A bird in the hand is worth two in the bush

Generally, investors are an optimistic lot. They tend to expect next year will be better than the last one. They tend to over-estimate their abilities. They tend to mistake luck for skill.

Investors are people, after all, and people tend to be over-confident. For proof, simply look at the success of lotteries. The odds are terrible, but the potential payout is huge, so people generally love to play.  

If you ask a lottery player what chance others have of winning, and what chance they themselves have of winning, you’ll almost always get two different answers. “I am special,” they seem to say, “and I will prevail over the odds.”

As far as evolution goes, this is a great attitude to have. Pessimists make lousy leaders, are chronically unhappy, and don’t tend to do what is necessary to succeed. Optimists, in contrast, tend to be better leaders, happier, and more confident in doing what they need to succeed.

When it comes to investing, though, the evolutionary program doesn’t work very well.  

Investing is basically a contest with other people–not a contest with nature. The goal is not just to pick winners, but to pick winners before other people do. Seeing that Apple has succeeded doesn’t do you any good, you have to have seen it before others and acted on that conviction to benefit.

This is why optimists tend to make lousy investors. They invest boldly because they are so sure of themselves. Unfortunately, they are not alone, and investment prices reflect the over-confidence of so many optimists investing boldly.

Optimists assume that high growth will continue. They assume they know more than others. They assume the distant future will look like the recent past. Unfortunately for them, it seldom does.

This attitude isn’t just reflected in the actions of individuals, but in their investment advisers, too. People tend to choose optimistic advisers. They want someone who confidently and boldly predicts good things will happen. They don’t really want a straight-shooter, they want a leader who they believe will take them to new heights. 

This compounds the problem, because even pessimists tend to prefer optimists as advisers. That leaves even fewer pessimists doing the actual investing, thus causing prices to over-reflect the optimistic attitude.

So, why do pessimists make better investors? Because, unlike optimists, pessimists tend to under-estimate their abilities, they tend to think things will get worse, they tend to mistake skill for luck. Instead of investing in “high potential growth,” they tend to invest in actual performance.

A bird in the hand is worth two in the bush. The performance that has actually occurred is worth more than the potential that hasn’t. High growth always slows over time, and low or negative growth almost always improves more than expected.

The pessimist invests in the bird in the hand instead of hoping for two in the bush. It rarely turns out there are two in the bush, and even when there are, they are almost impossible to catch.

The pessimist tends to generate better investment results because he isn’t over-confident.  He doesn’t invest in potential, but in the actual. Being unsure of his ability to predict the future, he doesn’t try. The pessimist ends up selecting investments that optimists hate, and thus pays a very low price for it. 

What happens going forward? The optimist ends up paying a high price and finds out the future isn’t quite as good as he confidently predicted. The pessimist ends up paying a low price and finds out the future isn’t quite as bad as he worried. The optimist’s investment tanks on disappointment; the pessimist’s investment rallies when things turn out less bad than most predicted.

This process is so counter-intuitive that few follow it. Who brags they invested in a near-dead company? Who loves to brag that they invested in Apple? It’s human nature, right?  

To get better results, though, you need to be a bit more skeptical. You need to worry that potential growth will falter, to question your confidence, or to find someone more paranoid than you to do the worrying for you.

It may sound counter-intuitive, but it works. When it comes to investing, hope is foul language. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A bird in the hand is worth two in the bush

Long term optimistic, short term pessimistic

Markets seem to be sitting on the edge of their seats, and for good reason. 

On the positive side, there are tremendous innovations in technology, growing and thriving emerging markets, and the possibility (I didn’t say likelihood) of real fiscal reform in developed markets.

On the other hand, there are very big fiscal problems in developed markets, increasingly burdensome regulation that’s slowing growth/innovation/employment, threats from bad growth and politics in emerging markets, and the ever-present danger of terrorism and natural disasters.

Markets are waiting to see what choices politicians make, because if they screw up–which is extremely likely–then things will get significantly worse before they get better.  If politicians straighten out the fiscal messes they’ve made, and reduce ineffective and burdensome regulations, then individuals and entrepreneurs will be free to innovate and grow everyone’s prosperity. 

If they don’t, then several crises will unfold and we’ll likely end up with the same reforms anyway.  Herb Stein once said that if something can’t go on forever, it won’t. 

The developed countries of the world have built up too much debt and entitlement programs which can’t possibly be paid for.  If/when politicians wait too long to deal with those mathematical problems, crises will result that will force change anyway.  We’ll get change, it just depends on which route we take.

One route will require much more pain and time and the other will require less difficulty and set us on the road to a big recovery.

Having studied history quite a bit, I think politicians and voters will put off the pain until it’s too late, but they can’t avoid logical consequences any more than the U.S. Congress can legislate gravity out of existence.

Canada in the mid-1990’s faced the music and have been booming ever since.  They saw that economic reality couldn’t be avoided and changed course.  They are very much the exception, not the rule.

If the U.S., Europe and Japan face the music, we can all get on with life.  If not, then tough days are ahead.

And, that’s why I’m long run optimistic and short term pessimistic.  I don’t think our politicians will face the music because voters don’t want to, either.  But, like a 3-year-old throwing a fit, that won’t change the facts.

If past market cycles are any guide, we’ll get down to 10x normalized earnings at some point, which would be 670 on the S&P 500 today, 890 five years from now, or 1200 ten years from now (versus a level of 1320 now, requiring drops of 50%, 33% and 10%, respectively).

It’s not inevitable, but it’s very likely.  Plan accordingly.

After that, we’ll probably have another long boom that will take the market back to euphoric peaks.  That will be a fun ride, and I’m very optimistic it will happen.  But, probably not as soon as I’d like.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Long term optimistic, short term pessimistic