Arnott: Institutionalizing Courage

May 31, 2012

Investors need courage to stick with the profitable strategy through both the good times and the bad.


Imagine a boss who is generally supportive of your efforts, but has some odd tendencies around rewarding initiative. Let's call him Mr. Market.1 Every time you go in for your annual review, Mr. Market gives you a raise which is usually 1% or 2% above inflation, and asks, "Whaddya think?" If you're "passive" and take whatever Mr. Market offers, you wind up with a steady but modest increase in your income, year after year, assuming the company is still doing well.

Mr. Market, however, does not view all projects equally. If you offer to take over some project that he hates, he boosts your raise by an average of 3–6%. With a little initiative, you can triple the average real raise—over and above inflation—that everyone else is getting.

Unfortunately, Mr. Market is also bipolar, with wide mood swings. If you're willing to take on a project that he really hates, he may give you a 15% raise, just to get it off his desk. On the other hand, if you're taking a project that he doesn't much mind doing, he may actually take away some of the normal raise. Because you run this risk every time you propose to take on a new project, it takes a modicum of courage to make these offers to the boss.

With a boss like Mr. Market, what is the right strategy for success? The answer is obvious: You need the courage to stick with the profitable strategy through the good times and the tough times. We'll come back to Mr. Market shortly. First, we need to understand the true nature of wealth, income, and spending.

Sustainable Spending As A Strategy
Although people tend to measure wealth in terms of the dollar value of a portfolio, we believe it is better to measure wealth in terms of the real spending that the portfolio can sustain over the entire life of the obligations served by the portfolio. In 2004, we coined the expression "sustainable spending," to gauge this true value of a portfolio.2 Jim Garland used the term "portfolio fecundity," to describe much the same concept.3

Consider a simple thought experiment. It's a bull market. Prices double on everything we own, while the dividend yield drops in half. Are we better off? The long-term spending that the portfolio can sustain hasn't changed a bit. In 1997, Peter Bernstein and I4 pointed out that bull markets are actually very bad news for those who are net savers, building a portfolio to fund future needs, because it costs more to buy the same real income stream (a very crude measure of sustainable real spending5) after the bull market than before. We're better off only if we're spending from the portfolio immediately, not saving more for the future!

Many people felt jubilation at the peak of the tech bubble, because they felt so wealthy. And they were—as long as they were inclined to liquidate their holdings and spend before the market lost its euphoria. If they were still investing (e.g., for some future retirement), those new purchases bought precious little yield! Reciprocally, people felt panic and dismay at the 2009 trough of the financial crisis, because they felt as if their assets had been wiped out. And they were—if they intended to liquidate and spend their assets immediately. But, for the buy-and-hold investor, their real income was higher than at the 2007 peak!

None of this is unfamiliar to the serious student of capital markets. So, what lessons can the thoughtful observer learn from "sustainable spending"? In the following discussion, we find bear market drawdowns have little impact on sustainable spending. Indeed, these sell-offs provide opportunities to increase our sustainable spending through disciplined rebalancing between asset classes or within asset classes, especially volatile ones like equities.

This requires courage: "no guts, no glory."6


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