Life can only be understood backwards — but it must be lived forwards. — Søren Kierkegaard
Whenever the markets get a little shaky, one comment that we hear a lot from our clients goes something like this: “I sure hope we’re making the right decision!” If pressed, we find that the clients are worried that our decisions will turn out badly — that is, that the consequences will be negative. For some, this is a very short-term worry: what if, over the next six months, the market continues to deteriorate, and their accounts are worth even less than they are today! And for others, this is a very long-term worry: what if this is the end of the basic capitalist system, and all investments are doomed to drift toward zero! Either way, if the markets continue to go down from here, won’t that show that we have made the wrong decision?
I don’t think so. In contemporary ethical theory, philosophers draw a distinction between an ethical framework used as a decision-making procedure and an ethical framework used as an evaluative tool. Given that we’re already talking about consequences, I’ll use Utilitarianism as an example.
The classic brief statement of Utilitarianism, from John Stuart Mill, is not clearly intended as either a decision-making procedure or an evaluative tool: “actions are right in proportion as they tend to promote happiness, wrong as they tend to produce the reverse of happiness”. We can read this as urging us to sit down and calculate out which of our possible courses of action will “tend to promote happiness”, and so to choose that one — or we can read this as urging that we should evaluate the actions we have taken by looking at how much happiness the course of action we decided to take ended up creating. Perhaps Mill means both; he certainly seems to use the principle in both ways.
So, according to one version of Utilitarianism, I should choose the course of action which is most likely to have good results, most likely to “tend to promote happiness”. As investment advisors we have an obligation to help our clients choose those investment options which stand the greatest chance of meeting their financial goals over the long run (and, probably, those which have the most beneficial impact on the entire world, since our global capital markets have that reach — an argument in favor of SRI!).
This seems at first like a daunting task, especially since “past performance is no guarantee of future returns”. But we know something about how this is done: Don Trone, one of the nation’s foremost experts on the fiduciary duties of investment advisors, has argued that “superior investment returns are a result of developing a prudent process or strategy, and then sticking with it”. This is why we write and implement Investment Policy Statements, and why we spend so much time and energy on due diligence of the managers we employ.
If we choose a prudent strategy, as Trone suggests, we stand the best chance of success in the long term. But there’s no guarantee that in any given period a prudent strategy will lead to maximal returns, nor that it will even lead to tolerable returns. In fact, in the short term, prudent strategies are almost guaranteed to under-perform imprudent strategies that involve concentrated, risky bets that happen to turn out favorably. Various newsletters, books, websites, and so on, will gladly sell you “the secret strategies of the super-wealthy”, and tell tales of someone who was lucky enough to make a questionable method work for a while.
If, at any particular point, we were to look back at our prudent-but-dull track record, couldn’t we say that we ought to have chosen some other tactic? Just after the ugly recession and market crash of 2007-09, we heard a lot about the opportunities we missed — specific stocks with triple-digit growth in 2008, whole market sectors that somehow managed to show a net gain in that ugly environment, the “wonderful” returns of long-term bonds. If only we had sold all of our clients’ accounts to cash on October 9, 2007, when the S&P 500 closed at 1,565, an all-time high! And invested every last dime in all-stock portfolios on March 9, 2009, when the market hit its low at 676, down 57% from its high! Here we have shifted gears, and we are using Utilitarianism as an evaluative tool — did our decision in fact work out for the best? — and our prudent strategy doesn’t look good.
This raises two crucial issues. First, the evaluation period is extremely important. Sure, we can say that if we had trusted the opinions in the newsletter of Advisor X during the market crisis of 2007-09, we would have come out far ahead of our prudent strategy. But we have to ask: how did Advisor X’s portfolios perform, especially compared to our prudent strategy portfolios, in other time periods? Bernie Madoff paid his clients tremendous, and tremendously constant, returns on the money they entrusted to him, until he was caught. Bill Miller’s Legg Mason Value Trust mutual fund beat the S&P for 15 years running, from 1991 through 2005 — but got positively crushed in 2006-09, when he took his usual concentrated positions in the very industries that led us into the recession. For short periods of time, some people can “beat the market”, and a few can do so for substantial periods — but only the absolutely exceptional can do it for very long at all.
Second, as the noted philosopher Yogi Berra (may have) said, “It’s tough to make predictions, especially about the future”, a sentiment which Kierkegaard would no doubt applaud. We must make our decisions based on a prediction of what we believe the most likely outcomes will be: we can’t do more than estimate the probabilities of the various outcomes, and choose the strategy that stands the best chance of meeting their long-term financial goals. After the fact, after the dust has settled, we may see that a different choice might have been better. But what if our choosing that alternative option would have changed something else, and it wouldn’t have turned out better after all?
If we could only take the point of view of an archangel (in the image of philosopher RM Hare), we could collapse present and future, and make accurate predictions about future events — and so be able to make perfect Utilitarian decisions every time. But, as fallible, finite human beings … well, we can’t. We are left with our predictive techniques, our understanding of probability and the relationship of risk to return, and the tools that our prudent investment process provides to us. If we make our investment choices on the basis of a prudent process, then even if the winds of Fortune blow in our faces, and it doesn’t turn out as well as it might have, we can still say that we made the right decision.
Header Image: “Prudenza”, by Gaetano Fusali