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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Monday, March 1, 2010

Winning Isn’t Everything

Americans are brought up to be achievers. The youth of today are taught to win at little league sports, get all A's in school, become eagle scouts, make the cheerleading squad, etc. etc. Winning is ingrained in us at an early age. Little wonder then that, as adults, we focus primarily on how much our investments earn each year. We like to tell everyone at dinner parties about our winners while we take pains to ignore our losers. We chase the latest, hottest new investment, giving little thought to the downside risks.

Malcolm Gladwell’s recent best seller “What the Dog Saw” (Little Brown and Company, 2009) includes an article he wrote in The New Yorker (April, 2002) that shows the downside of relentlessly pursuing big returns while ignoring the risks involved.

The article was titled “Blowing Up – How Nassim Taleb Turned the Inevitability of a Disaster Into an Investment Strategy”. The article focuses on two very different investment managers, Nassim Taleb, a relatively new up-and-coming money manager back in 1996, and a well known money manager named Victor Niederhoffer. The two met at Niederhoffer’s estate at Niederhoffer’s request. After spending much of the day with Niederhoffer and watching him trade, Taleb left, more than ever convinced that he didn’t want to be like Niederhoffer, in spite of his respect for the man. Taleb was concerned that his approach to investing, although very successful, might be due to nothing more than luck.

Basically, Taleb believes that stock returns do not behave consistent with a normal distribution used by statisticians. He believes, on the other hand, that catastrophic market events occur more often than a normal distribution would predict. Like Niederhoffer, Taleb runs a hedge fund and uses stock options in his investment approach. Unlike Niederhoffer, however, Taleb only buys options while Niederhoffer buys and sells options.

Without going into the nitty gritty of the two approaches, one could say that Taleb is taking a conservative approach that can ultimately pay off big when the next market crisis occurs. Niederhoffer’s approach often makes big market bets under the assumption that significant market events have a low probability of occurring.

Taleb’s belief in a higher probability for the rare market crash, according to Gladwell, stems, in part, from his personal childhood experience with the crisis in Lebanon which took place unexpectedly (at least for him and his family) in a matter of months. His experience with throat cancer, a disease most people consider rather rare, also made him more cognitive of the possibility of market “black swans” as he calls them (He has published a book titled “The Black Swan”).

According to Gladwell’s article, Taleb’s team uses complex quantitative methods to buy stock options with the majority of his fund’s money invested in safe U.S. Treasury securities. Taleb’s approach, unlike most investment strategies, often loses money on a daily basis. By design, however, it won’t “blow up” like Niederhoffer’s approach can, as well as those of many other hedge fund managers. When a market crisis occurs, it will however, likely pay off big for Taleb’s fund. According to Gladwell, “Taleb, by contrast, has constructed a trading philosophy predicated entirely on the existence of black swans, on the possibility of some random, unexpected event sweeping the markets.”

Following that 1996 meeting, Niederhoffer lost everything in 1997. For Taleb, Gladwell states that “the financial crisis of 2008-2009 made a staggering amount of money for his fund”, Gladwell went on to say: “Niederhoffer, by the way has lost and made and lost a number of other fortunes in the intervening years”.

Unfortunately, because most of us want to be winners, we want to see regular positive returns from our investments. We have great difficulty waiting for the big payoff inherent in Taleb's approach. According to Gladwell, experiments by behavioral economists have shown that “because we’re more willing to gamble when it comes to losses, but are risk averse when it comes to our gains, we like small daily winnings in the stock market, even if that requires that we risk losing everything in a crash.”

So what’s the lesson for the average investor? In some respects, Niederhoffer’s and Taleb’s approaches might be considered the two extremes of investing. The average investor, we believe, will best be served by adopting a broadly diversified target portfolio and rebalancing at regular intervals. They should expect periods of negative returns and avoid chasing the latest hot assets. They should understand that avoiding large losses is just, or even more important, than making big gains. Winning all the time isn’t everything!

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