135 - Investing in the Face of Uncertainty

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Mental Models discussed in this podcast:

• Second-Order Effects
• Mean Reversion
• Factor Investing

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Show Outline

• Today’s podcast will focus on a single precept: You can’t predict the future
• First and Second Order Effects
  • Margin of Safety
  • Preference for cash now vs cash later (Plays into want for profitable companies) Time value of money. 
  • Growth is important because it can correct for mistakes, but you know you can’t predict it
  • Some of what you “know” about investing may not be true
  • Importance of Zero-Based Thinking (what is the best decision today based on what you know today)
    • Wrong because past price performance can’t predict the future (it may, but it may not)
    • Wrong because it assumes that winners will keep on winning and losers will keep on losing
  • “Don’t catch a falling knife”
  • “Hold onto winners, trim your losers”
  • The central problem with rebalancing
  • It is definitely true that successful rebalancing CAN add value
  • It is also true that it is IMPOSSIBLE to know if your rebalancing will be successful
  • How then do you behave? How do you invest in the face of uncertainty?
• First order:
• Second order:
• Investing in the face of uncertainty
• You cannot assume business momentum. You plan for it and buy stocks you think will have it, but your strategy cannot assume it will continue.
• You cannot assume reversion to the mean. You plan for it and buy cheap stocks because it offers the opportunity of reversion to the mean, but your strategy cannot assume stocks WILL mean revert in the time frame you want.
• You cannot assume that growth will continue.
• You cannot assume a specific growth target will be hit.
• You cannot assume that your predictions about business quality will be better on company A than on company B. 
• The only thing you can know to be true is that the future is uncertain. 
  • I personally use some absolute rules (like no margin debt, no options, and no shorting). Not because they’re optimal, but because they limit my risk and allow me to take risks in other areas. 
• Some of your decisions will be a mistake. That doesn’t mean you don’t make a decision. Indecision is a decision. 
• Selling some winners may be correct and selling others may be a mistake. Your strategy needs to incorporate that understanding. “Absolute rules” can be helpful to limit mistakes, but they will inherently be suboptimal. 
• What is my point:
  • It would be a mistake NOT to trim when I am given the opportunity to do so. Failing to take advantage of opportunities that ignore zero based thinking will result in me having lower returns across an investment lifetime. 
  • You want to build a strategy that follows this precept: “If I lived my life 10,000 times, what strategy would result in a favorable outcome across the most possible lifetimes?” 
  • Don’t optimize for the “perfect” scenario.
  • Don’t optimize for the “worst case” scenario. 
  • Optimize for uncertainty. Prepare for the worse, plan for the best, and adjust daily. 
• There are aspects of my strategy that go against established norms. However, there are clear reasons for that. I know that I cannot predict the future. 
• Therefore, I am willing to sell or trim my winners when I believe it improves my potential returns and reduces my risk. 

Summary: 

• • You cannot predict the future.
  • Be more humble.