How Much Does Our "Investment Upbringing" Shape Us?

“Three Identical Strangers” delves into the age-old nature vs. nurture question. The documentary film chronicles the amazing story of identical triplets separated at birth and reunited 19 years later.

How did it happen?

A prominent psychologist worked secretly with an adoption agency to place the boys in very different households. He wanted to study how people with identical DNA would evolve if they grew up in different environments.

After a crazy chance encounter led to the three brothers being reunited (I won’t spoil the story), the boys discovered they shared many natural similarities. For instance, they smoked the same brand of cigarettes. Liked the same food. Two of them even attended the same college.

And yet the brothers also had key personality differences. The filmmakers hypothesize this resulted from growing up in different households. One brother was raised in an upper-class family, one middle-class, and one lower-class. The three also experienced different styles of parenting.

As I’m sure was the case for many, the film made me feel sorry for the brothers. Their lives should never have become a science experiment.

It also left me contemplating how investing bias might be skewed by the market environments we “grow up in.” 

Market environments shift dramatically over time 

I recently corresponded with retired money managers who got their start in the business during the 1970s. They described how an early mentor preached the importance of favoring companies with hard assets that appreciated with inflation.

In hindsight, it makes sense. Inflation was the main macro story of the 1970s.

After President Nixon severed the dollar’s link to gold in 1971, the dollar plunged, causing commodities to soar. From 1972-1973 the price of oil spiked over 300%.

The dollar continued to fall throughout the decade.

Why were hard assets attractive back then?

When someone buys a stock or bond, they invest in the future. Specifically, a future income stream. Whether it be dividends or interest, if the currency the income stream is priced in depreciates, the future payoff is worth less in real-terms.

For this reason, when the dollar depreciates over a prolonged period, money migrates away from instruments whose value is in the future (i.e. stocks and bonds), to assets whose value is already substantiated in the here and now. Tangible, hard assets (i.e. gold, real estate, art, oil, etc.). 

As inflation and hard asset values went up during the 1970s, so did interest rates.

Equity P/E ratios went the opposite direction.

In August of 1979, BusinessWeek published a now infamous article titled: “The Death of Equities.” Here is an excerpt:

Before inflation took hold in the late 1960s, the total return on stocks had averaged 9% a year for more than 40 years, while AAA bonds—infinitely safer—rarely paid more than 4%. Today the situation has reversed, with bonds yielding up to 11% and stocks averaging a return of less than 3% throughout the decade.

As a result, even institutions that have so far remained in the financial markets are pouring money into short-term investments and such “alternate equity” investments as mortgage-backed paper, foreign securities, venture capital, leases, guaranteed insurance contracts, indexed bonds, stock options, and futures. At the same time, individuals who are not gobbling up hard assets are flocking into money market funds to nail down high rates, or into municipal bonds to escape heavy taxes on inflated incomes. Few corporations can find buyers for their stocks.

The trend is your friend, until it ends

In 1978, Pittsburgh National Bank hired a young lad named Stan to cover oil equities.

Little did the hiring manager know Stan would soon take his job, and later become arguably the greatest investor of all-time.

Before he became George Soros’ right-hand man, and averaged over 30% annual returns for three decades, Stan Druckenmiller was promoted to head of research at Pittsburgh National Bank.

Druckenmiller explained his rapid ascent at the bank in an interview for the book,The New Market Wizards.

The director of investments was Speros Drelles—brilliant but also eccentric.

When he promoted me I was twenty-five, my exiting boss was 50 and all the other analysts had MBAs and had been in the department longer than me.

He said: You know why I’m doing this, don’t you? For the same reason they send eighteen-year-olds into war—they’re too dumb to know not to charge.

I think there’s going to be a huge, liquidity-driven bull market sometime in the next decade. I have a lot of scars from the past ten years, while you don’t. I think we’ll make a great team because you’ll be too stupid and inexperienced to know not to try to buy everything. That other guy out there (referring to Druckenmiller’s boss who he was replacing) is just as stale as I am.

As Drelles suspected would happen, the asset management playbook in the 1980s and 90s shifted from what worked in the 70s.

In the 1980s, President Reagan reversed the weak dollar policies promoted in the 1970s by Presidents Nixon and Carter, along with their Treasury departments. The dollar rallied sharply, and treasury yields began a long, steady slide lower. Much lower. 

As this occurred, hard assets lost favor.

Meanwhile, investors gained courage to bet more on the future, and huge bull markets erupted in stocks and bonds.

Staying nimble was a critical ingredient to Stan Druckenmiller’s success over subsequent decades, as he cemented his reputation as one of the shrewdest and most creative macro traders on the planet.

“You need to be decisive, open-minded, flexible, and competitive.” - Stanley Druckenmiller 

What’s next?

Are you staying nimble in your market outlook?

As a test, consider how your perception of markets may be impacted by the investing environment you grew up in.

For instance, there are many young people working on Wall Street who have never experienced a bear market in their careers. How will that impact them going forward? 

Conversely, if you’re part of the Baby Boomer generation, you likely recall the Tech Bubble and 2008 Financial Crisis. Those experiences may have conditioned you to believe all bear markets involve torturous drawdowns. You may be overly cautious with how you’re investing, considering the average bear market has been tamer than those two affairs were.

It’s important to take inventory of your investment experiences. It’s ok to have biases—we all do. The only danger is if you’re unaware you have them.

One risk on my radar now is the inflation outlook. With the U.S. unemployment rate hovering around 4% and labor slack mostly dried up, wage inflation pressure is likely to mount. 

Another factor that drives inflation is the dollar’s trajectory. In March of 2018, I penned a note expressing a bullish thesis for the dollar. Today, however, I’m leaning the other direction.  

* Government spending in the next few years will likely widen the budget deficit.
* A more dovish Fed will likely reduce the yield spread attracting foreign capital to U.S. bonds.
* The previously favorable technical setup for the dollar has flipped the other direction.

So, here’s the big macro “What-if” I am actively considering: What if the dollar is about to put in a secular top, and inflation accelerates more than people expect?

What would be the implications for bonds? Precious metals? Sector leadership? 

Another possible implication if the dollar turns: international investments would gain a positive currency carry that’s been lacking in recent years. Might that provide the fuel to spark a global rotation, closing the big valuation gap between U.S. and foreign equities? 

It may be a turn in the dollar. It may be something else.

All I know for sure is it won’t be too long before I need to adopt a different investing playbook. And when I’m convinced that time has arrived, I’ll probably start looking for a 25-year old to be my Director of Research.