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Are You Watching the Owner or the Dog?

The last 12 months (ended 6/30/2019) have certainly seen a lot of big up and down moves in financial markets. You can see this in official volatility measures, like the Chicago Board Options Exchange (CBOE) VIX index¹, with average levels over the 2018-19 year about 25% higher compared to the prior two years. You can also see it in monthly stock returns. For example, over the last 30 years the S&P 500 stock index has experienced a monthly change of +/- 2% about half the time. But in the last year there was only one month that did not approach or exceed that level! Some months were exceedingly positive (January, April, and June for example), and some months exceedingly negative (October, December and May were particularly nasty, each posting results worse than -6%!). Not to be outdone, the 10-year Treasury yield declined from 3.15% on 10/31/2018 to 2.00% at the end of June - a dramatic move in only eight months.

This kind of price action reminds me of the story often attributed to the late Ralph Wanger, former portfolio manager of Columbia Acorn Fund. Wanger likened "the stock market" to an excited dog on a very long leash, being walked in Central Park in New York City. In his story Wanger noted that the dog was being walked from Columbus Circle, through Central Park, to the Metropolitan Museum. At any moment there could be no telling what might grab the dog's attention and which way the dog would run - but in the long run, an observer would know that the dog was heading northeast at an average speed of about three miles per hour. It seemed astounding to Wanger that all stock market participants, big and small, seem to have their eye on the dog, and not on the owner.

It's hard to avoid investing's daily scoreboard. Reporting on the day's market action and the supposed "causes" of that activity are part of most news forums. What's happening in "the market" is often part of social discourse. And there's the monthly brokerage statements highlighting our paper gains and losses for the last 30 days or so. Just another part of the deluge of data in our lives.

But this is not another "ignore the noise and carry on!" sermon. Far from it - risk management in investing is as important today as ever. Complacency is ill-advised. Rather, I want to stress that it's critical to understand the utility of the information we see. In other words, am I even looking at the right scoreboard? Is this actionable data? What are the right questions to ask about what I'm seeing?

Entrepreneurs and business builders are accustomed to reports and data on a regular basis. For them, monthly (sometimes even weekly) reports can be important. Is the plan being executed as envisioned? If not, what adjustments should be made? Financial reports are a way to verify that the actions being taken are flowing through to results. Sometimes changes need to be made - and quickly. But even in those cases it's important to be focused on the right information (key value drivers), ask questions about what factors might be impacting the data, and be thoughtful about whether useful judgements can be inferred.

But in investing, monthly reports are unlikely to offer any useful information. Frankly, even quarterly and annual data may not be helpful, but of course we diligently review those reports anyway. Like the entrepreneur, we should be asking: am I looking at the right information? What's the context for these results? Is this actionable information? But unlike the entrepreneur, our investing instincts should be counterintuitive - price drops should be seen first as a source of opportunity and not as a problem. Price gains should be viewed as a diminution of opportunity. When prices fall the first question is, should I be a buyer? When prices go up the first question becomes, should I be a seller? For most investors most of the time the answer will be no (on both counts). But by learning to respond to financial market gyrations in this way, we can create a more constructive mindset and save ourselves from some poor decision-making².

Whether entrepreneur or investor, figure out the data that is most important (that's the owner in Wanger's story). Then set up your scoreboard so you don't get distracted by the dog.


1. CBOE VIX measures implied volatility for short-term call and put options on the S&P 500 stock index.

2. Inferior returns experienced by stock fund investors relative to the funds themselves due to poor investor buy and sell timing has been well documented by Research Affiliates, Morningstar, and others.


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