Unthinkable: Investing In a Surprising World
The unthinkable can always happen, and you have to run your affairs accordingly.
— Peter Bernstein
Historian Arnold Toynbee said “history is just one damn thing after another.” Lately, it has felt like it. Since the COVID-19 pandemic began in March 2020, there’s hardly been a dull moment. The markets have been hit by one surprise after another.
The word “unprecedented” has seen unprecedented use. But we are not living in unprecedented times. History may not repeat, but it does rhyme, and wars, plagues, natural disasters are nothing new. They have precedent. In The Lessons Of History, Will Durant notes that “In the last 3,421 years of recorded history only 268 have seen no war.” War, evidently, is more common than peace.
Why, then, are recent events, like the pandemic and war in Ukraine, so surprising?
One reason is that people believed these were “old world” problems and relics of the past. This is the denigration of history — the sense that what has happened to others couldn’t possibly happen to ourselves. But just because an event doesn’t happen often doesn’t mean it will never happen again. For example, an event with a 5% annual probability has a 99.4% chance of happening over 100 years.
Another reason is that the human brain is wired to project the recent past into the future. Our brains are not designed to anticipate inflection points. Yet it is precisely the inflection points that define history. As Nassim Taleb says, “History doesn’t crawl; it leaps.” History is nothing more than a story of totally out-of-the blue events happening to totally bewildered people over and over and over again.
In Antifragile, Nassim Taleb writes:
Consider a turkey that is fed every day. Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race 'looking out for its best interests,' as a politician would say.
On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.
In 2016 Barry Ritholtz asked Daniel Kahneman, the Nobel Prizing winning behavioral economist, how we should respond to surprises. Kahneman said:
Whenever we are surprised by something, even if we admit that we made a mistake, we say, ‘Oh I’ll never make that mistake again.’ But, in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson to learn from surprises: that the world is surprising.
At EPC, we don’t know what is coming next, but we know it is something. Surprises are a fact of life and an inevitable part of the investment game. Everything that can break eventually will. Investors should spend less time trying to predict when the world will break and more time building resilience to the inevitable breakage. We know wars, plagues, famines, and natural disasters will happen, but no one knows how to consistently forecast their timing.
Investors shouldn’t assume they’ll be able to foresee trouble and sell risky assets before it starts. Hindsight makes that look easy because history appears like a series of well-ordered events with obvious causes and inevitable affects. Living through history feels more uncertain because we don’t yet know how the story ends.
For example, how many people predicted that COVID lockdowns would lead to skyrocketing used-car prices? In retrospect, it makes perfect sense. But in April 2020, no one was talking about it. People were preoccupied fearing for their lives.
Investors should think probabilistically, like an insurance company. Insurance companies know hurricanes are inevitable but don’t try to predict their exact timing. The insurance companies that endure operate with a large margin of safety. A margin of safety is a deliberate amount of slack in the system. It is the opposite of efficiency.
Berkshire carries the right amount of cash on its balance for a crisis, which is too much for normal times. Its balance sheet looks bloated and inefficient during the good times, but safe and secure during the bad. Berkshire doesn’t try to predict the timing of catastrophes or bear markets, but it knows that they’re inevitable and expects them. As Ben Graham wrote, “The purpose of a margin of safety is to render the forecast unnecessary.”
At EPC, we try to avoid stupidity rather than seeking brilliance. Pundits who make forecasts are seeking brilliance. Sometimes they’re right, and bask in the limelight for a few years. Nobody makes brilliant, contrarian forecasts consistently. Who had the war in Ukraine in their 2022 forecast? The Economist’s World Ahead In 2022 makes no mention of it.
Avoiding stupidity means building a portfolio that’s resilient to as many future states of the world as possible. One way is to buy companies that are like cockroaches — very hardy and almost impossible to kill. We like simple, predictable, profitable, and replicable businesses with strong balance sheets and capable managers.
Avoiding stupidity means avoiding path dependence. John Maynard Keynes said “The market can remain irrational longer than you can remain solvent.” The world is inherently surprising, and surprising prices occur all the time. Who foresaw crude oil prices going below negative $30 in 2020 or above $120 in 2022? Or GameStop ripping from $10 to $350 in a few weeks? Or London Nickel futures rising 250% in two days, and then having trading suspended for more than a week? Or the Russian stock market going virtually to zero overnight. Investors need to ensure that they are never forced to buy or sell at an inopportune time. We do that by paying cash for our stocks. We don’t sell short or use derivatives.
Avoiding stupidity means avoiding extreme financial leverage. Bill Miller beat the S&P 500 every year for 15 years in a row, and then suffered catastrophic losses in 2008 that forced him to close his fund. His error was continuing to double down on banks all the way to their bankruptcies in 2008. Leverage doesn’t add or subtract value — it merely magnifies outcomes. Investors should avoid all-in bets when leverage is high because outcomes can become binary. Carl Richards says "Risk is what's left when you think you've thought of everything."
Avoiding stupidity means never taking liquidity for granted. The Russian stock market closed on February 25th and has yet to reopen. In 1914 it also closed as Russia entered WW1. It didn’t reopen until 1917, and then only for two months. It closed again when the Bolsheviks overthrew the Czar. Trading didn’t resume until 1992, 75 years later.
Investors that think this could never happen in the U.S. should know that it has. The New York Stock Exchange closed in July 1914 to avoid panic over the outbreak of World War One and didn’t reopen until that December.
Warren Buffett never expects liquidity. He said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years” and “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” This attitude focuses on investors on the business behind a stock, not the stock’s price.
Napoleon said “A genius is the man who can do the average thing when everyone else is losing their head.” It’s true in investing too. When the world goes crazy and surprises arrive daily, it is best to double down on the fundamentals and keep it simple. Dollar-cost average into simple, predictable, profitable businesses in replication mode, run by people you like and admire. Think and act like a long-term business owner. As Howard Marks says, “We can’t predict. We can prepare.”
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"Warren Buffett never expects liquidity. He said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years” and “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” This attitude focuses on investors on the business behind a stock, not the stock’s price."
This is quite problematic today with money market ETFs. There are vast sums held in these securities that are essentially people's savings. Should they 'break the buck' or the market closed, people lose not just access to stocks but their cash.