August 7, 2017: I Didn’t Learn Anything — Mistake vs. Temporary Underperformance

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I Didn’t Learn Anything — Mistake vs. Temporary Underperformance

We want to again delve into the subject of staying with a strategy for a long time to reap its benefits as we feel this is perhaps the most important deciding factor for investment success/failure. Let’s start an anecdote from Stanley Druckenmiller, a famous hedge fund trader who once helped George Soros’ hedge fund.

I didn’t learn anything

In this Bloomberg’s report Investors Find It Hard to Stay Course in Strange Winds, it told a story on Druckernmiller’s investments during the internet technology bubble till 2001:

Two years ago, hall-of-fame investor Stanley Druckenmiller recounted how internet stocks seduced him into straying from his investing principles. It was February 1999. Investors went cuckoo for the internet, and tech stocks were absurdly expensive. The S&P 500 Information Technology Index traded at a trailing price-to-earnings ratio of 66. Druckenmiller spotted the madness and decided to short internet stocks.

No one told internet stocks, however, that the party was over. A month later Druckenmiller had lost $600 million and his portfolio was down 15 percent on the year. He had never had a down year.

Frustrated, Druckenmiller sought advice from techies. It’s a new world, they told him. Throw away the old playbook. The technology revolution demands sky-high stock prices. Druckenmiller dumped his shorts and bet big on technology.

He was quickly rewarded. The Nasdaq 100 Index gained 93 percent from March to December 1999. Druckenmiller’s portfolio ended the year up 35 percent and his internet stocks traded at a breathtaking P/E of 104.

Drunk with internet riches, Druckenmiller plowed an additional $6 billion into tech stocks in March 2000. The bubble burst just days later and he lost $3 billion.

When asked what he learned from that experience, Druckenmiller replied, “I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself.”

The story is all too familiar to many in hindsight. After all, he didn’t learn anything as he knows that a strategy is not a strategy if he doesn’t stick to it. But we suspect it’s now forgotten by many or it isn’t known to many young 20 or 30 something investors who didn’t materially experience the bubble.

This reminds us of one of our favorite stories:

Bridge playing story

This is the story told by Ben Graham:

“I recall to those of you who are bridge players the emphasis that bridge experts place on playing a hand right rather than on playing it successfully. Because, as you know, if you play it right you are going to make money and if you play it wrong you lose money – in the long run. There is a beautiful little story about the man who was the weaker bridge player of the husband-and-wife team. It seems he bid a grand slam, and at the end he said very triumphantly to his wife ‘I saw you making faces at me all the time, but you notice I not only bid this grand slam but I made it. What can you say about that?’ And his wife replied very dourly, ‘If you had played it right you would have lost it.’“

Emphasis is ours in the two stories.

In both stories, the participants all made a temporary win (gain). In the first story, Druckenmiller quickly learned the hard way but in the second story, the husband hadn’t learn its consequence yet, maybe he would eventually? In fact, in a previous newsletter October 17, 2016: Investment Mistakes And Good Or Bad Investment Strategies where we brought up this story, we said:

In contract bridge card games, based on the distribution of the 52 cards, the bidding process (assuming players are rational to convey their holdings to their partners) and the cards played so far, one can infer probability of remaining cards in various hands, sometimes fairly accurately. Thus, rules are formulated for higher odds of winning.

In this example, the wife who followed the rules would have lost that particular game. However, if enough games are played, she would have done much better than the husband, who seemed to play based on his hunch (and “bravery”?). This is simply a statistical fact.

Mistake vs. temporary underpformance or even loss

However, the hardest part in investing is that investors often can’t distinguish a real mistake from a temporary underperformance or loss. In Druckenmiller’s case, he was temporarily swayed by the loss and believed it was a mistake not to go long (i.e. invest) in stocks because it was told, his ‘old’ strategy didn’t work anymore, it was a new world. It’s easy for him (and everyone else) to look back now and claim that he already knew that not sticking to his strategy would be a mistake, hence the ‘I didn’t learn anything’ saying. But it must be very hard for him to see this at that particular time.

Popular financial media benchmark investment funds and portfolios daily. When one sustains a period of under performance or loss, media and even investors themselves would fret about what ‘mistakes’ they have made. It’s commendable for humans to possess such a learning-from-a-mistake quality. After all, that’s how we have made most of innovations and improvements in history.

But a statistical activity like investing requires a higher order of ‘learning’: as we stated elsewhere in our newsletters, for an investing strategy to work, one has to commit to it for a long period of time (so that there are enough samples to make the strategy converge to its mean). For example, we stated in July 17, 2017: Long Term Stock Holding Periods For Retirement:

A strategic buy and hold strategy would require 15 to 20 years minimum to get a reasonable return
A tactical asset allocation strategy like ours would require 10 to 15 years minimum to get a reasonable return
A total return bond fixed income portfolio would require 2 years minimum to get a reasonable return (see July 24, 2017: Total Return Bond Fund Portfolios And Cash)

Of course, the implementation errors we mentioned in the previous newsletter are the real mistakes one should avoid (and ‘learn’). These include abandoning the strategy (or switching to another one as that one is working well recently), tweaking the strategy (panic selling at a market bottom in the buy and hold strategy, for example) and/or ignoring some of important rebalances required.

We have addressed this issue in many newsletters. We want to bring it up periodically as we believe this is the most important issue. Furthermore, at the moment, financial markets have been bullish for a long period of time and that can only make it more urgent to understand.

Market Overview

Factset reports that as of last Friday, 84% of S&P 500 companies have reported earnings and it registered 10.1% blended earnings growth. The earnings are indeed good. However, stock valuation is also extremely high. We want to show the two valuation charts, courtesy of John Hussman’s weekly commentary:

So by any means, US stocks are either close or above the valuation in 2000. We are now more or less in the Druckenmiller’s previous situation. Whether it’s the precise moment or not, no one can be for sure. But we are certain that it’s a time for investors to review their behavior and portfolios more closely and reenforce themselves to some sound investment strategies regardless of what’s going to happen next.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration has been in the office for more than half a year, it has stumbled and encountered many difficulties to implement its promised changes in terms of tax cuts, job stimulation and infrastructure spending. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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