Outfoxing the Markets’ Hedgehogs

Pundits, commentators, economists and the like tend to be hedgehogs who, according to the philosopher Isaiah Berlin, view the world through the lens of a single defining idea. Because many are highly educated, well spoken, and come across as “really knowing their stuff,” hedgehogs get a fair amount of media exposure which can lend additional credence to what they say (whether correct or not). Their intellect, combined with their strong convictions and deeply-held beliefs, give hedgehogs the confidence to make bold predictions about the future because they believe they completely understand how the past led us to where we are today.

But what if historical – and thus, future – events are determined by nothing more than sheer luck? For example, as Daniel Kahnemann points out in his book Thinking Fast and Slow, it would be difficult to discuss the twentieth century without bringing up Hitler, Stalin, and Mao Zedong.

“But there was a moment in time, just before an egg was fertilized, when there was a fifty-fifty chance that the embryo that became Hitler could have been female,” Kahnemann wrote. “Compounding the three events, there was a probability of one-eighth of a twentieth century without any of the three great villains and it is impossible to argue that history would have been roughly the same in their absence. The fertilization of these three eggs had momentous consequences, and it makes a joke of the idea that long-term developments are predictable.”

So then how well do hedgehogs predict short-term developments? Philip Tetlock, for his book Expert Political Judgment: How Good Is It? How Can We Know?, gathered more than 80,000 predictions from 284 political and economic commentators who were asked to assess the probabilities that certain events, both inside and outside their fields of expertise, would happen in the not-too-distant future.

Even though the experts only had three choices – there would be more of something in question (e.g. political freedom or economic freedom), less of that thing, or no change – they performed worse than they would have if they had simply assigned equal probabilities to each of the three possible outcomes. Even in their field of expertise, the specialists were not significantly better than non-specialists.

“In other words,” Kahnemann noted, “people who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options.”

Ouch.

Many investors and advisors tend to be hedgehogs, too. They study charts and graphs, balance sheets, price-to-earnings ratios, etc. to see what investments have done leading up to today and try to extrapolate how they will perform going forward. They watch CNBC and read economists’ and analysts’ predictions about the economy and the markets to confirm or challenge their own findings. But Kahnemann and Tetlock have shown such efforts to potentially be a giant waste of time.

What to do then? Instead of being a hedgehog, I say be more like a fox who, according to Isaiah Berlin, draws on a wide variety of experiences and for whom the world cannot be boiled down to a single idea. Recognize that reality emerges from the interactions of many different agents and forces, including blind luck, often producing large and unpredictable outcomes.

I believe the best way to do that is to try, as much as possible, to make your portfolio ‘antifragile’, a term coined by former options trader Nassim Taleb in his book by the same name. He describes antifragility as a state of not only not breaking under stress and unexpected shocks, but actually benefitting from them. He uses the multi-headed mythical dragon Hydra as an example – when the fictional Greek hero Hercules cut off one of its heads, two more heads grew back in its place.

Antifragility is wonderful in theory but impossible in practice – there is absolutely no way to guard against, and take advantage of, all contingencies. So what are some steps investors can take to try to mitigate and manage risk – to make their portfolios antifragile-lite, so to speak?

Do not invest based on an outlook, either yours or someone else’s. Instead, try to build a balanced, globally-diversified portfolio that is as outlook agnostic as possible with a goal of targeting steady returns over the long run rather than trying to constantly generate above-average ones in the shorter term. Orcam Financial Group’s Cullen Roche summed it up well in his recent blog post, “The Risk of Purchasing Power Loss”:

“The real goal…is to maximize the return from your real investments (like your primary form of work) and take (your portfolio) and allocate it in a manner that helps you (hedge) against two primary risks: 1) The risk of purchasing power loss. 2) The risk of permanent loss. You don’t need to “beat the market”. In fact, it’s inappropriate for almost all of us to own 100% equity portfolios unless you’re willing to expose your savings to that rollercoaster ride. We’re not competing with the S&P 500. We’re competing against inflation and the risk of permanent loss. Personally, I’d rather grind it out at work all day and know that the savings I generate from that primary income source is not creating even more stress and uncertainty in my life.”

Over time, some of your holdings will do better than others. By taking some profits from your “winners” and adding then to your “losers,” you can take advantage of whatever the markets bring by “selling high and buying low.” The value of your portfolio will inevitably experience downturns, but the aim is to try to mitigate the severity of those downturns as much as possible so your portfolio can spend less time climbing out of deep holes and more time trying to consistently increase in value, albeit unspectacularly.

Finally, and most importantly, give your portfolio options. Be exposed to the growth of the global economy but, when life throws the markets unexpected curve balls (as it always does and often when it is least expected), be sure to have back-door escape routes via hedges – investments that tend to zig when others zag, especially in times of acute crisis like 2008-09.

Committing capital to hedges is similar to committing capital to homeowners insurance – you spend the money hoping it will wind up being wasted because you know if either one pays off, something bad has happened. But in those difficult times, far from wasted, you will likely see it as money well spent.

When you stop and think about it, hedgehogs tend to hedge very little or not at all which makes them, well, just hogs. And we all know the old Wall Street maxim: Bulls make money, bears make money, but pigs get slaughtered.

Hedgefoxes, for lack of a better term, build investment portfolios consisting of both bullish and bearish strategies with an overall goal of trying to make money come what may. If you would like a free, no-obligation analysis of your portfolio to determine ways to try to make it more hedgefox-like, please do not hesitate to contact me.