"I have heard that your first fall off of a horse may determine what kind of rider you will be." I didn’t write that, my daughter Anna did. She continued:
"My heart dropped as I watched Sally fall to the ground, but I knew I had to stand back and watch to see how she would handle it. So did her coach, Sydney. Sally cried, stood up, got a hug from Sydney and hopped back on that horse with tears streaming down her face. Her lesson continued, and another rider who was in the arena came over to me and said, "That daughter of yours is going to be a great show jumper."
"There are so many basic things to learn before even thinking about going over jumps. That is why a coach is needed. A good coach knows when to push a rider and when to hold them back. It’s a matter of not only judging a rider’s skills, but also noticing when they become over-confident in their abilities or too trusting in their horse. It’s when they get these things right that they can guide the horse with clear and unambiguous signals.
"To the untrained eye this looks like nothing - barely perceptible movements - especially when watching an itty-bitty six-year-old. But I can tell you, it takes tremendous precision and skill. Over the last year, I have watched in amazement as my daughter has improved her skills and shown me what bravery, dedication, joyfulness, and passion looks like. I have also watched a relationship grow between a student and her coach. Sydney is an Olympic level rider who adores my daughter and treats her as a fellow rider with whom she is sharing her skills, imparting her wisdom and passing on her knowledge."
Anna’s not only my daughter, but also a fellow advisor with whom I have been sharing my insights and knowledge. And, like Anna being amazed by Sally, I have been amazed by the growth in Anna’s skills, passion, and dedication. Instead of just copying me, she is helping to push our firm into more efficient directions, new programs, and new ways of communicating.
Recently we joined with Integrated Advisor Network, a national advisory firm. This, along with the addition of my youngest daughter, Hillary, as an administrative assistant has made our operations more scalable and sustainable. We are adding a digital interface to our existing systems that will allow us to handle clients with relatively small account balances. And Anna is developing a podcast called Transitions to help people deal with the transitions we face in life – college to career, military to civilian, single to married, working to retired and so forth.
These changes will help us serve our clients better, increase our capacity to add new ones, and provide continuity if something should happen to me. They are not a means for me to slow down or to turn the reins over to Anna. Instead of replacing me, she is adding a focus on clients at the start and midpoint of their careers as a complement to the focus I have always had on clients at or near retirement.
When Anna was an itty-bitty girl, she was on a horse that spooked and, while she never fell off, she didn’t get back on for 30 years. Inspired by Sally, she started riding. Inspired by me, she became an advisor. However, it is her passion that is driving her now and her common sense that is keeping her from making over-confident mistakes and from relying too much on her dad (or trusting her horse too much.) You’ll have to ask Sydney or Sally about her riding, but I can honestly and unambiguously say, "That daughter of mine is a great advisor."
What I thought would be the most important event of the summer, my sixtieth birthday, turned out to be an afterthought. Starting off the chain of events that got in the way of my big day was the birth of our first grandson. He was named Dominic after his great-grandfather, although there was some discussion of naming him Otis after the manufacturer of the elevator he was born in. Needless to say, he became the center of attention. And as he settled in and the family settled down, the center of attention shifted to preparations for my youngest daughter’s wedding.
I thought there was a chance they could schedule a party for me between the events. But with the declining health of my wife’s mother and her eventual death the week of my birthday, that chance evaporated. The sum total of the attention I received was an unwrapped pair of shorts given to me by my wife with the comment that I could exchange them if they didn’t fit.
The lack of attention, while understandable, still hurt. That’s why I was so excited when my oldest daughter invited us to a party for the new baby in the lull before the next big event, my middle daughter’s wedding. It was obvious that this baby thing was just a ploy to setup a surprise party for dear old Dad. As the party approached, I kept telling myself to act shocked when they sprung the surprise on me. As it turned out, I was genuinely surprised because the party came and went without any mention of my birthday or me. It really was a party to introduce the new baby.
Maybe if I had read Dave Foster Wallace’s famous This Is Water speech, I would have had a more realistic perspective. The point of his talk was "that the most obvious, ubiquitous, important realities are often the ones that are the hardest to see… Because, my natural default setting is the certainty that situations like this are really all about me." In other words, we are hardwired "to see and interpret everything through the lens of self." So, "a huge percentage of the stuff that I tend to be automatically certain of is, it turns out, totally wrong and deluded."
Bob Seawright, who did read Wallace’s speech, takes his premise a step further in Finding What We’re Not Looking For, by saying "if you are automatically sure you know what reality looks like… you will miss out on… opportunities to learn..." And it’s not only "our default settings that conspire against us… [but also] our increasingly data soaked and algorithm-dominated world." Amazon, Google, and the rest of the internet don’t challenge our defaults, they cater to them. They are "unparalleled at allowing us to find what we are looking for. [But,] if we are going to do better and be better we’re going to need to find what we’re not looking for."
Finding what you’re not looking for is hard because you’re never sure if you have found it. You are always in an uncomfortable state of uncertainty. Certainty, on the other hand, may be delusional but it feels better. And that, explains Seawright, is why we look for investment professionals who show themselves to be "confident and decisive at all times… [when we should be looking for advisors] who show caution and humility in the face of uncertainty…" Why? Because when we invest with certainty, "we are usually wrong, often spectacularly wrong."
"How can it be wrong when it feels so right?" asks Barbara Mandrell in a song with David Houston. The answer is that the feeling of certainty is based on a self-centered perspective we reinforce with handpicked facts, which may or may not be grounded in reality. So, Seawright is adamant that we need to be "curious, humble, self-critical, give weight to multiple perspectives, and feel free to change [our] minds." But, even though we know he’s right, our default settings delude us into believing that it’s different this time and we can trust our feelings. And that’s why, contrary to the most obvious and ubiquitous realities, I still can’t believe the party wasn’t for me.
Bruce Wayne was right when, in the Batman Begins movie, he said, "It's not who I am underneath... but what I do... that defines me." For far too long I thought the opposite was true. And since I had no clue who I was underneath, I was left to believe the knowledgeable professionals who told me I wasn't normal. It started with my first grade teacher who wrote on my report card, "I think Guerdon is mildly retarded." Over the years, the expert opinion has been that I am hyperactive, obsessive compulsive, dyslexic, autistic, and a bit paranoid. However, the diagnosis I think is most accurate was provided by my coworkers when I was a beekeeper. Over the shop door they posted a cartoon showing a character contorted in such a manner that his head wasn't visible because it was perfectly positioned to perform a proctological self- examination. The caption was "Obvious Problem" and above it, they wrote my name.
While most people would think that having your head in such a position would be problematic, I learned to see it as an advantage because it gives me a unique perspective. As the Dean of Psychology at U.C. Santa Barbara told me, "Of all the students in our psychology classes, you see things from a different angle." And because I see things differently, I tend to do things differently. That's probably why an attorney said, "Guerdon is the best at what he does. Unfortunately, no one has a clue what he does."
What I do is question everything. I assume everything I know is wrong which, based on my psychological profile, isn't that hard to do. It is the exact opposite of the overconfidence that David & Goliath author, Malcolm Gladwell, says is the "disease of experts." It's a condition Phillip Tetlock identified in his studies on expert judgment. He observed that experts "...seem unaware of how quickly they reach the point of diminishing returns for knowledge when they try to predict...the performance of financial markets, [so their] expertise...translates less into forecasting accuracy than it does into overconfidence."
To illustrate the lack of forecasting accuracy, Nobel laureate Daniel Kahneman states the "research is conclusive." The chances of a mutual fund manager outperforming the market is "... barely higher than zero." A Wall Street Journal article by Gregory Zuckerman, Big Investors Missed the Stock Rally, reveals that the experts running Harvard, Yale, and Stanford's endowments "...missed out on much of the rally for stocks since 2008." And an Economist article about Hedge Funds Going Nowhere Fast states that "...over the past decade...the supposed sorcerers of the financial world have returned less than inflation." But, Kahneman says, the confidence of financial experts is not shaken even when confronted by these troubling statistical facts, they know and believe to be true, because the whole financial "...industry appears to be built on an illusion..." that it has the skill to predict markets.
Unfortunately, investors are seduced into accepting the industry's delusional thinking, explains Kahneman, because "Overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion..." In other words, overconfidence makes them believable. As Barry Ritholtz clarifies, in The High Cost of Neuro-Financial Errors, the "...more self-confident an expert appears, the more likely he is to be believed... [even though] the worse his track record is likely to be..."
Experts are confident underneath so what they do is predict. It's an obvious problem that isn't that obvious because illusions are hard to see through. But I see things from a different angle, which means I question the commonly held beliefs about the forecasting and predictive abilities of experts. It's the defining difference between what I do and what is considered normal. And it's why most people either don't have a clue what I do or assume my first grade teacher was right. So, as an investor, you have to decide -- Is it advisors like me, or the more believable experts who have the obvious problem?
“Paranoia strikes deep. Into your life it will creep,” may be lyrics by Buffalo Springfield but it appears to have been a state of mind for Jim Morrison, the lead singer of the Doors. His rhetorical question to his own definition of paranoia was a classic example of paranoia: “As I understand it, paranoia is defined as an irrational fear. But what if the paranoia is real?”
As a fellow paranoid, I empathize with Morrison. Dealing with irrational fears is difficult and it causes me to engage in some quirky behaviors. For one, I avoid intersections with traffic cameras whenever possible. That is especially true of the intersection of Cohasset and Mangrove Avenues that I avoid at all costs because I irrationally believe the light is timed to trap me. I think I got this particular paranoia from my Dad’s constant harping about speed traps on our summer travels to visit my grandparents. Before we left on our road trips, Dad would go to the AAA office to get a map with the locations of known speed traps marked on it. It was my job to read the map and warn Dad when we were approaching one of those bad places.
While I have not been able to rid my mind of its paranoid thoughts, I have been able to funnel some of that destructive energy into useful purposes, like helping my clients avoid financial traps. Similar to how I helped my dad as a kid, it is now my job to pay attention to the financial journeys my clients are traveling and to warn them when they are approaching bad places.
In the past I have been critical of the financial services industry because it has, too often, taken clients into bad places they should avoid. However, I don’t think that the people in the industry are bad. On the contrary, I think they are mostly good people. Unfortunately, they are usually very optimistic which, counter intuitively, is a bad temperament for investment advisors.
According to Daniel Kahneman in Thinking, Fast and Slow, “…optimistic individuals play a disproportionate role in shaping our lives.” They tend to be the leaders, who “…got to where they are by seeking challenges and taking risks.” They are talented and lucky, “…certainly luckier than they acknowledge.” The combination of luck and optimism leads to overconfidence. And Nassim Taleb, in the Black Swan, argues that overconfidence causes investment advisors to have an “…inadequate appreciation of the uncertainty [of markets and] inevitably leads [them]…to take risks they should avoid.”
To avoid excess risk (“bad places”), Kahneman says investors need advisors who have “…an unbiased appreciation of uncertainty…but [that]…is not what people want.” They want advisors who are confident, even though the confidence is based on an optimistic illusion of control that is not supported by the facts. This leaves investors in a quandary because, as the Urban Dictionary correctly states, an “…optimist [advisor] is a person who doesn’t have all the facts.” So, investors would be better off with a pessimistic advisor because, by definition “…a pessimist is an optimist who does have all the facts.” However, a paranoid advisor would have the best appreciation of the uncertainty of markets because, as the Urban Dictionary points out, “…a paranoid…has finally realized that the facts are after him *or her+.” And the facts are that markets can be bad places, where investors need paranoid advisors to map out and warn them of approaching financial traps because, when it comes to investing, “the paranoia is real.”
“Reality!” The word surprised me enough that I didn’t immediately respond, so the receptionist continued, “Hello? Hello?” I had called an 800 number to inquire about some financial planning software and had not paid attention to the name of the company. To the twenty-something young woman answering the phones, “Reality” was just the name of her employer. But to a graying hippie who came of age in the Age of Aquarius “reality” had a whole different meaning.
As a young man, my inner search for reality manifested itself in an outward wandering. After college, I put on my Kelty backpack, stuck out my thumb, and hitchhiked around the country for two years. By the time I finished, I was pretty sure I had figure out what was real. However, as I have aged, I have come to appreciate the words of the 18th century evangelist, John Wesley. “When I was young I was sure of everything; in a few years, having been mistaken a thousand times, I was not half so sure of most things as I was before; at present, I am hardly sure of anything but what God has revealed to me.”
Wesley observed what Plato understood and neuroscience has more recently explained: reality is elusive. It’s elusive because, according to the Bible, “…we see in a mirror darkly.” According to Plato, we “…see only…shadows…” And, according to neuroscience, how our brains interpret what our senses see may not be an accurate reflection of reality.
This distorted perception of reality causes real problems for investors because, it “…drives us to do things that make no logical sense,” explains Jason Zweig. In his book, Your Money and Your Brain, he describes the illogical things we do and why our brains make us do them.
“Your brain is better at asking ‘How big is it?’ than ‘How likely is it?’ Thus, the bigger the potential gain, the greedier you will feel regardless of how poor the odds might be.” “The pursuit of patterns in random data is a fundamental function in our brains [that makes us] believe that we are smart enough to forecast the future.” Overconfidence in response to a run of good luck, “…can fill you with a sense of false security…that…can lead you straight into investing danger.” Fear, the most powerful investment emotion, causes us to “…blink in the face of risk [which] is often one of the riskiest things an investor can do.” “Looking back, it is the errors of omission, not commission, that bother investors more. And yet, oddly enough, their actions almost certainly cost more money than their inactions.”
Since our brains are hardwired to make us illogical investors, Zweig believes, “The single greatest challenge you face as an investor is handling the truth about yourself.” The truth is that much of what you think you know about investing is wrong, but changing your perceptions will be hard. As Plato pointed out in the Allegory of the Cave, when the captive is released, “Will he not fancy that the shadows which he formerly saw are truer than the objects which are now shown to him?”
Conversely, Zweig says, “The intelligent investor is a realist…who [understands] financial risk lies not only where most of us look for it—in the economy or in our investments—but also within ourselves.” That’s why, like Morpheus in the Matrix, “I'm trying to free your mind…but I can only show you the door.” You have to “walk through it” or, like Cypher, you can decide that “ignorance is bliss.” It’s your choice. You can be captivated by the shadows or you can call my 800 number and choose to face reality.
It was just the king and I, a golf fan’s fantasy. As every golfer knows, the king is Arnold Palmer. As fate would have it, Arnie and I arrived at the Silverado Golf Resort in Napa, CA, at the same time and parked in adjoining spaces. Not wanting to impose, I kept to myself. But to my amazement, he came over and started up a conversation. I was star struck. As a kid, all my friends wanted to be Mickey Mantle, but I wanted to be Arnold Palmer. My encounter with the king only served to reinforce those feelings.
Today, the world of institutional investing is star struck with its own king and everyone wants to be like him, too. The king in question is David Swensen, the Chief Investment Officer for the Yale endowment. The investment style Swensen pioneered has become known as the Yale (or Endowment) Model and is heavily weighted toward hedge funds and other illiquid alternative investments. Because of his long-term success, a significant number of endowments, foundations, and pensions have attempted to copy his investment practices.
But Swensen says they may “…think they are emulating Yale, but they are not… because most endowments use fund of funds and consultants, rather than making their own well-informed decisions.” He explains, “If you are going to invest in alternatives, you should be all in and do it the way Yale does it — with 20 to 25 investment professionals who devote their careers to looking for investment opportunities… If you’re not going to put together [such] a team… your best alternative is passive investing… in [a portfolio of] index funds with low fees [otherwise], you’re going to fail.”
You’re going to fail, cautions Simon Lack the author of The Hedge Fund Mirage, because “…a huge imbalance exists between the [hedge fund] industry and its clients.” Using a golfing analogy, he says it’s okay to “…play a round of golf with the club pro for money, but you’d better use your handicap to get fair odds.” For hedge fund investors, the odds are unfair because they don’t have the clout to “…demand better terms, transparency, liquidity, fees, and information.” Some investors (and their consultants) think the playing field can be leveled using funds of hedge funds, but that’s not so, says Swensen. In a Wall Street Journal article, he blasts such funds as “…a cancer on the institutional-investor world. They facilitate the flow of ignorant capital… [and they layer] more fees on top of existing fees…”
The empirical results seem to overwhelmingly support the assertions of Lack and Swensen, but this reality hasn’t stemmed the tide of ignorance. While this may seem like an arrogant statement, it is actually much more grounded in humility. From Warren Buffett to leading experts on neurological science, a consensus is developing that the key to investment success is not what you know but knowing what you don’t know. In other words, investment ignorance comes from an overconfidence in one’s ability, whereas investment intelligence requires an awareness of one’s limitations.
I know that I will never be an Arnold Palmer and you need to know that you will never find a David Swensen to manage your money. You just don’t have the resources or clout to succeed in the world of alternative investments. Heck, with the increased competition for investment professionals and for good opportunities even David Swensen will have a hard time being David Swensen. That means alternatives probably aren’t a good alternative and indexing is still the King, and I (and you) need to humbly accept it.