3 steps to investing in a multi-polar world: revisit your beliefs, diversify, act!
Introduction
I had previously asked whether value investing will be making a comeback. Two weeks ago, GMO made another exhortation for investors to keep the faith. Its 2020Q3 newsletter is titled VALUE: IF NOT NOW, WHEN?
Yet, over the past two weeks, we had seen more than a few examples of topsy-turvies:
- Tesla’s market cap has hit US$660 billion, a more than 50% increase over that in 2020 Sep 30th;
- Bitcoin’s price is back at US$20,000 again, and then some.
So what is one to do in a world where many things can be true at once? I put together the following three steps to investing in a multi-polar world: revisit your beliefs, diversify, place your bets!
Revisit your beliefs
The first of 3 steps to investing in a multi-polar world is a lesson I learnt from Annie Duke’s Thinking in Bets. It is to periodically update my own beliefs.
If you had been brought up in the investment tradition of Buffett and Graham and Dodd, you would likely have missed the first dot-com bust. You would also likely have missed the second dot-com boom, still ongoing. You would have totally missed Tesla and Bitcoin. In other words, the performance of your portfolio could do worse than that of Berkshire Hathaway.
Within Graham and Dodd’s framework, there is simply no placeholders for intangible assets. The underlying assumptions for financial analysis do not include negative interest rates. Governments and regulators are rule setters rather than actual market participants pumping billions of dollars buying assets.
Thus, operating within the beliefs and assumptions of this framework, we would come to very different conclusions. These conclusions drive our actions which determines the results we get.
If the results we get from persistently following our beliefs is sub-optimal. Then perhaps we can do no worse than take a lesson from George Costanza, in the comedy Seinfeld. At Jerry’s suggestion, George experimented with doing the exact opposite of what he had been doing. The new course of action immediately brought favourable outcomes, until George reverted to his usual self.
What are the beliefs we currently hold that are hindering us from having our optimal performance?
Diversify
The second of 3 steps to investing is to diversify. This is also one of the first lessons in any investment 101. “Don’t put all your eggs in one basket.” “Manage your risks”, “Size your bets”. Whichever way you’ve heard it, the idea is simple. When you spread your investments across different assets, you reduce the chance that your total portfolio will get wiped out.
Traditional diversification
Textbooks and financial advisors have focused such diversification efforts across a few domains. These would typically include asset classes, sectors, currencies, and more recently factors and style.
- Asset classes: for a primer of what these are, the CFA Institute has a good guide. For a retail investor, the usual asset classes include money market instruments, bonds, equities (both public and private), real-estate and even commodities.
- Sectors: to understand these, a good place to start is the MSCI website on The Global Industry Classification Standard. During the course of a business cycle, some sectors will perform well while others will be swamped. Spreading out your bets across sectors reduces your chance of ending up with all the dogs.
- Currencies: these are fundamentally tied to the underlying economies of the respective countries. Despite the trade wars and pandemic lock-down, few countries are self-sufficient in all the goods and services its residents need. This means you will be paying for imported goods. Diversifying across currencies helps you manage the risks that the prices of certain imported goods go through the roof.
- Factors and Style: A typical investment style question is that on value-versus-growth, which I had mentioned on multiple occasions. This article is a good primer about what these are.
Beliefs diversification
Regardless of which of the above dimension you look at, one thing is common. You would only place bets on the areas that you believe is most likely to become a winner. For example, let’s say you think all the quantitative easing around the world would debase fiat currencies. Inflation would return with all these money chasing scarce assets. So you would hold more of real assets such as equities and real-estate, and reduce bond holdings. Yet another example is if you think value investing is dead. You would thus put most, if not all, your holdings in growth stocks.
I would like to introduce one other dimension into consideration: your beliefs. You should allocate assets to those areas that you believe would be a winner, as well as those you believe would never have a chance.
Let’s say you believe, as this Motley Fool writer does, that Bitcoin is a terrible investment. You can even write a thesis on 10 additional reasons why you believe so. After that is written and published, the most humble action you can take is to go buy a couple of hundred dollars worth of bitcoin. The reason is simple: you never fully know. Yes, not even the so-called experts know.
Nobody knows
Take Luckin Coffee for example. This once-upon-a-time investor darling listed on NASDAQ less than two years after the company opened its first outlet in Beijing. It made its early investors a handsome profit on the IPO debut. These early investors include old hands at the venture capital and private equity game. BlackRock, an asset manager with US$6.8 trillion assets under management, is one. So is GIC, a Singapore sovereign wealth fund, and CICC, a Chinese investment bank.
Within 12 months of listing, the bubble popped. The firm was found to have fabricated sales and cooked its books. Its early investors either (a) knowingly condoned and were party to the fraud, or (b) were totally ignorant of the shenanigans. Given that no one at these investment firms was hauled to courts, we have to conclude it was (b). In other words, those who claimed to have made hundreds if not thousands of deals did not know. If that’s the outcome of experienced and well paid “professionals”, the average Joe and Jane have no chance of ever being certain.
Profiting from not knowing
Hence, whatever your beliefs on the prospect of a company, you should allocate some capital to it. Yes, even those you believe would be a wash-out or even a fraud.
“That’s copping-out!” I hear you cry? Guess what, that’s what J P Morgan did months after its CEO Jamie Dimon warned that bitcoin was a fraud. I doubt the CEO and his executives at the bank really believed there’s money to be made in the crypto-currency. However, I am almost certain they acknowledged to themselves: we don’t know, but we can afford the loss in return for a (potentially big) win.
That is almost certainly the same calculations made by the BlackRock and GIC pros making the call on Luckin Coffee. The only difference is – J P Morgan had a good outcome (so far), while BlackRock and GIC had bad ones. The roll of the dice could turn out to be totally different.
Place your bets
Annie Duke’s recommendation for testing our own beliefs is to pose ourselves the question “Wanna bet?” And that is exactly the move we need to take to test out our revised beliefs on diversification.
I had also previously written about the science behind the benefits of bias towards action.
In the context of investment, you would never know if your beliefs is right or wrong until you either make a profit or loss on it. In other words, you need to place your bet.
And that is the last of 3 steps to investing in a multi-polar world.
Conclusion
The post-pandemic world is one where multiple things that seem to contradict each other can be true at the same time. To navigate this environment profitably, we will need to remain mentally agile. That leads to the 3 steps to investing above:
- Revisit your beliefs
- Diversify
- Place your bets!
