Investing in a Complex Market

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Today’s post was inspired by the excellent book: Team of Teams, by Gen. McChrystal

Modern destroyers use gas turbine engines for propulsion and electrical power. As a young junior officer, I was required to learn all about these marvelous machines. A gas turbine engine is complicated, but it’s not complex. Everything about its operation is defined by the laws of physics. Things can and do go wrong, but if you are equipped with the right skills and tools, any contingency having to do with a gas turbine engine has happened before and can be dealt with. Watchstanders in Engineering memorize casualty procedures on carefully prepared stacks of cards and practice over and over and over again, so they are prepared for every single gas turbine contingency that can occur.

Three of the seven gas turbines on a destroyer power the electrical plant, which in turn provides electricity to the entire ship while underway. This particular warship generates a substantial amount of power; enough to easily serve a town of over 10,000 people. Once tied to all of the other shipboard components, the electrical plant becomes part of a complex system. In a complex system, it is impossible to be prepared for every contingency because of the exponential probabilities of potential outcomes.

Case in point: My ship was maneuvering in the Cooper River channel when all of a sudden the lights on the instrument panels in Engineering started to cycle on and off in a circle around the room. Then, everything went dead. There was no procedure card for this as it was a complex problem nobody had ever experienced before. Fortunately, we were able to get power back up before running aground, but it was due more to luck and some quick thinking by watchstanders than any memorized procedure in a card stack.

Linear to Exponential

In Chess, there are 400 possible positions after each player has made their first move. By the time each player has made four moves, the number of possible positions has increased exponentially to over 288 billion. In Engineering on the USS John Rodgers, that would have been a lot of casualty cards to memorize! Chess is a great example of complexity, where every action creates a whole new set of possible outcomes.

But how does this all relate to the stock market, you might ask? By this definition, the stock market is a complex system and yet most people, including professionals who should know better, treat it as merely complicated. The result? Most who try to outperform the market by predicting stock movements fail. Like the weather (another complex system), some market movements can maybe be predicted over a few days, but those predictions completely break down as new information changes and the possible outcomes increase exponentially.

General McChrystal, in his book Team of Teams, says about Chess, “within twenty moves, it is more than likely that you are playing a game that has never been played before”.

In investing, every day, we are probably experiencing a market that has never been experienced before. How do we invest safely in such complexity? I think it comes down to two things:

  1. Resiliency. Our portfolios must be resilient and built to mitigate unforeseen circumstances before they occur. For this, Modern Portfolio Theory (MPT) is our best tool. MPT does not rely on forecasting, rather, it relies on sound principles of investing that mathematically explore the interrelationship between risk and reward. In turn, a portfolio can be shaped to accept a certain amount of risk and its commensurate return, within acceptable tolerances.
  2. Flexibility. On the planning side of things, we must be flexible. We must be willing and prepared to accept poor investment results from time to time, corresponding to the amount of risk we are taking. During the accumulation of wealth, this means we must maintain adequate cash reserves because:
  3. Cash gives us the flexibility to maintain long-term investment positions.
  4. Cash allows us to take advantage of opportunities when they arise.

During distribution, or retirement, flexibility means:

  1. Sustainable withdrawal rates that preserve principal as long as possible.
  2. A willingness to adjust withdrawal rates according to market conditions.

I believe resiliency and flexibility are the keys to success in complex environments. Are you trying to guess what’s going to happen next in the stock market? If so, I would encourage you to try a different tactic. Our investment decisions should be made based on what we know, right now, not what we think may or may not happen. I have to constantly remind myself of this very basic and important premise to successful investing. If I ever forget, the market is relentless in reminding me again!

Those are my thoughts, have a great Thursday.

~ Rob

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