Recently upon finding out I invest for a living, an acquaintance asked me to let her know if I see something coming in terms of a big market selloff, because she is approaching retirement and is scared of a bear market. This is both typical and mystifying to me in terms of the way regular folks tend to think. The reality is that I don’t know the future any more than she does. Investing equals decision making under the condition of uncertainty.

How an Investor Should Conceive of the Future

To properly conceptualize the future as an investor, you need to create different scenarios and assign subjective probabilities to them. You want a strategy and an approach that is robust against this subjective probability distribution of the future. You can’t control your returns, but you can control your risk profile. Managing your risk requires balancing the probabilities against their potential consequences. As Seth Klarman has said, nothing is more important than the ability to sleep at night.

How to Approach Investing In an Uncertain World

An investor’s task is to manage their assets and cash flows so they will provide for their needs over their lifespan. How do you do that? You estimate what you will need and make a plan that is likely to get you to a prosperous retirement. Don’t extrapolate to the best case scenario. Prepare for the worst and hope for the best. But, the big thing is to save and invest something. Anything is better than nothing.

If you are young and investing for retirement, Vanguard suggests putting aside 15% of your income toward this goal. If you can meet that number terrific. If not, 10% is a reasonable goal when getting started. If you get an employer match, so much the better as this will decrease the amount you need to contribute.

You also want to make sure that you have enough in savings and disposable income to cover your living expenses during the portfolio building stage of your investing life. You don’t want to get disheartened or need cash during a bear market and either stop contributing or sell your investments at a loss.

Munger’s Approach to the Market’s Vicissitudes

Charlie Munger has said that he doesn’t try to predict the ups and downs of the market, he just tries to swim better than the tide. He has also said if you aren’t able to endure a decline in the quoted price of your stocks by 50% and react with equanimity two or three times in your life, then you deserve the mediocre returns you are likely to get.

I always get a kick out of market pundits who talk about how uncertainty is high right now. Uncertainty is always high. While trends persist, often far longer than you may think, recessions and bear markets many times begin when the consensus is fairly cheery. Anyone who tells you they know what is coming next in the markets is a liar, and they are probably trying to sell you something.

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“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor — the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”
— William Bernstein

“Having, and sticking to, a true long term perspective is the closest you can come to possessing an investing super power.”
— Cliff Asness

Pim Van Vliet’s book High Returns from Low Risk examines the investment paradox that the lowest risk stocks (measured by volatility) outperform the highest risk stocks over the long term. This phenomenon has been established across markets and eras. The book builds on the work of Eric Falkenstein in The Missing Risk Premium and his paper on risk and return at SSRN.

According to the deans of finance, this should not be the case. For instance, the Capital Asset Pricing Model (CAPM) assumes a linear relationship between risk and reward. But of course this does not represent the real world.

So You’re Telling Me There Is a Free Lunch?

The following diagram shows a frown whereby risk increases return up to a point, but the highest risk stocks underperform the lower risk stocks. You should take some risk, but not too much.

Valuation Still Matters

Since the low risk anomaly has been identified, several ETFs such as USMV & SPLV have been created to exploit it. In recent years, a lot of hot money has chased the strategy and driven up the prices of low volatility stocks. The observation of the phenomenon has changed it.

So returns from low risk may be somewhat muted going forward until the excitement fades and the hot money moves on to chase something else. As in any other investment strategy, valuation matters, and you should seek a margin of safety.

Low Risk Outperforms in Bear Markets, but Lags In Bull Markets

While low risk stocks tend to outperform in a bear market, it can be difficult to hang on during a bull market when you are likely to lag. The sense that everyone else is getting rich can be hard to take without capitulating. Persistence over an entire market cycle is needed to get the outperformance the low risk strategy can deliver.

An Antidote to Financial Noise and Unnecessary Complexity

Pim Van Vliet’s book is a breath of fresh air. That one can ignore all of the noise and succeed with low risk stocks is a blessing for the individual investor, if he is willing to put in the work and can stand to be different from the crowd. I am perfectly happy ignoring the horserace and earning high returns with low risk.

I love to find boring, cash cow companies that it is hard to brag about owning. Sacrificing your ego for financial gain can be emotionally counterintuitive, but very lucrative. I would much rather have the cash register ring reliably than have bragging rights.

To me it is a matter of personal preference and goals. My goal is to comfortably afford the life I want to live. Pim Van Vliet shows that a low risk strategy can even outperform. I may beat the market without even really striving to do so.

A Dividend Oriented Strategy Beats Dollar Cost Averaging In Reverse in Retirement

While a low volatility strategy and a dividend oriented strategy are not precisely the same, I believe they are close cousins. A substantial benefit of the dividend growth strategy over the “living off of the pile” strategy promoted by most of the financial industry is that it is perfect for turning a portfolio into a stream of income during retirement.

This solves a major weakness in the mainstream advice to gradually sell off part of your portfolio every year in retirement. Dollar cost averaging in reverse destroys value just as dollar cost averaging in the accumulation phase creates value. A low risk, dividend growth strategy is simply much more practical in the real world for real people than trying to live off of the pile.

And the smoother ride of investing in largely defensive, low risk stocks with secure and growing dividends means that I won’t panic and sell during a downturn. The key is that I believe in it, and I know it will get me to my goals if I stick with it. That is much more than good enough for me.

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“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville

Find A Strategy You Can Stick With

“The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
— Cliff Asness

This is why protecting your downside is more important than maximizing your upside. Forget the horserace and look to a strategy you can live with in good times and bad. For me, that strategy is investing largely in defensive, high quality companies that grow their dividends. It may lag in a bull market, but I can sleep like a baby in tough times. The key is that I know it works and I believe in it. That inoculates me against selling and locking in a big loss during a bear market.

You Don’t Get Extra Points For Degree of Difficulty

“If you’re in a wonderful business for a long time, even if you pay a little too much going in, you’re going to get a wonderful result if you stay in it a long time.”
— Warren Buffett

High quality companies can be great long term compounders.

Figure Out What Not To Do And Don’t Do That

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
— Charlie Munger

Inversion is the key to Munger’s success. Learning from the folly of others and avoiding their mistakes gives you a huge advantage in life and investing. Figuring out what not to do is more important than trying to be brilliant.

The Cost of Taxes Should Be Included In Your Opportunity Cost Calculations

“Intelligent people make decisions based on opportunity costs. It’s your alternatives that matter.”
— Charlie Munger

“Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.”
— Charlie Munger

Something I struggle with is the temptation to always be doing something. If I have a position with a big gain that is trading above fair value, I start to play with alternatives. The problem is that action for the sake of action should be avoided. It helps me to remember Munger’s comment about the huge advantage you can get from letting a company compound tax deferred over the long term. Unless there is something fundamentally wrong with the business or I have a much cheaper and more desirable alternative, sticking with a high quality winner generally makes sense. This helps me by increasing my hurdle rate to action in such a situation. 3.5% is Munger’s high end estimate for a company with a 15% annual total return, so depending on the company, I adjust downward. Since my holding period is less than 30 years, I generally figure between 0.5% and 1.5% for the benefit for long term tax deferral. If it’s a close call, taking no action can make sense.