Discovering Unnecessary Investment Risk — Moneyball!
In the Nature of True Wealth Management essay, we identified three of its attributes: Living Our Lives with Confidence, Dollars of Future Wealth, and Avoiding Unnecessary Risk. Before discussing the latter, it helps to identify some different kinds of risk.
Nearly every traditional investment forecast is a combination these: interest rate, inflation, market, currency, business, political, economic or headline risk. One thing they have in common is that their potential impact is already included in the prices of liquid securities. Another common trait is that no investor or committee of experts can predict or control any of them.
Even more amazing — while nearly all investment strategists claim some kind of superior forecasting skills, none of them discuss the two risks we can actually control or anticipate. These essential two factors are underperformance risk and cash flow/sequence of return risk. They are ignored because it would render investment strategists to be irrelevant.
This is because the traditional industry value proposition is rooted in finding mispriced securities, industry sectors, or asset classes. To their credit, nearly half the time, the good ones are right. Yet this ignores the obvious question: how much unnecessary risk was taken by their investors for this opportunity to underperform?
At Poetic Justice Capital, one of our steadfast principles is to control what we can control. At the top of the list is risk exposure — how much do we invest in risk assets like stocks? The key is to balance that with other factors we know about or control such as savings habits, spending goals, life expectancy and financial resources.
In Moneyball, Oakland Athletics GM Billy Beane did the same thing. He evaluated baseball talent based on the performance a player could control. For example, he discovered that a pitcher’s ability could be discovered by home runs allowed, strikeouts won, and walks. Traditional metrics like ERA and wins became irrelevant. For batters, Beane replaced batting average with on base percentage.
At Poetic Justice Capital, we evaluate talent based on the factors that a money manager can control, and the ones relevant to our client’s success. At the top of the list are correlation to the broad market asset classes we want to own and expense ratios. Selection of asset classes is also key — they must have long and reliable historical data sets for correlation, median return, and standard deviation.
These three metrics are also potential assumption errors, are included in every asset class, and inherent to Efficient Market Theory. Yet traditional “best practices” include many “alternative” asset classes for their so-called diversification.
Not only does each one add these three potential assumption errors, in extreme markets, they correlate almost perfectly to the risk assets (stocks) they supposedly diversify.
Moneyball teaches us that pitchers have one job — get the batter to swing at bad pitches. It also teaches that batters have one job — do not swing at bad pitches! At Poetic Justice Capital, we do not swing at the alternative, sector, forecast, outperformance, social, or technical bad pitches. Instead, we respect the price mechanism of free markets and take control of our futures.
