Two ways of being wrong

There are at least two ways of being wrong in investing, and each has its own means of mitigation. One is to be flat-out wrong. Perhaps the most spectacular example of this (among many contenders) may be found in the hapless words of Professor Irving Fisher, a distinguished economist at Yale, who announced in mid-October 1929 that the stock market appeared to have reached “a permanently high plateau.” Another way of being wrong is to be right but early, a problem summed up by Fisher’s rival John Maynard Keynes with the dictum that the market can stay irrational longer than you can stay solvent.

Being wrong

We all make mistakes, although in portfolio management those can be costly. How to potentially reduce the damage done? The first way is diversification. Spreading investments around may help ensure that no one bad investment will have an undue impact on portfolio returns. The next is determining the size of those investments. All else being equal, the more uncertain you are of a stock’s outlook, the smaller your position should be. Investors may want to avoid taking large positions with a large potential variance in outcomes. The third way of helping to reduce damage from being wrong is to avoid unintended risk. Imagine, for instance, a skilled, bottom-up stockpicker who happened to construct a portfolio of just energy stocks because the dividends were appealing. If oil prices fell, the portfolio would be likely to fall too, overwhelming the manager’s skill. In this example, the manager took on unintended risk.

Being right but early

Even if an investment manager has skill and an investment thesis that will pay off, with equities that payoff may arrive at the “wrong” time. In the simplest case, consider an underperforming strategy. One reason not to sell is that it may soon begin to outperform. The manager, in this case, is right but early; the market has not yet validated the manager’s insight. Perhaps one will be told, “No pain, no premium.” That may be true, but what is to say that a premium will eventually emerge?

The importance of a plan

If a manager is not always right and not always right on time (and who is?), what is to help the nervous investor other than hope? One popular approach is to diversify the management itself by hiring multiple managers with different investing styles and time horizons. This is not without its own problems, however, since the diversification may be haphazard. Furthermore, the different managers may cancel each other out, leading more to an index-like portfolio.

Quantitative management, which identifies stocks to purchase by systematically analyzing large amounts of data, permits a different option by employing multiple (and diversified) alpha-seeking engines within a single portfolio using sophisticated optimization and risk management techniques. One manager, then, can potentially provide the benefits of a multimanager approach while avoiding the friction of using multiple portfolios.

To quote Keynes once more: the ignorance of even the best-informed investor about the more remote future is much greater than his knowledge. With investing, it’s so easy to be wrong that one of the ways of being wrong is being right, just early. It would be great to avoid ever being wrong; far better, however, to have a plan.