This is the fourth in a series of posts about my investing philosophy – Realistic.  Investors should be realistic about their expectations and the nature of the markets. No one can predict the future. After hearing 10 years of “The easy money has already been made”, it’s clear that most can’t even predict the present. It sure didn’t feel easy at the time. While no one knows the returns or risks in advance, investors with a reality-based approach to investing can craft a long-lived investment process.

Realistic Market Expectations

Expect markets to go up over the long term. This is not optimism or a leap of faith. It’s realism. Humans will continue to innovate and seek to put their capital to work. Not every asset class will go up at the same time forever, but that’s what diversification is for – to eliminate the need to predict what asset classes will go up or down.

Markets are generally mean-reverting, but individual managers, investments, and funds don’t do that. Bad investments are bad investments. They are not obligated to come back into favor. Themes that do tend to cycle (like value/growth) can rotate on a much slower (or faster) basis than expected. Trying to time the market by betting on what’s out of favor today is not “being contrarian”, it’s rolling the dice.

All Else Isn’t Equal

“All else being equal…” should not preface discussions about investment expectations. The Markets are an open system. They are not a closed, binary, cause-effect system. Tax code changes, Federal Reserve Policy (and the market’s reaction to it), news headlines, politics, and market disruptions/innovations (internet, fracking, Uber, Amazon, etc) all influence the markets and do not fit neatly into valuation spreadsheets. We can calculate how things SHOULD work, but we cannot predict how they WILL work.

Flipping a coin 100 times should garner approximately the same number of heads as tails. If the outcome of 99 coin flips is 99 heads in a row, what are the odds on the next throw? It should be a 50% chance for each side, right? On paper, yes. In reality, if someone has flipped 99 heads in a row, the game is rigged. Recognize and stay away from these investing Wooden Nickels.

Avoid false certainty and beware “mathiness”. Math “proves” nothing in investing. An easy way to lose money is to leverage up a small mathematical edge. Investment math is sales math often masquerading as legitimate behind the Greek letter of the moment.

Realistic Market Predictions

Who do we think makes the most accurate market predictions? Fund managers? They will tell you their asset class/style of investing is about to take off. Economists? They cannot speak to market returns, and if you ask ten economists you’ll get twenty predictions. They can’t even predict economic data let alone the entire economy. I don’t know the future and no one else does either. Anyone who tells you they do has something to sell you. The more willing someone is to predict what the markets will do, the less likely he is to face consequences for making that prediction. A pundit whose prediction comes true is perceived to be intelligent even though it’s more likely that they are lucky (or hedged so they wouldn’t be wrong). True wisdom comes from not having to predict outcomes at all. After all, it is better to be approximately right than exactly wrong. Forecasting tells you more about the person making the forecast than it does about the future anyway. The most realistic market prediction is “I don’t know”.  Just because you can’t predict the cause of market movements, doesn’t mean you can’t prepare for the effects. By definition, no one can predict a black swan, but diversification/asset allocation will save your butt if that Black Swan leads to a bear market.

Optimizing Portfolios

Investors should not be preoccupied with holding the optimal or best portfolio. They are better served by employing a strategy that’s good enough to cover a range of possibilities that’s likely to happen in actual practice according to real world experience. This sounds like settling for mediocrity, but it is actually protection from the calamity of flitting between binary, prediction-reliant bets. Perfection is the enemy of good. Adaptability and robustness of strategy are much more important than optimizing for unlikely scenarios.

Allow Room for Small Vices

Setting aside a small portion of the portfolio for personal trading or as ‘mad money’ can help scratch the trading itch that many investors get. This is the place to buy that next hot stock or maybe bet on a sector or country. These trades will not supercharge a portfolio, but they won’t sink it either. Instead, they will serve as a reminder as to why you shouldn’t daytrade the rest of your portfolio.  My mad money account recently reminded me how bad I am at market timing because of a trade I didn’t make!

If you missed them, my first three investment philosophy posts covered Risk-Aware, Focused, and Elegant portfolios.  Next week I’ll wrap it all up and introduce some investing tangents like Charlie Munger’s advice to fish where the fish are.