Mistakes of Omission Are More Costly Than Bad Investments
February 29, 2024
We’re more likely to make mistakes of omission, not commission.
—Warren Buffett
Simplification is something we value highly at Komara Capital Partners. We strive to make complex topics understandable and avoid unnecessary operational complexity by adhering to Albert Einstein’s principle of making things as simple as possible, but not simpler.
With the recent large movements in some stock market segments – which have prompted declarations of another tech bubble – we are reminded of the biases of commission and omission, and their relevance to trend following.
The biases of commission and omission correspond to statistical concepts known as type 1 and type 2 errors. Simply put, type 1 errors mean taking an action that should have been avoided, while type 2 errors mean failing to take a necessary action.
Trend following, which involves seeking to cut losses and let winners run, naturally accepts type 1 errors (commission) and aims to avoid type 2 errors (omission). We believe accepting a small, predetermined loss is preferable to missing out on a profitable investment. The issue with missing profitable investments, as some investors are currently experiencing, is twofold:
- Missing out on a profitable investment
- Being forced to take subsequent risks that would otherwise be unnecessary and likely avoided
In this Investment Update, we examine recent instances that highlight the cost of “sins of omission.” We also emphasize the importance of reviewing missed opportunities and the value of employing systematic investment strategies, like ours, to keep clients on track toward achieving their financial goals.
But first, here’s a summary of the global asset classes utilized in our portfolios and their exposures for March.
Asset Allocation Update
Source: Blueprint Investment Partners
Adjustments can vary across strategies depending on each strategy's objectives. What's illustrated above most closely reflects allocation adjustments for the Growth Strategy. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility
U.S. Equities
International Equities
Exposure will increase and remain underweight overall. Foreign developed will not change from last month, but emerging market equities have regained uptrends across both timeframes.
Real Estate
U.S. & International Treasuries
Exposure will decrease and move to underweight as the intermediate-term trend has turned negative. The long-term trends remain positive.
Inflation-Protected Bonds
Exposure will not change due to the relative weakness of the asset class versus nominal Treasuries.
Alternatives
Exposure will not change. The baseline allocation for gold is also our highest limit, so we are already at the maximum allocation as trends in gold remain positive across both timeframes.
Short-Term Fixed Income
Exposure will increase and move to overweight as it takes on exposure vacated by longer-duration fixed income instruments.
Asset-Level Overview
Equities & Real Estate
As February draws to a close, the S&P 500 Index continues to enjoy an excellent start to the year with the largest technology and communications companies fueling a rally and bringing equity asset classes into positive territory. After making a new all-time high for the first time since the opening trading day of 2022, the S&P 500 surpassed another milestone when it closed above 5,000 for the first time on February 9. As has seemingly become customary, other segments of the market, such as value and dividend stocks, continue to lag. However, returns still managed to be positive across the board. For March, Komara Capital Partners portfolios will generally see a small decrease to U.S. equities, as it returns exposure to previously weaker international equities, which is described below.
Looking abroad, foreign equities once again slightly underperformed their U.S. large-cap counterparts, but finished positive for the month. In emerging economies, the lag relative to U.S. has been jarring at times, with economic weakness in China continuing to drag EM equity assets lower. In fact, allocations to emerging market equities in Komara Capital Partners portfolios were at their minimum due to downtrends over all meaningful timeframes in February. The modest bounceback in the asset class will cause exposure in our portfolios to increase, but it will remain underweight as the system continues to favor stronger U.S. equities.
Real estate steadied in February after retracing in January. With the relatively flat returns during the last month, it will remain in negative territory for the year. Despite the year-to-date performance, the overall picture for the asset class has not changed, as the upward trends continue.
Fixed Income & Alternatives
With many segments in equities closing February at or near new all-time highs, fixed income generally continued to experience a retracement, as market sentiment about the timing of rate decreases continued to shift out further. From a price perspective, the strongest areas of the yield curve continue to be on the short-end, with longer-duration bonds being the weakest. Allocations in our portfolios will undergo a corresponding shift, with longer-duration bonds being vacated in favor of higher yielding, ultra-short-term bonds.
Gold prices are on pace to be down in February. However, trends continue to be positive as the month ends. As a result, exposure in our portfolios will not change and will remain at its baseline allocation.
3 Potential Catalysts For Trend Changes
Food Inflation: The last time Americans spent this level of money on food costs, George H.W. Bush was in office, the Super Nintendo was released, and the Dow Jones Industrial Average closed over 3000 for the first time.* Eating continues to cost more and more, even though overall inflation has eased from 2022 and 2023. Restaurant and other eatery prices were up 5.1% compared to January 2023, and grocery costs followed suit with an increase of 1.2% during the same period. (*Extra Points if you can guess the year.)
Economic Pause: The U.S. economic growth paused in January after brisk growth at the end of 2023. Retail sales fell 0.8% in January from December, worse than what was initially expected. Federal Reserve data showed January industrial production crawling down 0.1% compared with positive expectations. While technical factors may have exaggerated the weakness, a pullback by consumers could spell a weaker outlook for growth this year than in 2023, especially since consumers account for about two-thirds of economic activity.
Future Cuts: As of last week, interest-rate futures suggested that there was a greater than 50% chance the Federal Reserve would start cutting rates come the June meeting. The futures also indicated that investors believe the central bank will likely cut rates by a quarter-percentage point at least three more times by December. Joe Davis, Global Chief Economist at Vanguard, said recent data suggests current interest rates aren’t providing as much of a drag on the economy as Fed officials have thought.
Upside, Downside & Opportunity Cost
The cost of being wrong is less than the cost of doing nothing.
—Seth Godin
Discussions about trend following typically emphasize seeking to protect against downside risk and capital preservation. However, with many equity markets near all-time highs, we think it’s important to explore other facets of this strategy. For example, we believe trend following’s ability to capture the upside is crucial, even if this attribute generally receives significantly less attention.
Building on our previous Investment Update, we are taking a slightly different direction this month.
Systematic Investing Can Help Capture The Upside
The art and science of trend following seems to remain a mystery to many financial professionals. However, it seems to be generally understood that tactical, systematic, trend-following processes may provide beneficial downside protection during times of extended crisis in financial markets.
We have the privilege to discuss our process with many clients, and they generally either already know, or are quick to learn, that vacating weaker markets in a rules-based way can reduce the left side of the distribution where very bad things occur in markets. What appears to be less understood or underappreciated is the ability of trend following to capture upside in a way few investors have the courage to do on a consistent basis.
Take NVIDIA (ticker: NVDA) for example. We are beginning to lose count of the times we’ve heard some variation of the following statement. “Yeah, I bought it a while back and made a good return but got scared and sold it.”
As an illustration, let’s look at a basic and widely used trend-following strategy that involves buying an asset when its end-of-month price exceeds the 200-day exponential moving average. In the case of NVDA, this last occurred in January 2023.
Typically, trend following strategies don’t reduce exposure to an asset until certain pre-defined conditions are met. In this case, one might be to reduce exposure when the price of the asset class or position, at month end, is below the 200-day exponential moving average, which was the case for most of 2022 for NVDA but hasn’t been the case since January 2023.
Now, let’s bring the buy and sell rules together to summarize our point. Using those simple trend-following rules would result in an investor:
- Being out of NVDA for most of 2022, when the stock experienced roughly a 50% decline
- Purchasing NVDA early in 2023
- Continuing to hold NVDA until the trend reverses
Trend followers don’t exit when financial services pundits say it’s time to sell, or because their gut tells them to do so. The exit timing comes only when the trend reverses – period. We and others believe this provides an opportunity to ride the coattails of well-performing positions for as long as possible.
Why Do We Ignore Missed Opportunities?
While human nature often calls us to examine the cost of making a choice that in hindsight we shouldn’t have made (i.e., sins of commission), people rarely go back and diligently evaluate the cost of not doing something they should have done (i.e., sins of omission). The latter is otherwise known as opportunity cost. However, reflecting on opportunity cost can yield powerful lessons that inform future choices.
This lack of circumspection creates a bias, where future opportunities may be missed due to not fairly evaluating the whole historical picture and how alternative decision-making processes could have helped. For example, how many investors have let their memories of an investment that lost money stop them from reinvesting in a market, whether NVDA, the S&P 500, or otherwise, only to see that market make a sizable run without them?
Why do we ignore missed opportunities? Perhaps it is because what might have happened is opaque and fuzzy (i.e., requires work and self-knowledge). Perhaps a fear of finding the truth and experiencing dissatisfaction with what we discover causes us to avoid doing the research as a defense mechanism.
Unfortunately, we cannot give a simple answer for why we ignore missed opportunities, but what we can say is that, in our opinion, one of the most unheralded benefits of trend following is that it eliminates this blind spot and resulting bias. When we embrace a systematic approach, we gain access to a fully developed plan to address any and all market scenarios. Are the results always perfect? No, not any more than anything else in this world, but the drive for perfection is often the enemy of achieving what is optimal or sufficient.
It reminds us of a saying that economist Milton Friedman often used. In short, he said that those who focus on equality at the cost of liberty will get neither, but those who focus on liberty over equality will get a large measure of both. As it relates to this month’s Investment Update, we argue that those who favor perfect results over consistent returns will get neither, but those who favor consistency over perfection will get a large measure of both.
Without a doubt, the hardest part of serving investors is keeping them on course. Three years can seem like an eternity in our instant-gratification culture, but it is no time at all in the grand scheme of most investor’s long-term goal. In our view, good strategies are built for a lifetime of investment possibilities, not three or even five years, let alone a calendar year. This conflict is a big obstacle to helping clients achieve their goals.
Fortunately, we continue to encounter clients who are open to understanding more about this concept and embrace the challenge. For this we are eternally grateful. We will never be everyone’s cup of tea, but we are thankful we don’t have to be. We are happy to continue serving those who appreciate the consistency of a trend-following approach, and we will continue to search for more tribemates!
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If you have any questions about what transpired in the markets last month or portfolio positioning for the month ahead