Negative Knowledge

In the book “The Art of Thinking Clearly” Rolf Dobelli starts the epilogue with the following: 

The pope asked Michelangelo: “Tell me the secret of your genius. How have you created the statue of David, the masterpiece of all masterpieces?” Michelangelo’s answer: “It’s simple. I removed everything that is not David.”

Let’s be honest. We don’t know for sure what makes us successful. We can’t pinpoint exactly what makes us happy But we know with certainty what destroys success or happiness. This realization, as simple as it is, is fundamental: Negative knowledge (what not to do) is much more potent than positive knowledge (what to do).

Thinking more clearly and acting more shrewdly means adopting Michelangelo’s method: Don’t focus on David. Instead, focus on everything that is not David and chisel it away. In our case: Eliminate all errors and better thinking will follow.

The Greeks, Romans, and medieval thinkers had a term for this approach: via negativa. Literally, the negative path, the path of renunciation, of exclusion, of reduction. Theologians were the first to tread the via negativa: We cannot say what God is; we can only say what God is not. Applied to the present day: We cannot say what brings us success. We can pin down only what blocks or obliterates success. Eliminate the downside, the thinking errors, and the upside will take care of itself. That is all we need to know.

This is extremely applicable to decision-making and investing. Rather than focusing on getting it right, focus on not getting it wrong. Charlie Munger says “It is remarkable how much long-term advantage people like  [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Focus on eliminating errors in reason, as there are several dozen cognitive biases that affect everyday thinking, and go from there. 

Why does this strategy work? For the most part, life is what is known as a “loser’s game.” In a winner’s game, the majority of the points are won; a good play made by the winner of the play. In a loser’s game, a majority of the points are lost; a bad play made by the loser of the play. Point being, we should focus on avoiding mistakes, not making great moves. 

The Transformation of Emerging Markets

Three different sources of information came out earlier this month all centered around rethinking one asset class in particular: emerging markets. 

The first was an article written by Mohamed El-Erian, formerly of PIMCO, entitled “Rethinking Emerging Markets.” His article started by identifying three elements that typically define an asset class - 

First, its components share similar characteristics: geographic location, for example, or much more importantly for investment purposes, economic and financial commonalities. These similarities allow the investments to be modeled relatively coherently for expected return, volatility and correlations with other asset classes. Yet these assets aren't so completely homogeneous that they can be replicated via a single instrument, which also opens the possibility of out-performance thanks to active management.

Second, the majority of the components of the asset class are sensitive to an external influence that is strong enough and sufficiently encompassing to have a similar impact across the board. This can take the form of a single variable, such as the price of oil for producers, or it can be linked to a policy, such as the effect of the European Central Bank's quantitative easing on sovereign bonds.

Third, the actions of investors impose a self-reinforcing consistency in the way individual elements of the asset class relate to one another. This could be the case, for example, when the bulk of investors use a predominantly top-down approach -- which takes into account the asset class as a whole rather than its individual components -- or when markets are overwhelmed by large tides of capital, be they inflows or outflows.

El-Erian went on to suggest that the first two characteristics were no longer true. That is, emerging markets have changed so greatly they no longer have enough commonalities and are no longer affected by external actions across the board. His conclusion was that one should rethink asset allocation decisions and benchmarking to accommodate for the change in emerging markets as an asset class.

The second article, written by Ben Carlson, reviewed and expanded upon El-Erian’s discussion. Carlson offered up his own criteria for an asset class and then used that framework to analyze emerging markets himself. Carlson writes “Most professional investors benchmark their foreign stock allocation to the MSCI EAFE and then break down their funds or stocks further by region or country. But from an overall asset class perspective, this is still the benchmark the majority of investors choose to follow. I don’t see this changing anytime soon.” He follows this up by saying “A broad, diversified approach is still probably the best option for the majority of investors that don’t have the skillset or expertise to be able to analyze the different emerging market countries.” 

In other words, while Carlson acknowledges some changes in emerging markets as an asset class, he doesn’t see any significant changes in the way the investment management industry operates anytime soon.

The final source of information discussing the changes in emerging markets was the April issue of The Bank Credit Analyst publication. Their analysis indicated that there are large differences between emerging market countries on a GDP per capita basis; however, those countries still tend to have correlations close to one, particularly when a bear market occurs.

Stepping back for a second, I think that multiple sources discussing emerging markets as an asset class is informative in itself. The global economy is changing and will continue to change. It would be a mistake to assume that the current circumstances will carry forward indefinitely. The BCA issue noted that emerging markets are now more than 50% of global GDP on a purchasing power parity basis, as illustrated in chart 1: 

Chart 1, Shares of GDP

The Charles Darwin quote “It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change” is one of my favorites, both personally and professionally. As a young financial planner, it is important to be open to new ways of thinking because the industry will change. Financial professionals cannot assume the current landscape will always remain as is. As discussed in this blog before, financial planning and investing consists of making assumptions. These assumptions will change, and asset class assumptions are one of them. As countries rise and fall, the general categories of developed and emerging markets will change too. For example, the United States was considered an emerging market not that long ago; however, this is nearly inconceivable now. Point being, a young financial planner will likely be a professional for another 40 years. Think back to 1975 - how has investing and the geopolitical landscape in general changed since then? (see chart 2 below) Keep in mind it will continue to change. How will the state of affairs look in 2055? I would venture emerging markets will be very different to say the least. 

Chart 2, Developed and Emerging Market GDPs, 1950-2050

Sources:

http://www.bloombergview.com/articles/2015-04-03/el-erian-rethinking-the-emerging-markets-asset-class
http://awealthofcommonsense.com/are-emerging-markets-still-an-asset-class/
BCA Research
https://blog.wealthfront.com/emerging-markets/BCA Research

Predicting Black Swans

It is always amusing to see articles and television spots predicting black swan events; they are by definition unpredictable. To try to see them coming is pointless. In the financial world, the big event on the horizon is the Federal Reserve raising interest rates, and there has been much debate about when (if?) this will occur. This is an important issue; however, I would guess what the Fed does will not be the big event of the decade. Rather, the most significant event will be something no one will see coming - a true black swan.
 
Morgan Housel has a great article entitled “You Would Have Never Believed It” where he writes examples of the unpredictability of the future. A few excerpts:

“You would have never believed it if, in 2004, someone told you a website run by a 19-year-old college dropout on which you look at pictures of your friends would be worth nearly a quarter-trillion dollars in less than a decade. (Nice job, Facebook.)”

“You would never have believed it if, in 1900, as your horse and buggy got stuck in the mud, someone pointed to the moon and said, ‘We'll be walking on that during our lifetime.’”

“You would have never believed it if, three years ago, someone told you that Uber, an app connecting you with a stranger in a Honda Civic, would be worth almost as much as General Motors.”

“You would have never believed it if, after the lessons of World War I, someone told you there'd be an even bigger war 25 years later.” 

Housel concludes the article with this:
“But all of that stuff happened. And they were some of the most important stories of the last 100 years. The next 100 years will be the same.”

Research has shown that we tend to overestimate changes in the short-term and underestimate changes in the long-term. To try to forecast or predict bubbles, black swan events, and major world events is useless. To change your investment strategy in response to these predictions is even more foolish. 

Josh Brown notes the following regarding this:
“[Mark] Hulbert had made the point that no one will see the thing coming that derails the economy or the market next time around. It certainly won’t be something that’s on the front page of the newspaper each day like Greece or interest rates. I would add in that we still cannot pinpoint the events that have marked previous market tops even in hindsight.”

While it is important to monitor the economy and geopolitical environment, trying to predict the unpredictable is a losing effort. Financial planning consists of making assumptions: assumptions about rates of return, assumptions about health, assumptions about legislation, assumptions about inflation, assumptions about family, etc. Chances are these assumptions will not be spot on. Despite this, all plans, financial and otherwise, rely on assumptions. This is why it is important to have an emergency fund, power of attorney, and insurance in case your assumptions aren’t as accurate as you would have hoped.

Robo-advisors and the Fed raising interest rates are two examples of developments with consequences still to be determined. Many are predicting they will have a large impact on the investment and financial planning landscape, which they probably will. That being said, as Justin Frankel wrote two weeks ago, “Don’t let the noise about Fed moves disrupt an otherwise well thought out investment process.” He continues: “The anticipation and subsequent parsing of Janet Yellen’s testimony and other assorted speeches from Fed officials last month was (rightly or wrongly) often cited as the cause for market moves, but in reality any Fed-related anxiety has likely been overplayed by the media.”

While both the Fed raising rates and the emergence of robo-advisors may or may not be disruptive, they are not black swan events. It is far more likely some unforeseen event has a greater impact on the investment and financial planning industry. Point being, quasi-black swans can be important but will likely not be as significant as the true black swan events that no one sees coming.