Weekly Market Commentary 3-7-2011

Inductive reasoning is one of the many thought processes we use today to make decisions and has helped us survive throughout our history. It's our ability to make judgments (or should I say “educated guesses”) based upon past experiences.

For example: We might believe that snakes are scary and dangerous. This belief can be formed without having specific or deep experience with snakes because we can call upon our past teachings, readings and life lessons to draw this conclusion. In most cases, this type of inductive logic can keep us safe.

Now we know that not all snakes are dangerous. However, probability suggests that we should stay away or approach with caution, as some snakes can be deadly. We let the past influence our current actions based upon our ability to quickly draw on probabilities and outcomes.

Unfortunately, this inductive reasoning can lead investors far astray. By simply looking at the past performance of asset classes and drawing broad conclusions about the future can be probabilistically accurate and also be wrong. Whatever the odds are, if they turn against you, wrong is wrong.

That's why I always ask myself 6 questions before I invest in an asset class. I learned this several years earlier from Ben Inker at GMO, a well-respected Institutional Asset Manager. He reiterated these in “Back to Basics: Six Questions to Consider Before Investing” a white paper published in October 2010 and I thought I would share them with you:

1) Would a rational investor buy this asset class if it did not offer returns above cash?

2) Where do the returns from this asset come from, and who funds them?

3) Why would the funder of returns for this asset be willing to offer a return greater than cash in the long run?

4) Have the historical returns been consistent with the risk premium we expected?

5) Have the sources of the returns been consistent with the returns achieved?

6) Has something important changed to make us doubt the relevance of the historical returns?

While these questions aren't exhaustive they do help me from falling into the trap of only looking at past returns and not reflecting on the probabilities of being wrong. Unfortunately, unlike in life, jumping to broad judgments when investing doesn't always keep you from getting bitten.

I always appreciate any direct comments or feedback. Please send it to my email at: tphillips@phillipsandco.com

Tim Phillips, CEO