In Taleb’s book, Fooled By Randomness, there is an interesting take on analyzing history. He calls it summing across histories. His point is that regardless of the actual outcome, it’s the many possible outcomes that we should consider when determining after the fact if the right choice was made.
For example, let’s say a janitor buys a lottery ticket every day of his life and wins one of those times, thus making him rich. That outcome of him winning, even with buying a ticket every day, is highly unlikely to happen. If he repeated his life a million times, he would probably never win the lottery in all those other life paths.
On the flipside, let’s say a dentist drills teeth every day for a 30-year career and then retires with a large nest egg. If the dentist repeated his life a million times, it is highly likely that he would end with a large nest egg in the majority of life paths.
The point here is that when we analyze history, we shouldn’t let the actual outcome affect whether we consider a decision a good one or not. Rather we should consider all the paths equally and not give undue weight to a good result that wasn’t also highly likely to happen.
We aren’t too bad at acknowledging that there are possibilities in the future, but we are terrible at seeing the possibilities that existed in the past. In behavioral finance, this blind spot for the possible past paths is called the Hindsight Bias. A more common name for it is Monday morning quarterbacking.
Once we know the outcome we generally think that things could only have turned out the way that they did. For the lottery winner above, even though it is highly unlikely that he would win the lottery, and is a waste of $365 a year to play, if he wins, no one will tell him that he was stupid for playing. Instead, they will likely congratulate him and tell him he was smart for playing.
This is very similar to the way that mutual fund managers are treated. We see the returns they have generated in the past and assume that they must know something. They must have learned some skill or intuition that allows them to pick the right stocks at the right times. And we believe that this same skill will allow them to pick the right stocks at the right times in the future after we give them our money to invest. And we think this no matter how many times we hear the words “Past performance is no indicator of future results.”
Ignore the best-case
Summing over histories implies that we should pay more attention to the worst-case scenario (since we usually ignore it), and for the most part ignore the best-case scenario (since we usually over emphasize it, meaning we get greedy). It also implies that we should be looking to reduce the range of the possible paths to a range that includes only possible results that we are comfortable with.
So let’s look at two examples of what we might expect as possible histories from our investing. Since we have difficulty seeing the possible past histories, I’ll use two examples of real stocks, one that has gone well up to now, and one that has not. By using two examples with different outcomes, maybe we can make it clearer to our brains what we are missing when we only look at the actual outcome and not the possible outcomes.
Johnson & Johnson
One possible good path a stock could take in the coming 20 years is the path that Johnson & Johnson has taken over the last 20 years.
We want to believe that of course we knew 20 years ago that JNJ would still be around today and still be a strong brand with a high stock price. But at the time 20 years ago we couldn’t have known that. We may have believed we knew it, but there are many possible paths where JNJ could have taken a turn for the worse, and not ended up where it is today.
It might help if we briefly list off a few things that could have happened to derail the stock’s upward climb, but did not.
One possibility is that their products could have been the targets of multiple terrorist attacks. A few randomly poisoned bottles of baby oil could lead to massive recalls and a drop in sales as people prudently switched to a safer brand.
Another possibility is that their management team could have been embezzling funds like Enron or Tyco.
Another possibility is that some other company could have merely out competed JNJ and stolen market share from them.
So the path that JNJ has taken so far is really only one of many, and is actually an example of one of the better paths the company could have taken. Many other unsavory ones were just as likely 20 years ago (and even today).
The chart below shows the value of one dollar invested in JNJ over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed , while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if JNJ goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.
With the buy and hold strategy we could have made 22 times our money over the last 20 years. So we start out with $100k, and we end up with $2 million. Seems pretty simple. Nice and easy. We know how great of a company JNJ is so we just drop the money down and wait 20 years. (But of course as pointed out above, we don’t know that JNJ is going to be a great company, we only think we do.)
With the no lose strategy we could have only made 5 times our money over the last 20 years. So we start out with $100k, and we end up with $500k. That’s not bad. It’s a return of about 8.2% a year over the 20 years. But it’s a far cry from the $2 million for buy and hold.
If we stopped our considerations here our biases would convince us that buy and hold is the better strategy. Buy and hold had a higher return over the long-term, but we’d be ignoring the possibility of a loss on the downside.
Now consider a possible bad path that a stock could take like the path that Fannie Mae has taken over the last 20 years.
There are probably a great many pundits saying that they knew that FNM would collapse one day, and another great many that said FNM could never fail because of it’s implicit government guarantee. But again, 20 years ago, we had no way of knowing what path FNM would take. The changes in interest rates, the wars or lack of wars, the changes in different countries’ governments and economies are all things that were unknowable. We couldn’t know these things and so we couldn’t accurately predict how they would affect FNM in the future (whether or not we now believe we could have).
The chart below shows the value of one dollar invested in FNM over the last 20 years. One line represents the buy and hold strategy, and the other line represents the no lose strategy. With the no lose strategy the losses are completely removed, while the gains are only dampened. In this case we’re assuming a 15% lag in the profits for the no lose strategy. So if FNM goes up 20% in a year, the no lose strategy only gains (20% – 15%) 5%.
With the buy and hold strategy we could have made about 20 times our money over the last 20 years, with a peak of as much as 45 times our money. However, the chart only shows FNM through January of 2008. If we pushed it forward to today, where the last FNM closing price is $0.74 per share, we would have a 26% loss from our original money. So over 20 years, if we started with a $100k investment, we would have at one point had $4.5 million, but eventually only $74k left of our original investment.
With the no lose strategy we could have made about 23 times our money over the last 20 years. So we start with $100k and end up with $2.3 million. That’s actually quite good, better even than the JNJ buy and hold above. That’s the equivalent of a return of about 16% per year.
The thing to realize here is that both JNJ and FNM, and all stocks, are highly affected by randomness, and are vulnerable to situations and circumstances that we can’t know about beforehand. Even something that looks really good today (like JNJ now, or FNM about 6 years ago), could eventually turn sour, and do so very quickly. And it is nearly impossible to tell when a stock is turning permanently sour, or just “correcting” before moving higher.
The idea then is to choose the strategy where the possible paths lead to a comfortable outcome the most often, even if that outcome is not the highest success conceivable. So we give up a shot at the best-case result, in exchange for avoiding the worst-case result, and getting a high likelihood of hitting a comfortable-case result.