When the Sirens Sing, How to Avoid Giving in…

When I wrote What Stories Aren’t Being Told?, I did not expect a big response.  But I got 53 responses, more than double the responses of my next-most-responded-to article.  Many bloggers linked to it, and responses continued on for almost four days.

But after Dr. Jeff’s comment, I decided to write a second piece, What is Going Right? Now, part of that also sprang from an e-mail that Rolfe Winkler sent asking what is going right, but I did it as a kind of test to see if asking for optimism would yield a response.

Alas, but only eleven responses came and a few were negative in nature.  I only received one link.  What should that tell me?  The most obvious answer to me is that people by nature are more inclined to complain than to praise.  Though I could resort to the Bible for proof here, instead I will cite two researchers I first bumped into 28 years ago (before they were cool), Daniel Kahneman and Amos Tversky.  They found that losses delivered roughly three times the pain, when compared to pleasures of an equal-sized gain.  (Side note: this has many applications, and in our day and age, most of them are politically incorrect.  As investors, though, we know it — avoiding losses is a better motivator than seeking gains.  At least, those that avoid losses stay in the game.)

Look, I see it in myself.  I tend toward the negative in this era, because I think it is under-told.  Would it surprise you if you knew that I was one of the more bullish guys in my last three firms (1998-2007)?  But even if under-told, there is something that always makes the bear case sound smarter.  Skeptics almost always seem smarter than optimists.  But, the optimists usually win, except when there is war on your home soil, famine, plague, or extreme socialism.

Where does that leave me?  It leaves me with rules.  I have trading rules.  I have asset allocation rules.  I can lean against something that I think is wrong, but I can’t put all of my weight on it.  I listen to the Sirens, but I tie myself to the mast.  Discipline trumps conviction.

So, to close, I offer an old CC post to illustrate:

David Merkel
I Listen to the Sirens, but Like Ulysses, my Hands Are Tied to the Mast
12/27/2006 2:31 PM EST

When I had dinner with Cody two weeks ago, he asked me (something to the effect of): “If we have so many problems, why are you so net long?”

I told him about a hedge fund friend of mine who let his bearishness drive his macro bets over the last four years. The only thing that has bailed him out is that his analysts are really good stock-pickers… their fund has been in the plus column despite being an average of 25% net short, but not positive by much.

I tie my hands when it comes to asset allocation policy. After determining what I think the neutral policy should be for someone that I advise, I allow myself to tweak it by no more than 10% to reflect my overall levels of bullishness or bearishness. This keeps my emotions from taking over, and protects me and those that I manage for.

Besides, absent a major war on home soil, or a Communist takeover, markets have a tendency to eventually bounce back. (even if the bounce takes 25-odd years, as in the Great Depression). The question is whether one’s asset allocation is conservative enough to be around for the “bounce back.” So, it generally pays to play along with the optimists in the long run. Or, as Cramer has said, the bear case always sounds more intelligent. That can trap bright people who let legitimate fears of something that may happen a ways out get treated as a clear and present danger.

At present I am slightly bullish on the US markets and think that 2007 will produce moderate gains, 5-10%. There are things to worry about, but don’t let it blind you to opportunities that will emerge if disaster doesn’t happen. Instead, diversify. Stocks and high quality bonds. (Maybe even some municipal bonds.) Domestic stocks and foreign. There are ways to reduce risk that don’t cost that much in terms of performance. Use them, and don’t worry about the big, bad event. That event will happen, but it will usually be further out, and less bad than expected.

Position: none

Cramer wrote a piece two days later where he said:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

I asked him via e-mail whether he had read my piece, and he said he had not. Quite a coincidence. Before I asked him, though, I wrote this response:

David Merkel
More Things Can Go Wrong Than Will Go Wrong
12/29/2006 1:21 PM EST

I reflected on what I recently wrote when I read this bit of Jim’s piece this morning:

I am always reminded when I see the myriad negative articles about macro issues that you must be like Ulysses — you have to tie yourself to the mast and plug your ears — if you are really going to make money. The parade of horrible worries is so loud and so seductive that the toughest thing to do is to stay the course. And the toughest thing to do is almost always the most lucrative.

At my last firm, we conflated two maxims into: “Great minds think alike, but fools seldom differ.” Jim and I disagree on housing. In this case, though I still have many reasons to be bearish on housing, I don’t let it affect my investing to any great degree. For my broad market portfolio, I still own Cemex, Lafarge, and St. Joe. I even own a mortgage REIT, Deerfield Triarc. I’m not bullish on the consumer, but I still own Sonic Automotive and Lithia Motors.

The point is, it’s too easy to say “I’m too worried about the macro environment,” or, “I can’t find anything cheap enough to buy.” Will there be down years? Yes. Might the first decade of the 2000s have a negative total return? Possible, but unlikely. Like the farmer in Ecclesiastes 11, we have to cast the seed into the muddy spring soil, and not worry about the bad weather that might come. Diversification reduces risk, but not taking risk is possibly the biggest risk of all. The advantage belongs to those who take prudent risks.

Now, after all this, if you still want to worry, the biggest risks among the somewhat likely risks out there a breakdown in global trade and an error in Fed policy. I watch these things, but I’m not losing sleep over them.

PS — regarding Ulysses, he put wax in the ears of his sailors, but he tied himself up so that he could listen to the Sirens, but not do anything… it’s a tough discipline to maintain, but it helps me do better in the markets.

Position: Long CX LR JOE DFR SAH LAD

A very different era, that, but I am now bearish, and Cramer is still bullish.  I try not to change my positions often, and even then, I limit my behavior.  Discipline triumphs over conviction.


  • Josh Stern says:

    David, I know what you mean. But I’m curious in this context about the role of absolute valuation strategies in what you recommend. Is it a) no role (relative valuation rules!), b) plays a role, but only within the 10% stretch band, c) matters, but one can always find a portfolio’s worth of low absolute valuation stuff (if one doesn’t worry about the implied adverse selection bias that when everything else is pricey, the cheap stuff is much more likely to be cheap for a good reason), or d) something else?

  • I left you a positive comment on your “What is Going Right” thread, though it helped that two of the three stocks I mentioned in your Tickers for the Latest Portfolio Reshaping” thread have been on a tear since, with one (which now comprises about 30% of my stock portfolio) more than tripling.

  • Aref says:

    People often forget that being Short means accepting numerous interlinked elements, most of which that are not conducive to making money.

    1. You can lose more on your Shorts than you can make.
    2. Your problems get bigger, the more the price moves against you (whereas they get smaller when you’re Long).
    3. Because of this, the trend is not your friend! You can’t just run your book unchanged as things work; as you become less Short as the market goes down (resulting in less exposure as you’re proved right, unlike being Long).
    4. I think it’s fair to assume that people expect, generally, to earn > risk free from holdings stocks. As such, to profit from a net Short position, you already start in the hole absolutely (to the tune of the risk free+ any premium that may/may not exist).
    5. A ton of psychological factors (people are really good at hoping thinks will be better soon, and this can last far longer/be more irrational than the reverse).

  • I recently shorted BAGL, Aref, one of David Einhorn’s holdings. You can read my rationale for that here, if you want: New Short Position: BAGL.

  • This is probably the best article I’ve read in months. Skepticism is more intellectually gratifying, but it is less lucrative. I guess if you are to wait for the all clear, the opportunity will already have passed.

  • Aaron says:

    This is a good post. I like the nod to Kahneman/Tversky and avoiding losses.