Strategic faith

February 12, 2018

Would Dumbo have been a good investor?

For the uninitiated: Dumbo is an orphaned elephant with embarrassingly large ears. He is made to work with a quite unpleasant circus, where a Timothy (a clever mouse) tells Dumbo that he could be a star if he used his huge ears to fly.

But Dumbo isn’t convince he couldn’t pull it off. So the mouse gives Dumbo a ‘magic feather’, which allows him to fly. Dumbo later learns (mid-flight!) that the feather isn’t magic.

He could always fly. He just needed to believe.

Religions appear in almost all societies in some form.

But the details vary dramatically. The formation of the world, the names and organization of god(s) and interactions with humans, the ideas of souls and death. It’s clear what the big questions are.

Religion and spirituality help cultivate a system of ethics, a story about how the world, how life and death work, a supportive community to join, a way to cope with life’s foibles. It’s very valuable.

The benefits of religion don’t seem to depend on the exact theology. The details of the story aren’t critical.

But belief in the story is.

What if a critical ingredient to being a successful investor isn’t exactly which strategy you follow? It’s just that you have faith in that strategy?

By faith I mean the ability to take the leap into risking your money without guarantees, and to continue to adhere to the strategy, even in the face of disappointing results.

Markets must crash. Active strategies must underperform. Chasing performance produces lower returns. Buffett underperformed by 67% at one point! Even a clairvoyant who knew exactly what stocks would perform best would get fired, because the journey would be so terrifying.

An investor without a faith is doomed.

Most of us will invest for about 50 years, from age 30 to 80. Over that period the primary driver of non-savings growth will be that you invest in a reasonably diversified, risk-aligned portfolio with low cost and tax drag.

Once those boxes are checked, the exact flavor you choose isn’t hugely important. Market-cap, SRI/ESG, Smart Beta, Trend, Risk Parity, Global CAPE, home biased. Sure, sounds good. Go for it. Bikeshedding. They’ll all have periods where they look best, and periods where they under-perform.

Except! Except if you don’t stick with it. Except if you flop in and out of strategies with each glittering fad and temporary disappointment.

In U.S. large caps, performance chasing lead to a 2.3% underperformance. Over a period where the U.S. market went up about 7% on average, the average investor underperformed by 1.6%. The most active 20% of accounts underperformed by 6.5%. Net return: 0.50%. They would have been better off working a minimum wage job than trading their brokerage accounts.

Distill most investing mistakes down, and you get a simple story: cumulative time invested. Anything we can do which increases the total time an investor holds a reasonable portfolio, is a win.

It is better to have any reasonable faith, than none at all.

The cardinals of quant on the benefits of faith

Perhaps you think this is just hooey psychologist talk. If so, may I quote some (highly quantitative) professional investors?

trend has allowed me to stay in an expensive market to capture ~100% more return than my behavior would have otherwise allowed. - Jake

The evidence would say momentum, but because I’m a human, when I incorporate System 1 risk, I’m gonna say value. When momentum stops working for a while… well, value is something that you could put 50 guns to my head, and I will never.. Even if it goes 99% negative I will still hold my value stocks._ - Wes Gray ~34m

Faith allows you to hold on when the pain is sharp. It gives you a story of trial and redemption. Only the faithful shall reap the mana of heaven. Drawdowns (absolute or relative) separate the believers from the poseurs. The weak hands that fold ensures the true believer’s profit. Or something.

Why faith, not rationale

A common response will be “I follow {my strategy} because it’s rational. Here’s the evidence”.

Hello economists and engineers! Welcome!

Did you know that purely rational people have a really hard time making decisions?

In a series of studies of people with brain lesions, Anthony Demasio found that if you disconnect the simple, emotional, motivational part of the brain, people can’t make decisions. These people understood pros and cons. They considered options and explored alternatives. They weighed and measured. They were rational.

But they deliberated endlessly. They wanted more evidence, more time for analysis. They simply couldn’t come to a conclusion. An infinite filibuster.

The crux of making of a choice is not about logic and evidence. It requires emotional activation, a focus on execution towards an end, rather than if that end is right.

We often seeks out information to justify our pre-existing views. We are drawn to ideas which makes us feel good. Logic and evidence are two of our best allies in this confusing world.

That said, they aren’t perfect. They can help us filter out bad faiths, but they do not guarantee the results of what’s left. Past performance is not always predictive. Publishing an arbitrage anomaly is the best ways to exterminate it. The market abhors alpha. “The worst 10 year period of any backtest is the next 10 years”.

Markets are not governed by physics. There are no universal constants.

To believe an evidence based strategy will continue to perform moving forward either requires an odd belief that the future will be indistinguishable from the past, or robust underlying mechanics that do not undo themselves as we learn about them.

In all cases, a faith to act is the foundation. The intellectual house is built on top.

Religious virality

Not all religions are created equal in terms of their capacity for growth. If you are not born orthodox jewish, it’s very hard (impossible?) to become one.

Key characteristics of different religions enable them to grow memetically. The quants of today would say different religions have different virality and capacity factors.

I think this is (partially) why “passive” investing is such an attractive faith. It is the lowest-barrier-to-entry investing religion. It says “you don’t have to be an expert to win. You don’t have to trade and monitor things all the time. You don’t have to pay a high fee to get good returns.” Just get invested, avoid these stupid mistakes. It requires the least doctrine, the least assumptions to work.

The idea that you can win without beating others is central to getting millions of new people comfortable with investing. It may have enlarged the pie. It helped with the adoption of retirement programs like auto-enrollment by providing a fairly universalist default investment. It made a large balance of investors move their focus from recent performance, to costs. Because recent performance had nothing to do with future returns, but cost did, this was an improvement.

There are other faiths. Dimensional Fund Advisors (DFA) and to a lesser degree AQR (AQR) require converts to pay a steep entry price to be welcomed into to faith, and my impression is they have lower churn for having invested in their converts.

Finding our faiths

The truly disadvantaged are the investors who don’t have a mental model or scaffolding for understanding the world. They will simply look at the stream of returns, listen to the news, and react.

How do the faithless find a faith?

This is tough. You can’t tell someone “just believe in something, and you’ll be better off”. They need to actually believe in it. And if they believe that the only reason to have a committed faith is to get better performance… that is not true piety.

I don’t have a great answer, but I do believe we need help find or even define virtue in struggle, and salvation through constancy. Pain must be part of the story, which leads the hero to success. Investors must value their faith for the peace it gives them during their trials, regardless if it works financially.

The faith-less often want to know what the best faith is. There is no such thing.

There may be a best religion for each of us, but no single story that will allow all of us to make the leap that will confront us over those 50 years. Put a boglehead in a trend-following algorithm and they will bemoan the turnover and missed rallies. Put a risk-parity acolyte in a market-cap portfolio and the world might end. No one size will fit all.

If this piece feels like a work in progress, that’s because it is. Sometimes I write ideas out to see if still believe them. While my arguments are now more refined, I’d put myself at 68% confident. The gestalt came together over time by reading a few key books.

The True Believer

Big Gods

Descarte’s Error

The Meaning of Belief: Religion from an Atheists Point of View