Tuesday, August 22, 2006

With wisdom comes silence.

To be successful at investing, you have to constantly reexamine your starting assumptions with time. This is because you are constantly confronted with choices. Over time you begin to realize that not all choices are of equal importance and that for many important choices there is really no conclusive information to inform your decision. So you stay silent and watch.

There is always backchatter about short term macroeconomic conditions and what implications that should have for your investments. People hate to be in an informational vacuum, so they listen to the noise in the circuit, even if it has no meaning or useful information. Much careful thought and agony goes into carefully positioning investment portfolio's to capture macroeconomic trends. Thanks to ETFs it is now easy to create focused portfolio's to capture almost any investment theme.

This concern has almost no impact. It is a distraction from the real challenge which is finding cheap and safe investments. In order generate portfolio alpha from macroeconomic insights, you have to satisfy a several different conditions.

  • Your conclusions have to be substantially different than the market opinion.
  • You have to be right about your macro predictions.
  • The insight has to be actionable.

The first condition is critical. If you read about it in Barrons, the New York Times, or the Wall Street Journal it is too late; everyone else knows about it too. Whatever information is out there is already priced in. Because it is priced in, there is no excess risk adjusted return if you are in accord with the consensus.

Let's take the nasty outlook for homebuilders (XHB) as an example. If you agree with the housing bubble shopocalypse scenario, it doesn't do you any good because everyone else knows about it as well. Let's say that you think the housing collapse will be 3% worse than the market expects, it's still not enough to take actions that will generate excess returns above market noise. Given that the implied volatility of the S&P 500 (VIX) is currently about 12%, your predictions have to be at least that much different from the market consensus to have serious alpha impact. Therefore agreement with the crowd, or even agreeing with it more intensely, does not lead to excess return. You have to be able to disagree, and greatly disagree to have a palpable difference.

Having correct macro insights is sort of obvious, except for the fact that for any given scenario you can get several interpretations, and usually the average of all them is priced in. As such, usually everyone is partially right and partially wrong and it comes out a wash. That zone of indifference within 1SD of the mean estimate is quite large and usually encompasses most opinions. Without pricing inefficiency, excess returns are impossible.

Finally your insights have to be actionable. For example, I think that there will be big impact from a tightening phase in the credit cycle. Sadly there isn't much I personally can do with this insight, since I don't have positions in high yield bonds or leveraged equities. Taking a prudent approach means you don’t have to worry about things that are unimportant to thoughtful investors.

So the long and short of it: is to keep your eye on that fat pitch, and do not get distracted by the cheering and booing of the fans.


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