prices for wartime production needs, etc.? Don’t show me a chart about how low unemployment and how high GDP were and tell me that war is great for the economy. How about these people use their heads and realize that when you kill millions of people and destroy major productive resources you are not helping anyone? How wars affect the economies of all the players is completely unpredictable. Period. No chart will be able to predict the outcome of the situation nor explain it after the fact. One thing I do know, interest rates are not high on the list of considerations of people having their homes shelled and kids sent off to combat.

Thinking Spreadsheets Have All The Answers

“Step away from your spreadsheet and come out with your hands up.”

A lot of portfolio backtests (and their resulting charts) are just silly. Any moron can go into a spreadsheet to find what worked best in the past (especially when cherry picking dates). But it takes some real thinking to work out a strategy that can deal with future unknown risks. You can’t optimize for returns going forward because you don’t know what those returns will be. So anyone designing a portfolio based on what did best in the past is making a huge tactical error with their investments.

What I liked a lot about Harry Browne and the Permanent Portfolio is, as entrepreneur, I really feel he understood the nature of the unknown and investing risk. It’s not about going into a spreadsheet, hand picking some dates and assets to see what did best, and then going out and buying those investments. If investing were that easy we’d all be rich. Rather, backtesting can really only show you what didn’t work well in the past so you can avoid repeating those mistakes or at least be aware of those risks. Backtesting can never prove something will work best going forward. Also backtesting will never show you extraordinary events such as civil unrest, unprecedented government intervention in the markets, etc. These risks need to have some diversification applied as well and the Permanent Portfolio actually considers these risks that spreadsheet only portfolios do not.

This is why I find it so funny when some comment that an asset like gold is “worthless” in an investing portfolio because of some contrived spreadsheet work they did. I wonder if these people have ever gotten far enough away from their spreadsheets to see how the planet really works? I’ve been to over 25 countries in my life and I can tell you that economies can move quickly from good to bad and governments do stupid things all the time. Having some portfolio insurance like gold around is a really splendid idea.

So yeah the Permanent Portfolio holds gold and diversifies with other assets likes stocks, bonds and cash. But what in history suggests this is not a good idea? It doesn’t matter what your chart is showing you worked best over a particular time period. The fact is that concentrating your bets is dangerous and sometimes stocks and bonds don’t pay out on your timetable. This is just how life works so diversifying a little bit is prudent.

Use Charts Intelligently

Investing charts are one tool investors have, but I think they need to be used within their limits. Charts can’t predict the future, but maybe they can guide you away from notably bad ideas. Likewise, they can also be useful to test out theories for big flaws you might have missed. Even then, they need to be used with some judgement about the unpredictable future and the idea that history has many ugly details buried within it that aren’t simply explained in a chart of spreadsheet data. When looking at investing charts, just keep in mind that pretty colors and compelling growth patterns may not be enough to prevent disaster if you don’t use the data intelligently.