"Entropy" is an interesting word. It has two meaty definitions, the first is very scientific and the second is very interesting. Here is the official definition from Webster's:
1. A thermodynamic quantity representing the unavailability of a system's thermal energy for conversion into mechanical work, often interpreted as the degree of disorder or randomness in the system.
"The second law of thermodynamics says that entropy always increases with time."
2. Lack of order or predictability; gradual decline into disorder.
"A marketplace where entropy reigns supreme."
The first definition is kind of scary. "Entropy always increases" means that eventually the Universe will suffer heat death, when everything stops, or so some of my engineering-degreed colleagues tell me. But that will be many billions of years from now, so I think we can safely focus on the second definition today.
Entropy as a lack of order, a lack of predictability, a gradual decline into disorder. In the realm of portfolio management, that is scary enough.
When I started digging into this topic, it really struck me that I have been watching, advising, and discussing portfolio management for 25 years and I have seen this sort of entropy all the time. It's not a decline into chaos, but rather it is a slow decline into a lack of discipline. Portfolio management should be an extremely disciplined process. It's not a random walk theory whereby we just buy a little bit of everything with the hope that nothing blows up too badly. Sadly, as I watch portfolio managers across the spectrum from fixed income to equities, I see this gradual decline into disorder. When markets are fairly boring, it could become easier and easier to slip into an entropic haze and start doing things that just don't make sense. Remember, the easy path is towards entropy, and eventually chaos.
I think it really comes down to two very disparate
approaches. The first (and worst) is a very passionate intensity where someone
practices an approach of "diverse" sectors, an effort to ensure that there is
enough variety within the portfolio, always a having certain proportions of
certain specific sectors, under a relatively fixed policy, often written in the
distant past! The problem with this approach of managing by sector is that there
is no sector that is always a good investment. None. When we blindly and/or passionately
manage a portfolio by a prescribed percentage or allocation, those currently
good and those currently poor, we guarantee that at best we will be average. We
must be willing to that admit at any time certain sectors or groups of sectors will
be sub-optimal, and don't belong (for the moment) in our portfolio.
The second (and more difficult) path takes intensity, determination, and process. One of the things that we have been teaching for years is the seemingly easy, but difficult to adopt, truth that good portfolio management requires a simple, disciplined process. We need to identify current poor risk/rewards and eliminate them. We need to attempt to identify current good or even great risk/rewards and acquire them. And finally, we need to try to identify good combinations of risk/rewards—whose value can only be seen in that combination—and execute them.
One of the things that we have been teaching for years is the seemingly easy, but difficult to adopt, truth that good portfolio management requires a simple, disciplined process. We need to identify current poor risk/rewards and eliminate them. We need to attempt to identify current good or even great risk/rewards and acquire them. And finally, we need to try to identify good combinations of risk/rewards—whose value can only be seen in that combination—and execute them.
Let's focus on the first point. When we can identify poor risk/rewards, we need to eliminate them from our portfolio. This can be painful, because as the portfolio manager this often means that you probably originally acquired this "poor" risk/reward. That means that you either made a bad decision originally, or that something has changed. This may also mean that you need to realize a loss, which is never pleasant. Therefore, it becomes so important to be able to articulate why the investment is sub-optimal. This is where the idea of intensity, determination, and process kicks in. It takes effort to show people why an investment (potentially your prior decision) has become a less optimal risk reward decision going forward. Initially, it feels scary and a little intimidating, but once you have fully established this more difficult process on an ongoing basis, the payoff can be tremendous. As I mentioned last week, it does take some bravery to admit a mistake, but in the long-term it usually pays huge dividends.
Think about the alternative, which we discussed above. Being extremely passionate and having a lot of intensity in following a recipe—even when it is suboptimal—is the much easier path. You can ignore the value of past decisions, if they followed the allocation requirements, and so be passionate in saying you "did the right thing." It's a strange conundrum but being passionate in defense of poor choices can be the easier path. Being humble and contrite about a bad decision is so much more impactful. People will remember it and, as Screwtape said in his toast which I discussed last week: "I'm as good as you," doesn't work. Your peers will know that you will let them know when you've made a bad decision. Wow. Powerful character trait, too.
As Shakespeare expressed in his classic play Hamlet, "the Lady doth protest too much, methinks."
Going back to the title: entropy. We must remember that eventually markets will move to a more disordered reality.
Let's go way back to the 1920s. The market was roaring at that time. Inflation was starting to sneak into the equation and several of the then-dominant economies, namely France and Germany, left the gold standard. The market was soaring and had reached new highs. The "Great" War had ended, but as Gustav Stresemann (the German Foreign Minister) said at a speech to the League of Nations in 1929, "Germany is, in fact dancing on the edge of a volcano." Shortly thereafter, the stock market—and financial markets in genera—absolutely collapsed. Germany, France, and Britain lost nearly 50% of their gold reserves within 12 months largely due to the U.S. calling in their short-term loans. The problem was that all these governments had been borrowing like crazy and suddenly credit disappeared.
The volcano exploded and chaos ensued. And the U.S. had it better than most! Yet, one of every seven U.S. banks failed within 24 months.
Entropy will increase, sometimes slowly, sometimes more rapidly, but it always will increase. A disciplined approach is so critical in times when this becomes apparent to all as pride and passionate defensiveness will not get us through them.
Final, final thought: I recently discovered Blue Diamond Bold Salt 'n Vinegar Almonds. They are incredibly addictive and very tasty…give 'em a try.
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