Butterfly Wings, Long Winters, and your Portfolio. – Q1 2014

Butterfly Wings, Long Winters, and your Portfolio. – Q1 2014

“Spring drew on…and a greenness grew over those brown beds, which, freshening daily, suggested the thought that Hope traversed them at night, and left each morning brighter traces of her steps.”

― Charlotte BrontëJane Eyre

By Dylan B. Minor PhD, MS, CFP, ChFC, CLU, CIMA

Brontë’s words especially ring true this year, as we thaw out from a long, deep Chicago winter.  Indeed, at some 82” of total snowfall this season, we have easily doubled our average annual snowfall, as well as set a 35 year record, notching the third greatest snowfall on record.[1] These conditions created some real challenges, for which some resourceful Chicagoans rose to the occasion. To see how a local Chicago anchorman made due, see him tell his secrets through his singing of his version of “Let it Go,” which can be found here.

Shuttling back and forth between Chicago and Santa Barbara brought a strange contrast this past year: while Chicago set a precipitation record, Santa Barbara experienced a dismal level of precipitation; for Santa Barbara, we have not obtained even half of our 18.5” average annual rainfall.[2] Travelling several hours by plane moved me from flood warnings to emergency draught and fire season warnings. This reminded me of an important financial principle: different regions can perform differently during the same time.  That is, both in weather and finance, often one area lags its average while another far surpasses it. A properly constructed portfolio can potentially have such deviations average out for any given period, providing a much more stable trajectory to a long, successful retirement.

Another feature of weather that parallels finance is the difficulty of predicting it, which happens to be related to chaos. Most people do not particularly enjoy being around chaos. However, both our weather and fortunes are inextricably tied to chaos. Specifically, they are related to so called Chaos Theory. Chaos Theory tells us that small changes can later result in substantially different outcomes.

Edward Lorenz coined the term butterfly effect to capture this idea: he proposed that a few flaps of a butterfly’s wings could determine the outcome of weather a couple days later, including the incidence of a hurricane (or not). Lorenz was studying models to predict weather patterns. Weather is very difficult to predict, since slightly different initial conditions can lead to very different weather outcomes.  And these initial conditions can be hard to precisely identify. So too it’s difficult to predict financial market outcomes. Consequently, at Omega, rather than trying to predict the financial markets for a given period, we use our proprietary States of the World Wealth ManagementTM to gain exposure to different kinds of market environments simultaneously.

A final feature of weather that can inform our finances is appreciating its strength. In the end, we have essentially no ability to control the weather. We can, however, choose to work with it or against it. We can choose to enjoy the Sun by making a trip to the beach and better enjoy the rain by seeking shelter. Or we can instead choose to work against the weather and attempt a sand castle in the midst of a down pour. So too with the financial markets, we can attempt to beat the markets or instead harness their power through a proper core exposure to them, and then some exploration of further value outside of this core.

The first quarter of 2014 turned out to be a relatively good period for financial markets. Although Emerging Market Equity stocks fell almost ½%, other major stock markets gained 1% to 2%. Real estate was the real winner, charging ahead some 7% globally. Bonds also had a strong quarter, on whole earning some 2% in total return. ₃

All the while, we had some newsworthy items during this quarter. We had our new Fed Chairperson Janet Yellen, formerly of UC Berkeley, take the reins from Dr. Bernanke and also make history by being the first woman to accept such a high position. Putin signed a treaty to annex Crimea. The Ukraine sought an international bailout and is seeking to maintain its independence. China’s growth slowed to 7.7%. And the SP500 hit a new record. And most importantly, coffee was one of the best investments, increasing over 50% for the quarter. Hopefully, this makes your next cup of coffee enjoyed at Omega during your next visit all the more tasty!

So what is going to happen next quarter? My best guess is 72 degrees in Santa Barbara, a lot of Tulips in Chicago, and based on the butterflies, more disparate financial markets. So stay tuned!