“We have no control over outcomes, but we can control the process. Of course, outcomes matter, but by focusing our attention on process we maximize our chances of good outcomes.” – Michael Mauboussin
Barry Ritholtz wrote a great column for the Washington Post recently on an important topic that investors must understand to be successful over the long haul. Here is Barry with the takeaway from that article:
Process-oriented investing is a long-term approach to putting capital at risk by owning a broad variety of asset classes, making periodic contributions and regularly rebalancing. You can just hear the marketing guys screaming, “Boring! How can we ever sex up that sort of approach?!”
Focusing on your investment process, and not the outcome, should be your goal. Here is the payoff: Over the long term, a good process delivers highly desirable results, and generates better and more reliable outcomes. There is nothing boring about that.
It’s not easy to have this mindset, but it’s really the high probability way to think about complex and adaptable markets that are impossible to predict.
You can get lucky once or twice but your luck will run out eventually if you don’t have a disciplined process to follow when things don’t go as planned.
Yet there are times when our ingrained cognitive biases can creep in and ruin the processes we have in place.
Case in point is mutual fund manager John Hussman who has seen better days with the lagging performance of his flagship Hussman Strategic Growth Fund (HSGFX).
(Side note: This is nothing against Hussman. I have been reading his weekly outlook piece for years. He is an extremely intelligent guy. It takes a lot of guts to put your strategic decisions out there for all to see in real time. I am simply using his strategy for teaching purposes.)
He explained his strategy in a recent weekly commentary:
Our own discipline pursues stronger returns and smaller drawdowns than a buy-and-hold approach, but with an emphatic focus on the complete market cycle.
During the 2000-02 bear market the Hussman’s fund posted phenomenal performance by sidestepping most of the carnage and posting gains. Hussman does this by periodically hedging his stock market exposure through put options that should go up in price when the market declines.
The fund also posted impressive relative results during the 2008 crash by losing only 9% in while the S&P 500 was down 37%.
Predictably, billions of dollars poured in from investors seeking the Holy Grail of investing — upside participation with limited downside risk.
Unfortunately for Hussman and his investors, it’s been downhill ever since as he has continued to hedge market exposure throughout the entire bull market recovery.
The five year annual return (through 2/26 per Morningstar) on the fund is -3.5% against the S&P’s 22.2% a year. Ten year returns are -1.2% annually while the S&P has delivered around 7.1% a year.
That’s over 105% in relative underperformance over 10 years.
Hussman uses an exhaustive data set to make his hedging decisions based on a long list of historical factors. And while 2009 threw out extraordinary values in the stock market, Hussman decided to override his quantitative approach to add a more robust data set going back to the Great Depression.
He explained this thought process in another weekly update:
Unfortunately, it was unclear at the time whether the state-of-the-world was better characterized by post-war data (in which our existing methods had performed well) or in Depression-era data in which our existing methods allowed greater periodic losses than I viewed as tolerable.
A small part of me respects the guy for sticking with his hedging process all the way up.
But I also think he changed his system at the bottom of the market to coincide with his views for what should happen and has now stubbornly stuck with those same views to the tune of terrible performance.
The Depression-era data was always there, so why add it to the process only after a huge panic in the markets? It’s never clear which data set we should be using to compare to the current situation because every cycle is unique. There are no perfect solutions.
The big lesson here is not that Hussman made an error in judgment that cost his fund performance numbers.
It’s that our cognitive biases are often the worst when we need to ignore them the most. Human nature tends to become magnified at the extremes.
We get greedy after participating in large gains or missing out on large losses and scared after seeing a big drop in the market. Making process changes after extreme gains or losses is an easy way to allow the recency effect to creep in.
You need to ask yourself a few questions when setting up or altering your process and rules:
(1) Would I have been able to follow these rules during past market cycles?
(2) Does my process take into account the fact that I will be wrong at times?
(3) Does this process systematically automate good behavior that’s not based on short-term outcomes?
(4) Am I changing my process to validate my current forecasts?
I don’t know the exact logic behind Hussman’s thinking, but I do know that it was not easy for many to buy at depths of the market in early 2009 even though the stocks were trading at their lowest prices in years.
Market timing is probably the strategy that holds the most appeal to investors because it looks so easy in hindsight. It’s also the most difficult to put into practice in actual market conditions.
Timing indicators can look great in computer backtests but fail to work in real time.
Forcing yourself to buy back in once you’ve taken all of your market exposure off of the table is so hard on your psyche. There will always be a reason to wait just a little bit longer to try to nail the bottom.
Trying to time the market means your decisions rely almost exclusively on outcomes, which completely contradicts the entire process > outcomes theory.
As exciting as it can be for investors to try to go all in or all out, you are much better off with a diversified approach that doesn’t rely on your ability predict short-term market moves.
Hussman even admits that he believes a diversified long-term approach works if the investor has the discipline to adhere to such a strategy:
I have no argument at all with investors whose strategy adheres to a disciplined buy-and-hold, diversified across asset classes, over the full course of the market cycle. In contrast, I have great concern about investors who discover buy-and-hold at the top, and adhere to it only long enough to abandon it at the bottom.
It can be uncomfortable to stick with your process and rebalance to sell higher in one asset class and buy lower in another in the same way that it’s difficult to time the market.
This is why they say investing is simple but not easy.
I’m all for updating your thought process when the facts change. But most of the time you will be better off sticking to your plan or doing nothing at all.