The Courage of Discomfort
Professional investors are often afraid to go against the grain. But failing to do so can come at a great cost.
“I’m comfortable with this.”
Very often I’ve heard such a rationale used to signify a final investment decision, ostensibly after a careful and dispassionate consideration of the potential risks and return. Unfortunately, more often than not, this comment simply signifies a lack of the conflicting thoughts that should accompany a difficult decision, and if anything, is evidence of the predominance of emotion in the decision maker’s process, as opposed to rational analysis.
Why should we expect to be comfortable with a tough decision?
Well, from an evolutionary perspective, there is some basis — and value — in such comfort as a decision-making criterion. Take the animal world: As any group forages, it benefits from the shared watchfulness of all of its members. Each member can eat comfortably, content in the knowledge that should a predator appear, many other individuals will alert the group to the predator’s presence and likely provide ample time to escape, be that a sprint across the field or a scamper up a tree. Each individual’s risk is mitigated by shared social responsibility.
On the other hand, the benefit to straying outside of the group to find a modestly better grazing ground is extremely limited. And more importantly, it comes with a much higher risk of being the one animal to get caught. In this situation, discomfort is highly adaptive; it’s self-preservation’s way of telling you that something is not right.
The best interest of the hunted herd is usually aligned with the individual best interest of each of its members. And it’s important to realize that it is only in the last few dozen millennia — a blink of the eye relative to the millions of years of our species’ evolution — that humans have been more hunter than hunted.
Survival in financial markets, however, is a decidedly different animal.
I have a good friend in Chicago that at one time made a living day (or more accurately, night) trading European equity futures and derivatives. At one of the prop shops where he worked, his trading desk manager, a burly Irishman from Chicago’s south side, once asked how much risk he had on.
My friend’s response was “I’m comfortable with the level of risk I have on.”
The highly caffeinated desk manager’s reaction was immediate and explosive.
“Then you don’t have enough risk on!” the former floor trader bellowed, balling up his substantial fists and slamming them down on the table. “The market doesn’t pay you to be comfortable!”
Needless to say, my friend never used his comfort level in describing an investment ever again.
After hearing this story — and laughing hysterically, knowing well both parties to the exchange — I gradually came to reflect upon the wisdom of the grizzled trader’s comments.
Unlike the foraging creatures in our anecdote above, it actually does pay handsomely to step out of your comfort zone in investing. And conversely, our comfort often blinds us to the considerable risks of conformity. Too many investors are more willing to fail conventionally than succeed unconventionally.
Warren Buffett has famously said “be fearful when others are greedy and greedy when others are fearful.” This sage advice from no less than perhaps the greatest investor of all time speaks directly to this issue of comfort through conformity.
When animal spirits are strong, and the equity market has had a sustained rally, investing in equities is quite easy, despite the reality that risks are likely higher and forward-looking returns lower. On the other hand, after a steep selloff, when many investors are panicking and selling non-economically, stocks are generally offered at their biggest discounts. Subsequent returns after such bargain-basement buying opportunities are much higher than long-run averages.
For example, it was a very easy decision to buy stocks in the late nineties, during the peak of the tech boom. As of December 1998, U.S. stocks had averaged total returns of roughly 20 percent per year since the beginning of that decade. To someone excitedly buying at that time, the annualized return of -1.8 percent over the next ten years would have been extremely disappointing.
Sadly, most research that shows that this is exactly the behavior most investors — retail and institutional alike — display: buying stocks or hiring managers after strong recent performance, only to have them underperform afterwards.
Conversely, investing in equities in December of 2008 would have been enormously contrarian and extremely uncomfortable, but an investor courageous enough to do just that would have earned 14.5 percent annually over the following eight years.
Going against the crowd is always uncomfortable, but often well compensated.
One could argue that the simplest definition of a fiduciary is someone whose job it is to make the uncomfortable decisions without getting the benefit of it. It is our duty to own that discomfort on behalf of our beneficiaries, who are often incapable of or unwilling to do so.
The market doesn’t pay us to be comfortable. However, if we can muster the courage to make rational investment decisions without concern for the opinions of convention, it will pay our beneficiaries handsomely for our discomfort.
Christopher M. Schelling is the director of private equity investments for the Texas Municipal Retirement System.