What’s Next?

Heraclitus is said to have been the first to assert that nothing endures but change.  Yet I doubt that it was original even to him.  In life and in business, a major key to success is anticipating the changes that the future holds and adapting to them. 

Aaron Sorkin gets it, whatever you think of his politics.  In The West Wing (I’m still a big fan – my lovely bride and I just watched a couple of episodes again this week), when President Jed Bartlet asks, often brusquely, “What’s next?,” it means that he has made up his mind and is ready to move on, even if and when his subordinates are not (see below, from Bartlet’s first presidential campaign, as he is getting acquainted with his young staff).

When Josh Lyman is on his near-death bed at the end of “In the Shadow of Two Gunmen,” President Bartlet leans forward to hear Josh ask in a whisper “What’s next?’’   When new President Santos, in his last scene of the show, finishes a quick meeting on his first day on the job, he says to Josh, his new Chief of Staff, “What’s Next?”  President Bartlet, when asked by his wife what he is thinking about as he flies home at the end of the series, no longer the President, says simply:  “Tomorrow.”

Good leadership means anticipating what’s next and figuring out what to do about it (“When Tomorrow Comes”).  But it isn’t easy.

Blockbuster once owned the video/DVD marketplace but declared bankruptcy in 2010. Other similarly dominant businesses – CompUSA, Border’s and Circuit City, for example – have suffered similar fates. In retrospect, we can see what happened.  Most obviously, the internet happened.  The internet is what came next and these companies (among others), powerful though they were, failed to adapt. 

But an interesting and necessary question that needs to be asked is why these successful companies with exceedingly well paid and presumably smart leaders didn’t see what was coming and/or simply didn’t adapt or adapt quickly enough.

The answer lies, at least in part, in our inherent behavioral and cognitive biases, most particularly the sunk costs fallacy (due in part to loss aversion and framing effects).  Sunk costs are, of course, costs that are entirely retrospective and cannot be recovered.  Truly rational decisions depend only upon likely future costs and revenues.  As such, sunk costs should not affect a rational decision maker’s evaluation of what to do going forward.  But they do.

Whether it’s law students sticking it out even though they hate law school, carnival game-players continuing to play despite lots of losing in order to win a silly prize, or the Jets hanging on to Mark Sanchez, we all look to avoid the seeming “waste” of quitting “early.”  In the investment world, where the data shows that we should generally cut our losses and let our winners run, we tend to do just the opposite.  It’s partly a simple matter of ego.  We hate to change course and are overly optimistic anyway, so we far too routinely refuse to make adjustments even though we should.

As a young varsity baseball coach (many years ago), I learned this lesson the hard way.  I was trying really hard to do a good job and to make the right decisions, so I struggled throughout the pre-season trying to come up with the right line-up.  But when I did, it never worked out the way I had anticipated.  Sometimes my evaluations were wrong.  Some kids were better in games than practices and for some it was the other way around.  Some players progressed more than others or more quickly than others.  Some caught on to what I was trying to do better than others.  But I had a lot of myself invested in my decision(s) and I was thus far too slow to make adjustments and changes.  

As recounted in Daniel Kahneman’s fabulous book, Thinking Fast and Slow, Richard Thaler has posed the sports fan’s dilemma.

“Two avid sports fans plan to travel 40 miles to see a basketball game. One of them paid for his ticket; the other was on his way to purchase a ticket when he got one free from a friend.  A blizzard is announced for the night of the game.  Which of the two ticket holders is more likely to brave the blizzard to see the game?”

We all know the answer – the fan that paid for the ticket is way more likely to drive through the blizzard to attend the game.  Sunk costs – wisdom and safety be damned.

As noted, advisors can and often do suffer from this problem in terms of money management, but the problem impacts their business management too.  I have written recently (more here) about alternative investing now being a very “crowded” trade.  I didn’t expect it to be as controversial as feedback to this point has suggested.  Indeed, it seemed obvious almost to the point of axiom because it is axiomatic in the investment world that as an approach or asset class becomes more popular, it suffers from both falling expected returns and rising correlations.  In other words, good trades get crowded and their advantages tend to disappear.  This crowding happens because success begets copycats as investors chase what has been hot.  Mean reversion only tends to make matters worse. 

Those of us who have been around long enough have seen this ongoing give-and-take happen time and time again.  Whether we’re talking about large-cap Dow stocks in the 60s (the “Nifty Fifty”), gold during the 70s, Japanese stocks in the 80s, U.S. stocks (especially techs) in the 90s, or alternatives (it seems now) in the first decade of the 21^st century, the trend is your friend right up and until it isn’t anymore.  

So I didn’t think my comments about alternative investing (paraphrased as “maybe it’s time to look somewhere else where it’s less crowded”) would be so controversial.  One can still make a good case that alternatives are useful for diversification purposes (to reduce volatility) but the argument that alternatives should be a consistent source of alpha going forward is a pretty tough one to make. Ten years ago only a few endowments used alternatives.  Now they are ubiquitous, to the tune of hundreds of billions of dollars.  That’s astonishing growth and, or so I thought, ought readily to suggest overcrowding. 

Boy was I wrong.  I heard (directly and indirectly) from a number of advisors who disagreed.  Some vehemently.

But, upon reflection, it is clear that lots of advisors have a lot invested in their current approach.  It’s a source of pride that it has worked well for them and their firms.  They have gone on record as advocating it and its benefits.  Those who were around and benefitted from a hugely profitable product or approach find it hard to believe that those days are going or even gone.  They see me as having challenged their intelligence.  Part of it is sunk costs.  And some of it is perhaps ego.

But I’m not telling advisors that they were wrong or foolish to have acted as they did.  Au contraire. Instead, I’m asking them to consider what’s next and adapt accordingly. I’m asking all of us to think about tomorrow.

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