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Fifteen Shades of Grey

One of my first posts on this blog was focused on the value of grey thinking in the context of investing. As human beings, we oh-so-crave everything in our lives to be delineated in black and white terms. Perceiving concepts or ideas in binary terms – as opposed to a spectrum – allows us to apply heuristics in our day-to-day decision making. Unfortunately, financial markets are not so cut and dry.

As investors, we are constantly being asked to pick tribes, exude confidence, and pack things into tidy little compartments. What follows are fifteen (well, sixteen really but fifteen made the title of the post more clever, so sue me) such examples in which the black and white perception is in reality various shades of grey:

1. Diversified vs. Concentrated

Most people would agree that the S&P 500 is diversified, with 500(ish) stocks in the index. But as Michael Batnick pointed out in the chart heard round the world, the five largest S&P 500 stocks have a market capitalization roughly equal to the bottom 282 S&P 500 stocks.

You could own a hundred funds and be concentrated in one risk factor or you could own five funds and have a healthy balance of risks. What matters is not the numbers of line items on your statement or how many pretty colors comprise your asset allocation pie chart. What matters most is that you understand the risks you are taking and set appropriate expectations regarding the range of potential outcomes.

2. Domestic vs. Global

Let’s say you’re the ultimate homer with your portfolio and only want to own U.S. stocks, so you buy an S&P 500 ETF. In your head, you’ve immunized yourself to the market events and economic shocks of other countries. Not so fast. All of the companies you have exposure to may indeed be domiciled right here in the U.S., but their customer base and revenues are influenced heavily by the global economy. In fact, roughly thirty percent of S&P 500 companies’ revenues come from outside our borders. Don’t kid yourself into thinking an intentional home bias eliminates the risk of foreign markets. Like it or not, we are all global investors.

3. Efficient Markets vs. Inefficient Markets

Very few (if any) efficient markets hypothesis disciples truly believe that markets are perfectly efficient. Similarly, no honest active manager would lay claim that markets are wildly inefficient and easy to beat. Alpha doesn’t grow on trees.

My favorite way of thinking about market efficiency comes from AQR’s Lasse Pedersen:

Efficiently inefficient is the real world, it is the one in which investors live day to day. A world where competition within the investment profession results in markets that are almost efficient, but certain inefficiencies exist that may reward those for selectively taking risk and absorbing the associated costs of doing so.

4. Active vs. Passive

Repeat after me: there     is     no     such     thing     as    passive     investing. There are only degrees of active. You can actively trade using passive vehicles much in the same way you can be a buy-and-hold investor that owns actively managed funds. Hell, even the S&P 500 – perhaps the embodiment of “passive” investing – has a committee that decides which stocks to add or subtract from the index.

5. Traditional vs. Alternative

Thirty years ago emerging market stocks and high yield bonds would have been considered alternative. Today, they are staples in many asset allocation models. One man’s traditional is another man’s alternative.

The Barron’s cover story this past weekend was on Direct Lending, or as they called it – “the hottest frontier in alternative asset management.” The same lending activities that banks have been doing for centuries is now considered alternative because it’s being done by non-bank entities. Go figure. In reality, most asset classes and strategies that are marketed as alternative are simply just new ways to invest in old ways of making money.

6. Liquid vs. Illiquid

I would consider a hedge fund with a one-year lockup an illiquid investment. But to the Yale endowment, it might be one of their more liquid holdings given how much money they have tied up in Private Equity and Real Estate with +10 year commitments. I might own a small cap stock and be able to get in an out of it with ease. A large mutual fund might find it challenging to traffic in the same stock for fear of moving the market due to their size. Liquidity is in the eye of the beholder, in public and private markets alike.

7. Uncertainty vs. Certainty

It might feel like a safe move to get out of the stock market and put all of your savings in a money market fund or stuff it under your mattress. You’re making trade-off between certainty today and uncertainty tomorrow. But all of that uncertainty you thought you unloaded has instead been dumped on your future self in twenty years in the form of lost purchasing power.

8. Growth vs. Income

You invest in stocks for growth. Some of those stocks pay dividends, which is income. Bonds pay interest, but not all bonds are the same. Some are very risky and should be treated as growth investments. Many investors were carried out on stretchers in the GFC from bucketing anything with a yield into their “safety bucket.” Think function over form.

9. Systematic vs. Discretionary

All systematic, rules-based investment approaches were designed with the discretion of people. And many discretionary managers embed systematic components into their investment process in an effort to reduce – but certainly not eliminate – biases.

10. Cheap vs. Expensive

Investment expenses can be looked at in absolute or relative terms. A “smart beta” ETF that costs 25 bps might appear dirt cheap at first glance. But if you look under the hood, you might discover that for all intents and purposes the fund isn’t that much different than the broad market – which you can own for 5 bps. In this scenario, you are actually paying a great deal for the minimal amount of active risk being taken. On the flip side, the price tag for a liquid alternative mutual fund might seem steep at 1.50%, but when measured against a similar hedge fund that charges 2 and 20 it’s a bargain.

All else equal, low cost is better than high cost. But all else is rarely equal in the world of investing. Cost is an important factor in making investment decisions, but it’s not the only factor. All incremental costs need to be weighed against the expected benefits and all cost savings should be accompanied by an understanding of what you’re forgoing.

11. Luck vs. Skill

The role of luck in investment outcomes is wholly unappreciated. You could have the most sound, evidence-based process in the world and get your face ripped off. Likewise, you could be a complete buffoon and make a fortune because someone got you into Bitcoin at the right time. We all want to play the blame game when things go against us and be lauded when things go our way.

Michael Mauboussin has a great litmus test for how much luck is involved in a particular activity: how easy it is to lose on purpose? You could lose a game of one-on-one basketball pretty easily if you wanted to. Markets are a little different, which is why you have dart boards outperforming some of the most highly regarded money managers in the world. Does that make the dartboard skillful? No. Does it mean all of the success these managers have accrued is due to dumb luck? Of course not. It means that regardless of your skill level, luck will play a major role in your investment outcomes for better or worse.

12. Long-term vs. Short-term

My definition of the long-term is likely different than a couple that’s going to retire in two years. We all have different time horizons, but the one common thread we share is that the entirety of our investment lives is no more than a sequence of interconnected short-terms. No matter how you define it, we are all “long-term investors” until s**t hits the short term fan – then all bets are off.

I find it helpful to think of the long-term as the tide, the medium-term as waves, and the short-term as ripples. Rising with the tide and riding the waves is only possible if behaviorally you can navigate the ripples.

13. Investing vs. Speculating

There is a degree of speculation in all forms of investing. There are no iron clad rules to financial markets. We have a couple of centuries of market data to support our theories, but in the grand scheme of human history investing as we know it today is a relatively new endeavor. We can have a high degree of confidence that what has worked in the past will continue to work in the future, but there is an element of faith involved too.

14. Fear vs. Greed

Human beings are perfectly capable of being greedy and fearful simultaneously. We like to bucket investors as being either risk-seeking or risk-averse when the truth is that we’re all a hodgepodge of both.

15. Risk Premiums vs. Behavioral Anomalies

There are contentious debates within academia (think Fight Club for finance nerds) as to whether the historical excess returns from factors like Value and Momentum exist as compensation for taking on additional risk or as mispricing due to systematic behavioral errors. The fact that there is little consensus likely supports that both play a role. From my vantage point, having both risk-based and behavioral intuition for a given factor can only strengthen its long-term efficacy.

16. Bullish vs. Bearish

Bullish or bearish on what? And according to whom? Every trade has a buyer and a seller. In other words, there’s always a bull or bear case to be made by someone. There are cyclical bulls during secular bears and cyclical bears in the midst of secular bulls. We all joke about the phrase “cautiously optimistic” that gets regurgitated on TV and in market outlooks ad nauseam, but isn’t that the ultimate expression of grey thinking?

The silver lining for investors is that a successful investment experience is not predicated on things being black and white. And in the immortal words of Jerry Garcia, “every silver lining’s got a touch of grey.”

About the author

Phil Huber, CFA, CFP®

Phil is the Head of Portfolio Solutions for Cliffwater, a leading alternative investment adviser and fund manager. Prior to joining Cliffwater in 2024, Phil was the Chief Investment Officer for Savant Wealth Management, a multi-billion dollar wealth management firm. Phil has been involved in the financial services industry since 2007. He earned a bachelor’s degree in finance from the Kelley School of Business at Indiana University. He is a member of the CFA Society of Chicago. More about me here. Twitter: @bpsandpieces

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