Thursday, January 1, 2015

Marks' "failure of imagination" and the new year


Howard Marks often talks about the "failure of imagination" as one of the key problems with investment management. Investors do not see the full set of possibilities no matter how improbable. Additionally, most investors do not think about second order effects of the some shock to the investment world. For example, investors did not see the decline in oil prices and certainly have not fully realized the secondary impact of the decline across markets. This will lack of imagination will continue to be played out in 2015.

This failure of imagination is being unable to conceive of all of the alternatives or possible outcomes.  What is not thought of cannot be handicapped. It cannot be put into the possible states of the world. The lack of imagination increases the likelihood of surprises. For many, the surprise event is only a surprise because it as not not though possible no matter how unlikely.

The failure to imagine means that we do not see or accept change when it occurs. Market failures are rare events, so we naturally are not going to imagine what the world will do differently in those situations.

The failure of imagination is also being unable to think across assets. If an event occurs in one market, will it spill over to the next market or asset class? You may imagine a decline in oil prices, but do you fully realize what this means for growth or inflation? Can you conceive what the impact will be on interest rates or credit markets? The quantitative analyst will focus on asset correlation, but this is a much simpler idea. You do not need the stats to think about the linkages across markets. In fact, assuming correlations stay the same may be the greatest lack of imagination.

Is it possible to gain investment imagination? It is not easy, but there could be some simple steps to help the process. The first and foremost understanding what the world is like at a given moment. If you do not know the current state, you cannot determine or imagine different states. Second, is engaging in the research of looking for change in relationships and understanding the history surrounding past market events. Your imagination is limited if you do not know the history of markets. The final and hardest part is conceiving what can change in the current environment. Of course, a simple way to increase imagination is to just not follow the consensus or think about what is an alternative to the consensus. The consensus at the beginning of 2014 was for higher oil prices. The simple imagination test is working through scenarios which could cause a lower oil price.  Imagine the opposite as a start. For example, good risk management is just imagining what you will do if something goes wrong.

 For 2015, let's increase our investment imagination. 

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