This pot was originally shared on my eToro feed on 30 January 2022. Make sure to follow me there as well, and did you know that you can copy my trading there for free? Create an account today, copy my portfolio by searching for user “Allseasonsport” to automatically duplicate my All Seasons Portfolio strategy effortlessly.
Is a good investment outcome always a sign of a great investment decision?
Intuitively, one could believe so, but more often than you might believe, that is actually not the case.
The past decade has favored stocks massively, meaning that investors who ignored diversified investment strategies and who applied poor risk management, have actually benefitted, while prudent investors have seen their neighbors get richer on meme stocks, cryptos and ARK Innovation ETFs.
But are all these stock investors geniuses for achieving such a great outcome? Hardly. Such a belief among these investors – that they are superior investors – is just a form of outcome bias or “resulting” as described by Annie Duke in her book Thinking In Bets.
In short, this means that not all decisions with good results are necessarily good decisions.
More often than we think, the outcome is formed by luck. Even when the probability of a loss is 95%, every 1 in 20 cases, there is still a positive outcome (5% of the time). And when an investor wins on such a bet, he/she is biased to believe that it was due to his/her superior knowledge that brought the gains, rather than luck.
In other words, the decision could have been catastrophic to make, but as it by accident turned out well, the investor thinks that the decision was a good one.
And with a layer of hindsight bias on top, the decision is rationalized afterwards to have been sound, even though far from all facts were on the table when the bet was placed.
The long bull market in stocks has spurred risk-taking and this culminated last year. How many honestly think that a decision to invest in Gamestop at a high price of $150 was a good decision based on the company’s fundamentals, even though you later sold in panic nearer to the top, or that you bought Dogecoin after it had rallied after Elon Musk’s tweet and by chance not making a loss.
Rather, it was more probable that such a trade would have resulted in a great loss, but just because that particular outcome didn’t materialize, the meme stock investors are found all over eToro and Reddit touting their brilliance.
The past decade has rewarded concentration rather than diversification among retail investors: a good result for a bad decision. Balancing risk and lowering the probability of losses has, on the other hand, been punished by missing out of the gains reaped by imprudent peers.
For the rest of the 2020s, for which the outlook is much more uncertain and stocks start the decade at extremely high valuations. Now, if ever, is a good moment to pause and think, and adopt prudent risk management.
It is, however, impossible to know what will happen with any asset class, and uncertainty is far from gone from the economy.
Even though some possible outcomes are “priced in” asset prices, that just reflects the market consensus of what the investor collective thinks will occur, or rather, expects will occur.
It is when expectations change from one day to another, after new information becoming available, that asset prices swing the most. Then this new information gets included in that day’s price of the asset. It is the changes in expectations that are the most important aspects of investing, as the largest gains (or losses) are found when expectations of a future reward change for an asset.
But can you reliably anticipate what expectation changes will occur and when? Quite unlikely. For a particular market move, you may have a more or less qualified guess, but at the end of the day, you are just playing with probabilities. For any bet you take, there is always a chance of being wrong.
When looking at a macro driven way of trading, in other words the large factors driving changes in prices such as economic growth and inflation, you would be looking for changes in these factors when taking your positions to benefit from these bigger scale trends.
It is extremely difficult to get these right, and there is just so much noise in markets that it is difficult to identify what is priced in already and where the opportunities lie. Most commonly, when the economic regime is noticed to be changing, the change has usually commenced much sooner, and asset prices have started to move.
A great example of this is the prices of commodities and gold for the past 24 months. Let’s consider the latter first. It was only in late March 2020 that central banks started stimulating the economy at large scale. The gold price followed upwards for a couple of months in the beginning of the pandemic, but then stagnated abruptly, and has barely moved from the USD 1,800/oz level since. Many investors and “gold bugs” have been stumped by this: “inflation is soaring, but gold is not doing anything”. Why is that?
Well, if you zoom out a bit, you will see that the price of gold already had risen by about 60% from 2019 to mid-2020. That is a heck of a lot of inflation covered in the flight to safety rally, so it is just natural that it takes a breather now before the next phase.
And for commodities, these have rallied already since before we started to see the higher prints in CPI, with GSCI (Goldman Sachs Commodity Index) rising by more than 40% the last 12 months in an continuously upward sloping trend.
What does this mean for an investor? It means that if you just stare at economic growth numbers or inflation prints, and only then place your bets, you are likely to miss out on the largest parts of the rallies and being late to the game. This is not how the smart money does it.
What is the wise thing to do instead?
Instead of trying to predict (where you work with probabilities and are likely to make many failing bets), it is better to construct your portfolio to always be prepared for any possible outcome. This way, you will capture all rewards all the time.
You will, of course, in such case also have loosing bets in your portfolio as well, as everything cannot perform well all of the time. But this is mitigated by balancing the risk in your portfolio so that you have equal risk allocated to each possible market regime (inflationary boom, inflationary bust, stagflation, and disinflationary boom). This way, you will attain the risk premiums from all asset classes (which are paid to you at different times for each asset) and at the same time earning extra returns from a rebalancing premium.
You are less likely to make huge gains, but also you are avoiding the largest drawdowns. Stability is the key for long-term wealth, and that is how the smart money invests.
This line of thinking, by preparing rather than predicting, is a cornerstone in the philosophy of risk parity investing, and particularly for the All Seasons Portfolio strategy.
Rather than trying to make predictions and accidentally believing a bad investment decision was a good one just because it happened to have a good outcome because of resulting and hindsight bias, the All Seasons Portfolio is built to be prepared for any possible outcome, and to provide more stable returns than the stock market.
The strategy does not guarantee positive returns every day, week or even month, but the risk-adjusted return will be better than for the stock market. Even though my portfolio is down this past month, it is still better than the S&P 500 and Nasdaq so far this year.
In a decade that is likely to favor prudent risk management and sound diversified asset allocation, a balanced strategy such as the All Seasons Portfolio strategy is likely to make you sleep better at night, and where assets such as commodities, gold and TIPS will balance out negative returns of stocks and bonds in a rising yield and inflationary environment.
Despite the negative performance of my portfolio so far this year in January 2022, due to interest rate risk, I remain convinced that the strategy will deliver on its promise of risk-adjusted returns superior to that of stocks and a 60/40 stock-bond portfolio.
You are more than welcome to stick around for this journey that I have been on for several years already with this strategy, and I look forward to interacting with you along the way. And make sure you look up my profile on eToro, if you haven’t already.
All the best,
The opinions shared in this article are those of the author and do not constitute investment advice in any form. Any mentions of my trading strategy are for descriptive and information purposes only of what I do with my money. All investments carry the risk of capital loss.
This post includes affiliate links for eToro, and by clicking the links, I may get a compensation, at no extra cost or disadvantage for you. On eToro, the trading on my account is done with my own money, and if you chose to copy my trading, I have skin in the game and incentives to stick to my strategy and perform well.