Written by: Corey Janoff
This blog post was originally published on our previous blog website, FinancialClarityBlog.com on November 21, 2017, and has since been revised and updated.
Today I want to focus on a lesson we can all learn from turkeys. For those of you that read Nassim Taleb’s book, The Black Swan, you may remember his story about the turkey. The book itself is a little slow and tough to read without falling asleep unless you are really into learning more about some contrarian investment concepts. But there is definitely some good stuff in there. For those that didn’t read the book, the story goes something like this:
Once upon a time on a farm, there lived a turkey. The turkey had a great life. Every day, the farmer would take great care of the turkey. The farmer would feed the turkey well and pet the turkey’s feathers. The turkey could run around the fields of the farm, bask in the sun, air out its wings in the breeze. Life was good for the turkey. Every day, day after day, the turkey lived this comfortable life. The turkey grew to expect his daily routine of getting fed, pet and running around the farm. One day, the farmer got up, fed the turkey, and pet its feathers like he always did. Then the farmer took the turkey into the barn and chopped off its head. It must have been the week of Thanksgiving.
This is definitely not the most uplifting end to the story. However, there are parallels we can learn from this story that apply to the investing world. Things are going great…until they aren’t.
We often are blindsided by change, because we have grown comfortable and expect the usual routine. That is the whole premise of Taleb’s book. Those unexpected, rare, black swan events are what really shake up investment markets.
Morgan Housel calls them tail-end events (picture a typical bell curve with a fat middle and narrow tails on either end). The tail-end events are the rare, mostly unexpected outcomes…but they make all the difference when they do happen. Housel writes:
In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on. We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5%. Then 36 million people lost their jobs in two months because of a virus. It’s absurd. Tail-end events are all that matter. Once you experience it, you’ll never think otherwise.
If mass markets expected housing to crumble, homes to foreclose, mortgages to go unpaid, and banks to go out of business, then 2008 wouldn’t have been 2008. It would have just been another year. We may have seen housing slow and the economy dip into a mild recession, but if we were prepared and could foresee what was to come, we would have made necessary adjustments well in advance to mitigate the damage.
Whoever would have thought a terrorist attack on US soil, killing thousands would ever be a possibility…until 9/11 happened?
Every year there is a different company or asset class that is a can’t-miss investment. Until it misses. Recent past performance is a horrible predictor of future performance. Just because an investment has been rising in price recently, doesn’t mean it will continue to rise in price.
Unfortunately, that is one of the only metrics many individual investors look at. “This stock has risen 40% so far this year, so I should invest in it. It just keeps going up and up and up!”
Correction, this stock has (past tense) gone up in price. That doesn’t mean it will continue to go up in price, or that the price won’t decline moving forward. It also doesn’t mean it won’t continue to rise. The past is the past. Moving forward, every day is a whole new day.
The Morningstar Mirage
The Wall Street Journal wrote a story a few years ago about The Morningstar Mirage. Morningstar is an investment analysis company that is famous for its star-rating system. The 5-star scale measures a mutual fund’s past performance compared to its peer group and assigns that fund a star rating. One star is the worst, five stars is the best.
Morningstar acknowledges and admits that the star rating system is a backward-looking system that rates a mutual fund’s past performance compared to its peers. It shouldn’t be construed as a future predictor of performance.
There is no correlation between star rating and future performance. Everything tends to gravitate towards the mean. The average 5-star fund is a 3-star fund ten years later. However, money tends to get pulled out of the one & two start funds and flock into the four & five-star funds. The amount of money invested in the fund depends heavily on the star rating Morningstar assigns them.
Just because a stock/mutual fund/asset class has outperformed recently, doesn’t mean it will continue to do so. And just because a stock/mutual fund/asset class as underperformed recently, doesn’t mean it will continue to do so.
What happens when investors only focus on recent returns is an overly concentrated portfolio? If you invest money into the high-flying sectors that have done really well recently and moved money out of the areas that haven’t done as well, you end up with a large portion of your portfolio concentrated in one or two sectors and don’t have much (if anything) invested in other areas.
How your portfolio looks when you only invest in areas that have performed well recently
If the tides change and the areas that have recently done poorly start doing well and the areas you are invested in that have recently done well start doing poorly, you end up getting crushed! The bulk of your portfolio is now struggling and you are missing out on growth in other areas.
How your portfolio looks when the few sectors you are invested in start performing poorly and other areas start performing well
This is why diversification and investing your portfolio according to your time horizon and risk comfort level is important.
If you have a long time horizon until you need your money, you can afford to invest more in the risky sectors, since you have time to weather any storms that arise. You will have more opportunities for growth over time, compared to investing only in conservative areas.
However, you don’t want to concentrate all of your wealth into a few sectors, because when they don’t do well (which they won’t from time to time), then you have other areas to carry the weight.
As you get closer to needing your money, you should reduce the possibility of a cataclysmic event devastating your investment portfolio, because you no longer have the time to let your portfolio recover.
Don’t be a turkey. Don’t get too comfortable with how things are now, because it won’t be this way forever. Seasons come and go. Winter is coming and things will die off, which creates opportunities for a new life in the spring.
Any examples are hypothetical and for illustrative purposes. Investments involve the risk of loss, including total loss of principal.