Reframe Finance #5

Practical aphorisms, low volatility investing, prospect theory

Hi everyone,

Here is your weekly dose of financial wisdom.

Practical Aphorisms

  • You are rich if and only if money you refuse tastes better than money you accept.

  • The ultimate freedom lies in not having to explain why you did something.

  • Self-discoveries last.

  • Your brain is the most intelligent when you don't instruct it on what to do.

  • What fools call "wasting time" is most often the best investment.

  • To understand how something works, figure out how to break it.

  • Success is not being on top of a hierarchy, it is standing outside of all hierarchies.

Nassim Taleb, The Bed of Procrustes

The Tortoise & The Hare

Pim Van Vliet discovered that akin to Aesop’s fable where the resolute tortoise beats the arrogant hare in a race, low risk stocks outperform high risk stocks over the long term. This paradox gives reason to discard the deeply rooted belief in the world of finance that higher returns come with higher risk.

In High Returns from Low Risk, Pim shows that high risk stocks outperform in bull markets, but low risk stocks outperform to such an extent in bear markets and sideways markets that their overall full cycle performance is superior.

Over an 86 year period, buying the 100 lowest volatility stocks from a universe of the 1000 largest US stocks, and rebalancing the portfolio quarterly returned 10.2% annually versus 6.4% for the portfolio consisting of the 100 highest volatility stocks.

To increase these returns, Pim recommends a multi-factor strategy. The idea is to combine exposures to multiple drivers of returns (i.e. factors) to soften the effect of drawdowns and increase the potential for outperformance.

  1. Rank the 1000 largest US stocks by volatility and discard the 50% highest volatility from the set.

  2. Rank the remaining stocks simultaneously by dividend yield size (income), and the performance of their 1 year share prices (momentum).

  3. Buy the top ranked 100.

You can perform this filtering process with a stock screener (e.g. investing.com).

With this more advanced strategy the annualised return becomes 15% over 86 years. And during these 86 years there is no decade that sees losses. The investment paradox is persistent through time.

The idea is to win by not losing.

The Psychology of Wealth

In Thinking, Fast and Slow, Daniel Kahneman explains that in situations where both a gain and a loss are possible, we dislike losing more than we like winning. This is formally known as prospect theory.

The implication is that your total wealth is less relevant than the last change in it.

Indeed, we react to changes in wealth relative to the number we are currently anchored to, rather than our total accumulated wealth. Due to this anchoring bias, wealth itself does not really make us happy (above a subsistence level); but positive changes in wealth may, especially if they come as steady increases.

“Wealth does not count so much into one's well-being as the route one uses to get to it.” — Nassim Taleb, Fooled by Randomness

To going against the grain,

Alex Vikner