Nov 16, 2020
“An investment operation is one which upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
–Benjamin Graham, The Intelligent Investor (Chapter 1)
Come on 2020, can you just get on with it? Thank goodness we have entered the fourth quarter. The final stretch! Yet, this is a critical quarter as we’re all sitting on the edge of our seats watching what may be one of the most contentious Presidential elections in history. Moreover, the uncertainty about the trajectory of COVID-19 in the upcoming fall and winter seasons have us all anxious. Slightly numb to it all, even.
As it relates to investing, our reminder about the election is that it’s dangerous to mix our political views with our investment decisions. Warren Buffett has stated it himself that “if you mix your politics with investment decisions, you’re making a big mistake.” Now let us be very clear, we are not saying that this election, or politics in general, do NOT matter to the markets. They do. But making investment decisions based on our predictions about political outcomes can be a hazard to our investment success.
There are two general reasons for this, and we’ll explain each concept further in this letter. First, politics can be emotional, and once you let your emotions or bias seep into your investment decision making process it can cloud your objective reasoning. Second, and something we’ve talked about before, is that markets move on “second order effects,” meaning it’s not enough to just predict the correct outcome. You must be right AND different than the market expectation (in other words, it’s not the outcome that matters but how the outcome differs from the general, or consensus, expectation).
Let’s talk about emotions and bias a little more. Frankly, this is probably the biggest driver of investment mistakes and is at the core of why we have the wild market cycles we continue to observe. The pendulum usually swings from extreme optimism to extreme pessimism on the foundation of our faulty human psychology. Our hard coding is for near-term survival, which is not always ideal for long-term money decisions.
So, as it relates to politically-based predictions, our emotions tend to allow bias to cloud judgement – to the point where the prediction is not so much based on what we logically think will happen, but rather influenced by what we want to have happen (or inversely, impacted by what we fear will happen if we’re more of the “half-glass-empty” type). One condition we have observed frequently is the concept of confirmation bias. Put simply, it sets us up to only let information in that confirms our beliefs and disregard potentially conflicting, or disconfirming, information. I think we can all relate when we think about the newspapers we prefer to read, or the television news stations we watch. You are what you eat (and read and watch).
Therefore, our point here is not that it is impossible to predict a political outcome. Rather, it is very difficult for individuals (and professionals) to do so without being influenced by personal bias. Not to mention the fact that there are still always many “unknowable’s” out there, especially the events that can still occur between now and election day.
But let’s just say that you are pretty good at blocking out noise and bias and are able to objectively predict the outcome of an election. Knowing whether that specific outcome will create a positive or negative reaction by the market is also quite difficult. First, you are trying to appraise whether or not the prevailing outcome is favorable for markets (i.e. Democrats vs. Republicans) – what we’ve learned is that there really isn’t statistically significant data that says one party or the other is better for the markets. We’ll put it this way though: the markets actually tend to do alright when there is political gridlock. Why? Because markets prefer certainty, and at least for a temporary period, business leaders know what to expect (or not expect) when little progress is being made in Washington. If businesses are confident in investing and hiring, we tend to see marginally better economic growth.
Additionally, the markets do a pretty good job weighing probabilities (in the short run, at least) and handicapping the market for the odds of different potential outcomes. If the market has already “priced-in” the outcome that you predict, there may be very little, if any, market reaction. This goes back to the point about the market moving on second order effects – it’s not the news that matters, but how the news differs from expectations (this is the same reason why a stock with a highly profitable quarter can drop on a good earnings release, while a stock with a dismal quarterly loss can still rally on the “bad” news if it is better than feared). Expectations matter.
This might be a little confusing. However, the point is that in the short-term the market can feel more like a casino than a favorable place for investors to make money. Akin to a casino, it might seem “like the house always wins” as hapless novice investors can lose money to the “smart-money” investors taking the other side of the trade (hedge funds and market makers, for example).
We are not necessarily condemning the notion of short-term trading but want to make a clear distinction between the practice of short-term speculation versus long-term investing. Just as our opening quote explains, there can be both intelligent investing and intelligent speculation. Our approach has been to use intelligent (long-term) investing by evaluating individual businesses for acquisition. Then make a purchase when we are confident that there is a high probability of safety of principal (in the context of a diversified portfolio) and a reasonable expectation for a rate of return that compensates us for the level of risk taken.
As for the NPF-run investment strategies, we continue to observe and assess the political and geopolitical landscape as things develop and make individual security selection changes where appropriate. We manage and mitigate risk by controlling exposures to companies and industries that we assess could be adversely impacted by certain political outcomes (i.e. Healthcare or Energy). But at the end of the day, our focus is on selectively buying high-quality, well-managed companies that tend to have a good track record in almost any political climate, over the long run. We prefer to be owners of businesses, and not just “renters” that hope to capitalize on short-term moves due to external events.