The greatest deception men suffer is from their own opinions.
– Leonardo da Vinci
What better idea than to bring up the Seven Deadly Sins during the holidays? In our constant need to Google everything, absorbing as much data as possible, we came across this graphic created by a Jennifer Hagey. We do not know Jennifer, but she has come to entertain us as a result of this creation. We note how she skillfully cross references each of the Seven Deadly Sins to create a resulting emotion, action, or character trait. We invite you to analyze the graphic at your leisure.
When it comes to investing, it is easy to see its association with some of the Sins, particularly Envy, Gluttony, and Lust. However, our focus in this newsletter is on Pride/Hubris. According to Wikipedia, the seven deadly sins were historically segmented into three categories;
- lustful appetite (Lust, Envy, Gluttony, Greed)
- irascibility (Wrath)
- intellect (Pride, Sloth)
Our first two newsletters focused on the lustful appetite of investors and investment professionals. Lust, Greed and Gluttony driving irrational behavior and short sightedness. Envy driving a reluctance to move from active management. This newsletter is our attempt to address the third category, intellect. (We will avoid the irascibility as it is the holidays).
It’s easy to confuse Pride with confidence. To make long term investment decisions, one needs to do enough leg work to get to a point to have confidence in placing money into an asset. The issue is making sure that the confidence doesn’t lead to hubris, where one forgets that they are working with imperfect information and place too much emphasis on their reasoning, or biases, to “double down”. All investors have suffered from this (present company included). Emotion takes over and drives one to hold on to beliefs that may actually prove incorrect and warrant further evaluation.
This has also shown itself in the many stories we have heard of employees of large companies, investing heavily in their own company’s stock (Enron and Lehman act as examples). All is fine and good until the rug is pulled from underneath them and they find they have no job and much less savings.
This is where asset allocation comes into play. The whole point to allocating assets is diversification. Broadening ones holdings to compensate for the probability that one may be wrong in their assumptions. Though this is an easy idea to comprehend, we see individuals having issues accepting it in practice. The idea to protect the overall asset level is pushed to the side when investors see individual securities drop in value. However, that is the exact point of diversification; when one item doesn’t work out, another does.
Some look to diversification as a way to reach for higher return, to take “a little extra” risk as greed sets in. However, we like to stick to a more traditional approach. We look to diversify risk rather than return. Diversify opinion. Diversify imperfect information and the conclusions that result from it.
This does not mean that we want to avoid taking investment stances. If a client has a large exposure to technology stocks and shown through time to demonstrate skill in that area, why would we want to counter that skill? We wouldn’t. The same holds true for those that have amassed wealth through real estate or other forms of illiquid private investments. Our intent, through the use of our allocation process is to attempt to confine the risks taken to those areas where we, along with the client, feel high confidence in opinion. It also requires us to work to identify any unintentional risks and to accept them or work to protect the funds from them.
This approach drives our need to build personal balance sheets for our clients (more on balance sheets at a future date). We look to, with as little emotion as possible, take an inventory of our clients financial position including future savings, illiquid assets, and future liabilities (new homes, ideas on starting a new company, education, and of course retirement). Once we systematically layout the financial health of our clients, we can have a better discussion and layout the risks inherent in their positioning. Only then can we feel comfortable proposing an investment strategy.