Follow that Blind Man

By David Dasari, CFA, CAIA, FRM, CFP

March 2020

Follow that Blind ManWhat can a blind poet, from 2,700 years ago, teach us about investing? Plenty, it turns out. The poet Homer tells us the beautiful witch-goddess, Circe, warned Odysseus about the dangers on his voyage back to Ithaca. Upon her advice, Odysseus plugged his crew’s ears with beeswax and tied himself to the mast of his ship. Circe said he would sail by an island of lovely Sirens. Countless sailors previously had sailed by it. However, none survived. They changed their course towards the island after hearing the Sirens’ beautiful songs. As a result, they wrecked their ships and killed themselves on the island’s rocky shores. In contrast, Odysseus could neither change the course himself nor order his crew to their death.

Similarly, an investor will hear many alluring songs on their investing journey. Pundits and their media enablers have an entire repertoire. According to Stefan Theil1, the media makes several mistakes in covering the economy and markets. They inflate bubbles by jumping on bandwagons. They focus on personalities and dogfights. They elevate big and well-known companies over all others. They obsess over short-term market movements and quarterly numbers. Finally, they engage in gloom and doom mongering during crises. In such charged settings, the pundits’ songs become irresistible. Undisciplined investors who listen to them will destroy their portfolios on the rocky shores of the markets.

In contrast, disciplined investors focus on a process for making investment decisions. It is true the value of any process is its overall success. However, too many investors focus on immediate results of a particular decision. They tend to neglect process because it takes time and mental energy. Both euphoria from a success and disappointment of a failure conspire against thinking critically about process. They will remember wins and forget losses. Consequently, process rarely gets their attention.

A disciplined investment process has analytical, psychological and operational parts. Analytics include macroeconomic outlook, financial statement analyses, capital market assumptions, asset allocation and due diligence. An informed global economic outlook—over both short and long-terms—sets the table. Then, investors can evaluate investments in light of current relevant economic indicators. Historically, what are the drivers of returns of different investments? How do current economic indicators affect those drivers? What should be reasonable expected returns? A host of other questions remains. Without a deep, historical knowledge of links between economic indicators and investments, investor decisions become untethered. Thus, the pundits’ songs can easily lure investors to change course.

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Another analytical part is examining company financial statements. Unearthing the story buried in the numbers, comparing it to management’s story—especially in the current economic context—is time consuming and intellectually taxing. Looking at different earnings estimates, listening to management calls, reading reports, evaluating competitors, examining trends are all as unglamorous as necessary. Weaving disparate strands into a coherent investable thesis is not easy. Otherwise, slick stories from investor relations departments selling “blue skies” could easily lure away unsuspecting investors.

Investor psychology is a critical part to an investment process. Self-understanding and anticipating likely response under stress is crucial. At the end of February 2009, S&P 500 index had lost 43.6% and bonds gained 2.99% over the prior year. An investor with a 50/50 allocation in stocks and bonds would have lost over 20% of their portfolio—the very definition of stress. What would they do? In a fight-or-flight response, they would likely sell stocks (after the loss) and sit in bonds or cash. In fact, many did. Not knowing what the future held, such a response was understandable. On the other hand, a disciplined investment process would have rebalanced the portfolio and remained patient with it. That patience was immediately tested. The market continued to go down the next nine days, bottoming out on March 9th. The Sirens’ song would become irresistible.

Over the next year, however, the S&P 500 gained 55.3% and the bond market made 4.6%. The rebalanced portfolio would have gained 3.5% by February 2010 over two gut wrenching years. The undisciplined portfolio, on the other hand, would have lost 16.6% permanently. Subsequent market performance would only widen that difference.

Even without acute stress, investors generally think risk is a bad thing. We think risk as neither good nor bad. Instead, it is a neutral description. As long as investors are paid for it, risk is not a bad thing. It is only bad if investors are unpaid for it. To be sure, many investors would readily agree with that statement as logical when considered in a detached way. Yet, they tend to react in incorrect and emotional ways when actually making decisions. For example, in 2019, the S&P 500 index gained 31%, much higher than a 40-year historical average of 9.4%. If a portfolio had twice its risk, even a 31% return may not be enough compensation. Yet, most investors would be celebrating. By contrast, in 2018, the same S&P 500 index lost 4.5%. If a portfolio had the same risk as S&P 500, then a similar loss—while not fun—is reasonable. In fact, this “loss” is the risk (hopefully only for the short term). If an investor sat out of the market in 2019 because of 2018 loss, they would have lost twice: locking in 2018 loss and missing 2019 gain. Understanding their psychological responses ahead and binding themselves to an investment process will keep investors from harming themselves…like Odysseus.

1 The Media and Markets: How Systematic Misreporting Inflates Bubbles, Deepens Downturns and Distorts Economic Reality, Harvard Kennedy School, Shorenstein Center on Media, Politics and Public Policy. Discus-sion Paper Series, #D-86, June 2014.

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Another part of a rigorous investment process is operational. Whether investing directly or hiring professional money managers, investors sticking to an investment process as a routine is critical. Although not always assured, institutions have less of a challenge in this area than individual investors. Here, operational overlaps with psychology. Investors tend to embrace investments during good times and avoid them during volatile times. Regardless of market direction, evaluating relevant economic news, tracking company earnings, deciphering ambiguous statements of central banks, rebalancing portfolios are all part of routine execution of an investment strategy.

Once an investment process is set, investors have to stick to it—with patience. Famed investor Warren Buffet reportedly said, “The stock market is a device of transferring wealth from the impatient to the patient.” An investment process enforces patience. It minimizes the bad influences of pundit Siren songs. With a process, investors take proactive steps to reduce psychology driven harmful reactions to market uncertainty. Homer tells us Odysseus does return to Ithaca after a series of (mis)adventures. However, he would not have made it home had he destroyed himself reacting to the Sirens’ song. Knowing that, Odysseus tied himself to the ship’s mast. Investors should similarly tie themselves to an investment process for their journey to end like his journey.

David Dasari, CFA, CAIA, FRM, CFP is a senior portfolio manager at Hancock Whitney Bank. He has been in the investment management industry for 20 years. Prior to Hancock Whitney, he held various positions at AssetMark, BNY Mellon Wealth Management, Wells Fargo and Regions Bank. He has been involved in all aspects of investment management from Capital Markets Assumptions, Asset Allocation, Due Diligence of third-party managers, Separately Managed Accounts Portfolio Constructions and Portfolio Management for Institutional and High Net Worth clients.

David holds a Bachelor’s Degree in Biology from Macalester College. He also holds a Master of Science Management (MBA) from Purdue University in addition to a Juris Doctorate from Hamline University School of Law. He holds the Chartered Financial Analyst designation, the Chartered Alternative Investment Analyst designation, the Financial Risk Manager designation and is a Certified Financial Planner.

About The Author 4

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