Addressing What We Know We Don't Know (3 of 3-part series)

"I don't have to be right. I just want to win."

- Kevin Plank, Founder, UnderArmour

You know what you don't hear uttered much these days?

"Hey, isn't that the contrarian's Ferrari parked over there?"

I'm as guilty as anyone. We like to be right. And from what we know about behavioralism, we really, really don't like to be wrong.

But at what cost do we hold our views?

Look, we are all largely self-centered people. We are predisposed to believe that the circumstances surrounding our particular environment are unique - that this time it's different. And we have strong survivorship biases - especially around our financial security.

The fact is, inefficiencies in the market will persist. If valuations were always rational, this would all be a lot more straightforward. And while we may claim to be investing with a long time horizon, we also own our decisions daily, in real time.

The logical portfolio response to this uncertainty is to anchor our investment approach to some factors we feel can be reasonably known.

We can basically divide risk in the world around us into three categories:

• Things we know ("knowns")

• Things we know we don't know ("known unknowns")

• Things we can't possibly know ("unknown unknowns")

Returns follow risk: there is rarely much return offered for betting on unassailable facts (knowns) or any predictable way to profit from extreme tail events (unknown unknowns). As investors, we spend most of our time trying to conquer the known unknown world

This mental struggle is largely moot for stringent buy-and-holders. This camp effectively expands the "known zone" through a reliance on efficient markets; in its efficiency, the market provides a proper level of premium for the current level of risk. Everything else is an unknown unknown that should not bear upon investment decisions.

For a more active investor, the answer is not as binary. While not claiming omniscience over future price moves, the view here is that markets are frequently irrational. That valuations matter. The concept of a known unknown does a very good job of encapsulating that opinion: future outcomes - while uncertain - are probabilistically tied to deviations away from measurements of fair value.

Investors differ on how much of the unknown future they attempt to gain an edge - to convert an unknown to a "more likely known." The toolbox for this endeavor can be filled with fundamental and technical indicators. Those signals can be applied to a portfolio with a wide range of asset classes or just a few. These assets can be analyzed as an indexed group or as individual securities.

This sounds overwhelming for even the exceptional individual investor. That means a lot of sleepless nights, and likely inefficient investment performance.

It is crucial as investors that we narrow the scope of known unknowns that we address in our investment plans, so as not to be paralyzed by the myriad uncertainties confronting us. To do this, we need to reevaluate both our asset selections and portfolio construction methodology to determine the nature of the risks we are taking - with the goal of having greater assuredness in our plan, and as little pure risk (unknown unknowns) as possible.

So, what are some things that can be reasonably known? Here are a few thoughts:

• Costs matter. In fact, the management fee is about the only thing you can know with reasonable certainty when you buy a fund.

• Tax efficiency matters. This is a complex discussion for another time, but incredibly important. Tax inefficiency is a very real portfolio drag.

• Dividends matter. They are a vital component of returns, not to be overlooked (nor chased without regard to value).

• Valuation matters. All else equal, I'd rather buy something cheap than something expensive.

• Diversification matters. It's referred to as the only free lunch in investing. But only if you pay attention to...

• Correlations matter. Diversification is pointless if comprised of highly correlated assets.

• Global perspective matters. Home country bias ignores valuable diversification opportunities.

• Mean reversion matters. It's in the nature of markets that exhibit long term efficiency. But also...

• Momentum matters. It's in the nature of markets that exhibit short term inefficiency.

• Risk tolerance matters. Honesty informs expectations, keeping in mind that circumstances can change over time.

So, practically, what does this mean?

1. Asset allocation should be comprised of low-cost, tax-efficient funds within significant global market sectors that display long-term attractive risk/reward and limited correlation to each other.

2. The equity component of this mix should contain some core exposure (most market-cap weighted vehicles are skewed towards growth companies), complemented by a focus on dividends and value.

3. Portfolios should be rebalanced regularly to capture mean reversion, in the process selling high and buying low. That said, some buffer zone can be applied to allow short-to-intermediate-term momentum to run.

4. Plans should be revisited periodically to determine whether they are optimized in relation to current risk tolerance.

And, hopefully, get some sleep.

DD