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Messy Realities of Life and Investing

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The late Stephen Jay Gould was an unusually keen observer of the world. He enhanced his work as an evolutionary biologist with an enormous breadth of knowledge that allowed him to make connections between seemingly incongruous things. Using baseball statistics, the action of worms or the gradually declining size of Hershey bars to explain important scientific observations, he revealed aspects of reality that would not have been accessible or even interesting without his creative reframing.

Gould was particularly focused on the disparity between the world we perceive and the world that actually shows up. He wrote that we carry “historical baggage” of a tradition that incents us to create “sharp essences and definite boundaries,” even though reality is more ambiguous and messy.

In 1982 Gould was diagnosed with abdominal mesothelioma, a particularly nasty and incurable cancer with a median life expectancy of just eight months. He opined that someone on the receiving end of that information would conclude that he had about eight months to live.

Yet Gould knew that median meant that half the patients would not survive more than eight months, and half would survive longer than eight months, perhaps a lot longer. As it turned out, Gould lived another 20 years, never succumbing to mesothelioma.

Gould wrote about his experience to illustrate that our reliance on statistical measurement — as powerful and useful as it is — is not the real world. “Variation is the hard reality, not a set of imperfect measures for a central tendency.” Gould was fierce in making a firm distinction between the truth of the world and the elegant abstractions we create to understand and exploit it.

When biologist Richard Dawkins and philosopher Daniel Dennett attempted to shoehorn all of evolutionary change within Darwin’s framework of natural selection (something that Darwin himself would not do), Gould went after them in a famous intellectual smackdown. He argued that, like every other insight ever made, natural selection could not and cannot account for everything observed in the real world.

Financial Schooling

Investing entered the modern era when universities started to turn large portions of their intellectual and financial resources towards economics, business, investing and finance. The result is that today we have a greater understanding of almost every aspect of the investment process and a growing toolkit of sophisticated and useful investment products.

The big lesson that came out of academia — at least one that’s on many people’s minds today — is that it is hard, really hard, and maybe impossible, to construct a diversified portfolio that consistently outperforms the market.

The insight that a portfolio built to mimic an index would outperform most professional investors took a while to be accepted broadly. But now that it has, the question being asked by more and more serious investors is, “Should I waste my time trying to find an active manager, or should I just index?” Given recent trends, the answer for many is the latter.

The historical rule on Wall Street is that every successful investment strategy that has ever been created gets too popular at some point. There has never been an exception to this rule — so far.

Perhaps the capacity for indexing is so big and/or the ego of a certain percentage of investors is so large, that there will always be enough investors who want to make their own choices (maintaining the balance that gives indexing its advantage). Perhaps not, and the rule will ultimately kick in at some point. For now, indexing is king of the hill and its kingdom is expanding.

ETFs are approaching $3 trillion in assets and represent nearly 30% of all the dollar volume of all exchanges. There doesn’t appear to be much if any strategy that you can’t execute using ETFs, whether your time frame is 30 years or 30 milliseconds.

The popularity of ETFs has cemented a trend that was already well established and supported by considerable research: the use of asset classes as a primary mechanism for diversification. ETFs made asset class diversification as simple as Legos. Seemingly there is no corner of the earth, no commodity, no currency, no industry, no subgroup that can’t be represented by an ETF and plugged into (or pulled out of) a portfolio with the push of a button.

ETFs eliminate three structural weaknesses of mutual funds: the uncertainty of capital gains, the uncertainty of performance and the burden of costs. They are tax efficient, hew to whatever index they are tied to, and cost next to nothing. If there is a downside, the benefits appear to greatly outweigh it.

Yet every choice has a cost, and rarely is that cost insignificant. The risks most commonly cited seem to be rehashes of old complaints: the extra risks of indexes during late-stage bull markets, or the mechanical risks of ETFs during periods of severe market volatility. These are legitimate observations. But the real risks of ETFs and/or indexing are not functions of the investment vehicles themselves. Rather, our growing reliance and success with these simple but incredibly valuable investment tools has changed our perception of investment reality.

For investors today, the hidden essence of investing is the abstraction known as the market average. The real-world businesses are inconsequential except for the fact that when aggregated they create this important essence, which can now be easily exploited by index-shaped funds and ETFs. This is the perceptual trap Gould warned us about. And yet how can we argue with decades of success? And isn’t it a bit of a stretch to take an insight in biology and argue that it is applicable to investing?

Imperfect Tools

Uncertainty is a constant reality — in investing and in life. Physician and author Atul Gawande insightfully writes, “Medicine’s ground state is uncertainty. And wisdom — for both patients and doctors — is defined by how one copes with it.” In his new book “Nonsense,” Jamie Holmes illustrates Gawande’s insight by referencing a 2005 study that used 46 actors to visit various doctors posing as patients. Half of the actors were given scripts describing classic symptoms of a single medical condition; the other half had scripts describing the same condition but in a more confusing manner.

In all the cases where the symptoms were vague, doctors ordered invasive testing. In only three cases did the doctors press for additional information from the “patients” to clarify the symptoms. Holmes writes, “Ordering a test provided an escape from thinking about ambiguity.” He concludes it was much easier for the doctors to rely on the test to remove uncertainty than it was to rethink their own assumptions and ask, “What else could this be?”

Gould’s insight over something as mundane as statistical measurements was always much more than a problem in biology. The lesson he was trying to teach us (one that applies to biology, to medicine and to investing) is that we can’t ever forget that our best tools, our best insights, from our best and most famous thinkers are all imperfect in some way. And while we can and should use all the tools at our disposal, we always need to have a plan B: to keep one eye on the real world. That small but meaningful adjustment in how we perceive investment reality is all we need to stay out of trouble.