Are you seeing the whole picture when it comes to investing?

by Dana on February 19, 2009

See the Whole Picture

Thank you to Penny Daily for including us in its Carnival of Investing Strategies #5.

What makes a successful long-term investor? Is it an exceptional understanding of the market? Is it a Blackberry full of Wall Street contacts that tip you on every insiders’ move? Is it a PhD in quantum-physics or mathematics?

No. Because if that was the case, then most investment funds with their well-paid, well-educated, and well-connected managers would not be walking around with their portfolios 50% lighter.

So what is it about the market that suckers in so many people? How is it that some investors are ruthlessly spit out, and others remain relatively unscathed in the long-run?

Knowledge.

But not just business knowledge. What has been taught in business school and other rudimentary business classes do little to improve one’s chances when it comes to investing. Why? Because the knowledge presented in those accounting and finance classes only give you a myopic look at the whole picture.

For example, say you are an accounting maven but know nothing of what’s going on in the mortgage market in 2006. You look at the balance sheet of banks, match up the debit and credit sides, check off the triple-A rated loans, and marvel at how the bank has managed to grow so quickly in the last few years. But any economists looking at the picture would be alarmed at the rate of growth, probe deeper into the loan ratings, gasp at the poor judgment exercised on part of the bankers, and issue a warning. Someone who is schooled in politics would take a hard look at the political contributions made to head of committees that signed off on the predatory lending policies and yell foul! And any Tom, Dick, and Harry, who’s been canvassed by sketchy pseudo-lending institutions would tell you that if it walks like a scam, and quacks like a scam, it is a scam.

So there, it only takes someone who is in touch with reality to smell the foul. If confined to an academic or industry-conformed bubble, it will take someone who is willing to see the whole picture and dare to ask questions to reach the same, sane conclusion.

Here’s another more direct investing example, taken real-time off the happenings of the current market bloodbath.

When the market started going off the deep end beginning of the year, many respectable economists and analysts called for a sharp decline in the US dollar.

Not that the dollar didn’t deserve it. The stock market was abysmal, debts were piling up, inflation was fuelled by the astronomical rise in crude prices, and the gold bugs went nuts.

But the dollar didn’t fall, at least, not in 2008. Contrary to what many expected, the greenback went from strength to strength against the pound, the euro, the Aussie and Canadian dollars. How could they have been wrong? Their analysis made so much sense.

Myopia was to blame, again. Two things worth noting, both should drive you to pick up the paper and read the World section and brush on financial history.

First of all, many experts failed to survey the whole picture while predicting the greenback doom. Instead of examining the economic health of other currencies relative to the US, they either ignored or failed to consider the effect of a US belly flop. It turned out that part of the Eurozone had just as much of a real-estate fuelled credit bubble as the US. Many had even more dire loans made out to emerging markets that were unlikely to be recovered in the near future. Ouch!

Remember the fuzz raised when upscale retailers in the New York area accepted euros in fear that the dollar would become worthless, and everyone rushed out to open their euro accounts? Nowadays, the very survival of this currency is debated. The market is fast, furious, and seems to retain no medium to long-term memories. Who else but you can add all these episodes to your experience notebook and defend your money against market schizophrenia?

Secondly, nobody seemed to remember the experience of LTCM. I watched a PBS documentary on the failure of LTCM in first year statistics class, and later went on to read “When Genius Failed”. On a curious note, this book was on the curriculum for the CFA Level III exams back in the days.  Not sure what the case is now, but considering most buy-side investment advisory would require their analysts to hold such designation, did nobody remember the lessons from mass de-leveraging?

It turned out that in September and October, when panicking investors started withdrawing their capital en-masse form the market, many investment funds were forced to liquidate their holdings regardless of performance. This exodus of cash resulted in two things. One, an enormous demand for the US dollars rose as people liquidated out of their holding currency to settle accounts. Two, mass withdraw resulted in a capital exodus (i.e. forced liquidation) from the well-performing commodities group. This, combined with a reduction in demand for certain raw materials, contributed to the weaknesses in the currencies of commodity producing countries, namely, Russia, Canada, and Australia. The weakening of many previously perky economies, whether its due to a fundamentally weak economy and credit system, or the reduction in commodity revenues, further drove jittery investors to the relative “safety” of the dollar.

I didn’t see this coming, of course. But unfortunately, nor did many of the economists or analysts whose job it was to pay attention to these events and extrapolate these scenarios. A truly brilliant analyst, like a good historian, should be a good storyteller. They should be able to navigate through the muddy terrain that is the ecosystem of the market, and find a stable tree to build their theory from. From this tree, they should be able to split off the branches, testing assumptions and viability of their stories. They should anticipate thunderstorms, tornadoes, snow in July and the odd Indian summers. They should consider the vast ecosystem of where the tree is planted, consider the various interactions the tree would have with the other inhabitants in the woods.

Because staring at that one branch and self-congratulating on the infallibility of one possible scenario will in no way help you see the bigger picture. It’s only by recognizing the existence of the bigger picture, and acknowledging and anticipating the inter-connectedness of the wider business ecosystem, that any of the business education can be put into use.

picture source: boojamon