The “First Pancake” Rule of Investing

The “First Pancake” Rule of Investing

If you have ever made pancakes you know this to be true.  The first pancake usually goes to the bin.  Or a super hungry kid.  Or a dog 🙂

I am not sure why this but it seems to be a law of nature that the first pancake will either be not done enough or too done.  

What’s really interesting is how we react to this.  

Everyone just seems to accept the fact that to get a stack of perfect pancakes, you need to screw the first one up 🙁

With pancakes, we accept failure as the first ingredient to success.   

BUT when it comes to investing…WE react completely differently.   

Heaven forbid that we have a stock in our portfolio that shows a loss!   

Investors will focus obsessively on one investment that is losing money even if the rest of the portfolio is in the black.  

This behavior is called loss aversion.   

Investors have been shown to be more likely to sell winning stocks in an effort to “take some profits,” while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”

It also doesn’t help too that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.

We refuse to eat burnt pancakes and make no hesitation to throw them out and so too we should refuse to hold a losing stock position.  

And if you think that hiring a professional money manager saves you from such mistakes, I have bad news for you.  A couple of white papers by Barberis and Thaler (2003) and Shefrin (2000) find that professional money managers are far from immune to these biases. They are human after all.

And this leads us to the big reason that we use a systematic, rules-based process for our investing.

Rules based investing helps eliminate human emotion and the negative impacts of human behavior.  

By consistently applying the same rules over and over, we can quantify our probability of expected outcome.   

We know that there will be some “burnt pancakes” along the way.  But we also know that the quicker we are to get rid of them the sooner our plate is stacked with “perfect pancakes”.  

So the next time you are staring at your portfolio, remember the “first pancake rule”.  

Hedging Tail Risk within an Adaptive Asset Allocation Framework

Hedging Tail Risk within an Adaptive Asset Allocation Framework

Systematic models offer investor many benefits that can include the automatic and dynamic process of defensively adjusting a portfolio during periods of market duress.  


When using cross-sectional or time-series momentum to rank and allocate a universe of ETFs the common rebalancing period is monthly.  I have tested longer and shorter rebalancing periods and the returns degrade significantly. 


One of the more common questions I receive is “what happens if there is a significant market event between monthly signals?”.   If there is an Achilles heel to monthly rebalancing, this is it.


Nassim Taleb made popular in his book, “The Black Swan”, the idea that important events are both rare and unpredictable.  It is the nature of this unpredictability that causes angst for investors.  


One approach to managing this risk, and as practiced by Universa Investments L.P, the firm to which Nassim is an advisor to, is to engage in tail risk (portfolio insurance) through specialized option trading.  (Incidentally, in a recent interview, Taleb sees worse tail risks than in 2007.)


Such an approach is more practical to an institution that can afford to engage in such a strategy and who makes the decision to allocate a portion of their portfolio to portfolio insurance. Overall the strategy provides asymmetric, positively-skewed payoffs exposed to small losses when refuted and very large gains when not.


For a smaller investor, attempting to construct an option strategy could be both time consuming and costly and assumes one has the expertise to do this on their own.


Inverse funds are not a solution either when considered as a permanent allocation given the mathematics of the daily rebalancing.  Inverse funds can and do work to provide a source of positive returns during market declines but should not be used as a permanent allocation as a way to hedge unpredictable market declines.  I have found a way to successfully utilize them into our rules-based strategies but their use is for limited periods of time only.   


This begs the question as to what an individual investor can do.


Fortunately, a new ETF from Cambria (Meb Faber’s company) may provide a solution for investors who want to make a more permanent allocation in an attempt to mitigate tail risk.  


The Cambria Tail Risk ETF (TAIL) invests in a laddered portfolio of “out-of-the-money” put options with a portion of the fund’s assets while the majority of the assets being held in intermediate treasuries.   


What I like about this strategy is that the income from the treasuries can help offset some of the costs associated with the put options.   The other potential advantage is that the fund will buy more options when volatility is low and  fewer puts when volatility is high.    


What could go wrong?  Since the greatest percentage of assets are held in 10 year U.S. Treasuries, any losses in the credit markets could negatively impact the price of the fund in addition to the expected losses that will occur during rising stock prices and periods of low volatility.


Historically, the 30-day correlation between 7-10 year U.S. Treasuries and the S&P 500 has ranged between .58 to -.89 with most of the observations since the beginning of 2001 being negative.   This would imply that the USTs are in themselves a non-correlated return stream. And of course, a basket of market puts will also be negatively correlated to a U.S. stocks suggesting that TAIL should provide true diversification for investors looking to add a non-correlated strategy to a long-biased portfolio.


Within the framework of a systematic rules-based approach such as used within Portfolio Cafe models, I see TAIL as a potential tool to help mitigate unpredictable market events that can be easily implemented with minimal costs.    


Three Investment Lessons from a Baseball Legend

[vc_row full_width=”stretch_row_content”][vc_column][vc_single_image alignment=”center” image=”262″][/vc_column][/vc_row][vc_row css=”.vc_custom_1453148015986{padding-top: 60px !important;padding-bottom: 60px !important;}”][vc_column][vc_column_text]Growing up I was a baseball fan for as long as I can remember. The Reds and the Mets were my early favorites but once my parents set down roots in the midwest I became the Cardinals fan I remain today.

Despite team favorites, there was one baseball player that all fans liked and his name was Tony Gwynn.
Tony Gwynn was one of the best pure hitters of all-time. He won the batting title 8 times and a .338 lifetime batting average (for those non-baseball fans, it was the highest career average for any player who started after WWII).

And when Tony Gwynn was eligible for the Baseball Hall of Fame – he got in on the first ballot (not that there was any question he would get in on the first try).

This past weekend, Tony Gwynn passed away at the age of 54 from salivary gland cancer and the baseball world is mourning.

So what does a baseball legend have to do with successful investing?[/vc_column_text][vc_video link=”″][vc_column_text]


For Tony Gwynn, it was about getting base hits. He didn’t try to hit a home run – he would just beat you with singles and virtually never strike out. Sure, the home run hitters get all the glory, but Tony didn’t care about the glory, he beat you with the singles. And it was those thousands of nice and easy base hits that added up to a hall of fame career.

Investing Takeaway: When it comes to investing, what makes a long term winning track record is not the occasional 10 bagger that you are lucky to find yourself owning. Rather, it is the small but consistent wins that compound over time…the dividends collected, option premium earned, the costs saved, and the consistent profits that can be earned from trading a system that provides positive mathematical expectancy.
Show me an investor who has blown up his portfolio and I can guarantee you that it was because he or she was swinging for the fences…always trying to hit the ball over the fence and paying little attention to managing risks or capital control. As in baseball, small consistent wins can keep you in the investment game for a lifetime.


Tony played for twenty years. By knowing what he was good at and focusing on that one thing (base hits), he played professional baseball for two decades. He knew by just getting hits, it will help his team win and he wouldn’t be the “flavor of the month”. The final result was 3,141 hits over twenty years.

Investing Takeaway: Successful investors find what they are good at and once they do, they stick with it. A successful investment approach is one that meshes with an investor’s personality and goals. For some investors, it might be the intensity of day trading and the idea of going home flat every night that works. For others, it might be growing a portfolio of dividend achievers and letting compounding do its magic over time. Regardless of where you fit within the spectrum, the key is to find an approach that fits and to stay with it.

Ideally, I want an approach that can capture most of the upside while protecting me from most of the downside.

For me, systematic, rules-based investing is the approach that I am most comfortable with. It keeps my emotions in check, it provides discipline, it manages downside risk, and it automatically adapts to the ever changing markets. I don’t have to worry about guessing what the markets are going to do next. I know that my models will adapt and that’s all I need to know.

Investors who are constantly chasing systems and investment fads typically make no progress and are often near dead broke. There is no Holy Grail and no Get Rich Quick Scheme…give it up before its too late if you find yourself getting caught up in this.


In a era where professional athletes hop from team to team for a bigger paycheck, Tony Gwynn was loyal. He played his entire career for ONE team, the San Diego Padres. The relationship he had with San Diego fans led to the team literally building a statue of Tony at the ballpark!

Investing Takeaway: Once you have found the approach that works for you, follow it day in and day out. Yes, I know that can be boring. Within all us is the desire for excitement and for change….but when it comes to investing, the more times we can repeat a process that has positive mathematical expectancy, the more likely we will be successful. Don’t believe me? Think about a casino. They know and they have built their lavish buildings on players staying at the table, hand after hand, roll of the dice after another. The problem here though is they have the edge and you don’t. In investing, it is easy enough to find an approach (Portfolio Cafe, cough, cough) that gives YOU the edge. You simply have to be willing to stick to the discipline of following a system. Find what works and become loyal to the process.

They broke the mold when they made Tony Gwynn, both the baseball player and the man. And there are many lessons to be learned by looking back and reflecting on his life.[/vc_column_text][/vc_column][/vc_row]