What do we know?

September 21, 2018

I had a history of leaving chemistry exams in a type of existential haze, asking myself questions like "Do I know anything?" or "Is anything real?" In full disclosure, chemistry and I were not the best of friends. It was largely chemistry's fault - I wasn't the one who designed a science with almost as many exceptions as rules.

But following up on my early September email, in which I pointed out the long, erroneous history of the so-called experts' market predictions over the past decade, I don't want you to think the know-nothing haze still resides. There are things we know in investing, where "know" is defined as a high probability of being true in the future.

Without the ability to filter fact from fiction, you'll quickly end up like a builder who doesn't find bedrock. The building may look beautiful at the start, but in a few years "parallelogram" might be the most charitable description.

It is an ongoing struggle to define what is known. While securities prices might be a random walk (1), it is this effort that adds conviction to the process. Here are four principles:

1. Asset allocation. We talk a lot about fees, but asset allocation is equally important. Asset allocation is what stocks, real estate, and bonds we invest in, and in what percentage quantities. It is a, if not the, primary driver of long-term returns. Asset allocation, unlike fees, is harder to communicate: I have not been able to distill it to one sentence. Given it's value, we also view it as a client-only area.

2. Diversify. Harry Markowitz won the Nobel Prize for his work on the efficient market. Just slightly less honorable, his ideas underpin One Day In July. At 91 years of age, he was asked to distill his life's learnings to one sentence. He did it in one word: "Diversify." We know the future will not resemble the past precisely, and it is diversification that protects us from our own sense of certainty.

It is important to understand that very few inbound portfolios we see are well diversified. Generally there is more underlying correlation in the investments people hold than they realize.

3. Reversion to the mean. Simply put, things will go back to their averages over time. For periods of time, sometimes years, certain asset classes will trade above their historical price-earnings ratio, and others will trade below it. But over time they will "mean revert," meaning they will trend back to their average. The rebalancing activity of a well-managed portfolio utilizes this effect to boost returns.

4. Emotions matter. Human emotion always will be a factor in an investment program. It applies to all of us at One Day In July, and it applies to clients. Our job is to minimize emotion, designing systems and processes that decouple it from the investment process.

With these pillars as our foundation, we can build, financially, with confidence.

(1) If you are interested in the Random Walk hypothesis, more info is here.

Dan Cunningham