“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
― Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)
Stop me if you’ve heard this one before:
“The stock market averages about 9% per year, so if we model your wealth to grow at 9% per year you’ll have roughly this huge amount of money when you retire.”
Does that sound familiar? We’re taught to appreciate the power of compound interest, and there is no doubt that it’s a central concept in the long journey of investing and building wealth. So we’re repeatedly told that all we need to do is invest broadly in the stock market for a long period of time and everything will work out in the end.
What happens if this seemingly sound advice harbors some fatal flaws that even many financial professionals overlook?
Project Hedgehog began as a series of instructions I decided to record for my son. Some of the ideas I’ve developed over the years on the topic of long-term investing are a bit unorthodox. If I didn’t document the strategies and processes in a structured way then it wasn’t likely that it would they’d be easily found anywhere else. I happened to be talking to a friend about that writing project early on, and he was more interested in the strategies than I expected anyone would be. At one point in the conversation he stopped me and said, “You should write a book about this. Where did all this come from?”
His question stumped me at first. I can remember being interested in different aspects of trading and investing for my entire adult life. Value investing in the Ben Graham / Warren Buffet style always intrigued me. I went through a phase in my late 20s where I was obsessed with dividend growth stocks. I spent years learning how to effectively trade derivative contracts alone and in conjunction with equity ownership. I’ve used forex hedges to protect foreign investments from currency fluctuations. The list is long! But after thinking about my friend’s question, I realized that I could trace the real beginning of Project Hedgehog back almost 40 years.
At the end of the summer of 1987, I was entering my junior year of high school. The one I attended was of the “boys-only”, “wear-a-tie-every-day”, “you’re-going-to-college-or-else” variety. Think of something like “Dead Poets Society” fast-forwarded by one generation. The curriculum was no-nonsense for the most part: a healthy dose of math, science, history, language. Not too many offerings that could be considered “fluffy”. I don’t remember spending much time on art or music. No shop or trade classes of any kind, even though those were still common in high schools back then. Just the basics.
One of the courses I took that particular school year in the history/social studies category covered a mix of current events, writing, and some miscellaneous practical skills for navigating the world. We were required to read several current publications regularly such as sections of the daily newspaper and a weekly news magazine. From those, we chose topics to discuss in class and or cover in written essays.
The highlight of the course for me and likely the starting point of what ultimately became Project Hedgehog was a stock market competition. We formed ourselves into small teams and were tasked with constructing portfolios of stocks and bonds using a set amount of fake dollars. We were to track the performance of these portfolios against the real market returns of the investments we chose and crown a winning team at the end of the school year based on who made the greatest profit. It was something like playing fantasy football, except we used stocks and bonds instead of NFL players. I guess that the intention was to give us a basic understanding of investing and get us in the habit of monitoring financial news.
Looking back, it was even more of an anomaly to have a stock trading activity as part of a high school curriculum than it would be if that popped up somewhere today. Keep in mind this was only 1987, so we were still years away from the cultural and technological advances that would ultimately bring active trading in financial markets into the mainstream - widespread internet access, availability of online trading platforms, the hype of the “dotcom” stock craze in the late 90s, etc. As a sixteen-year-old at the start of the school year I was only dimly aware of what stocks and bonds actually were, much less in possession of any knowledge about why I should care about them.
It was a great time, however, to introduce the subject. We were in the middle of the roaring 1980s and the U.S. stock market was riding a multi-year wave of optimism about the economy coming out of the recession of 1981-82. The Dow Jones Industrial Average (DJIA) had more than tripled during the five-year stretch from August of 1982 through August of 1987 when our schoolroom contest began.
My stock project team - being a competitive bunch - spent a fair amount of time researching and discussing various investments and strategies we could deploy in our portfolio. We focused heavily on the past track record of the companies in which we invested. If a company performed well over the last few years, why wouldn’t that continue in the current year? We also had no concept of diversification. If we found a few companies we really liked, why would we add other stocks to the mix that we liked less than those originals?
What no one seemed to know (including my team members, our instructor, or basically anyone else on earth) was that the start of that particular school year represented a localized peak for financial markets. The enthusiasm of the previous five years was dissipating and the “bubble” was about to pop. After a bumpy ride with mixed market returns in September, the signs of weakness turned to panic in October. On October 14th, the DJIA dropped 3.8%. On the 15th, another 2.4% drop. Friday, October 16th saw an additional 4.6% drop.
Then on Monday, October 19th, the bottom fell out completely. That day alone the DJIA fell 22.6%, the largest single-day drop in the history of the index. The massive crush of sell orders overwhelmed the computer systems used at the exchanges, and orders went unfilled for hours at a time. Both analysts and traders were caught off guard by the swiftness and steepness of the decline.
Other global markets experienced the same results with the UK, Hong Kong, Canada, and other stock markets all collapsing in similar fashion. The Federal Reserve stepped in over the following days and weeks to purchase billions of dollars of financial assets in an attempt to provide liquidity to struggling markets. October 19th, 1987 is still referred to as “Black Monday” in stock market lore.
Of course the portfolios of all teams in our little stock competition were simultaneously demolished in a matter of days. No one was really sure what to do. Will the market keep falling? Do we sell everything? Do we hold and hope for a quick recovery? We were as confused as the rest of the world was.
I’m sad to report that the intervening decades have bleached out my memory of what happened at the conclusion of that contest. I don’t remember which team won, or how well any of the teams’ portfolios recovered over the rest of the school year. But a few formative ideas came into my mind through this first experience in the world of financial markets.
The first idea that stuck with me was that no one seemed to be aware this crash was coming. The observation that humans are unable to foresee the future is not new, even though we still seem to spend an enormous amount of energy trying to anticipate a variety of things that might occur. We use words like “predict” or “forecast” to label guesswork about what could happen next. We might even be so bold as to assign probabilities to these possible outcomes to make ourselves feel like our guesses have more mathematical precision than should be warranted. But we will always be held in suspense until the moment in time arrives and we learn what actually happens.
The second concept that I thought about much later is more subtle than that first, and that is the disagreement ongoing to the present day about what caused the “Black Monday” crash. There did not seem to be any specific event in the financial news of the day that preceded the collapse. And of course countless articles and books have been written since the event attempting to explain the causes. Some say it was just a correction that was going to happen sooner or later. Some blamed a larger than expected trade deficit. A weaker dollar will sometimes be brought forward as a cause, puzzling because softer currency can also be attributed as the cause of inflation of asset prices. Computers and programmatic trading are the culprit in some descriptions. Investor psychology, lack of financial “circuit breakers” in the systems, rising interest rates, etc. The list is endless.
I think of this inability to explain why a past event has happened as simply the reverse of the very human mistakes we make in attempting to predict of future events. We like to use phrases such as “hindsight is 20/20” or “Monday morning quarterbacking” to describe our backwards-forecasting of the causes of things that have already happened. But these efforts are usually as ineffective as predicting the future.
I spent some time looking and it appears that there is no natural opposite of the word “predict” in the English language. The word “ignore” comes up as an option. I don’t think that word works very well because it implies that if we’re not constantly trying to predict the future it means we’re not paying attention. I also don’t like using the word “explain” for the activity of retroactively assigning causes to past events. Explaining events of the past sounds like a good idea as we should attempt to understand what is happening around us. But calling something an “explanation” probably lends more weight to its accuracy than it should.
In the absence of a good word to explain this concept, we can go ahead and invent a new one for use in Project Hedgehog:
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Post·dic·tion
Noun
A potentially misguided statement of causal explanation of a past event intended to make us feel like we understand more about our world than actually do.
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We’ll use this new word alongside “prediction” to describe these concepts when they come up. And as we explore ideas for long-term investing, we will avoid both prediction and postdiction and just look at the real information that’s available to us.
We will often see that “prediction” and “postdiction” are often joined together. When we think we have a good idea of what conditions caused a past event (postdiction), the recurrence of those conditions causes us to think the event will happen again (prediction). This can create an infinite loop of poor judgment and potentially bad ideas. History repeats itself less often than we imagine, especially in financial markets.
This concept is at the heart of Project Hedgehog. We wanted to find a way to invest for the long term without prediction of the future or postdiction of the past.
Next up: What is Project Hedgehog?
Questions? [email protected]