In 1747, Scottish physician James Lind proved in a controlled medical experiment that citrus fruits were an effective cure for scurvy. Citrus fruits had been used by sailors since at least 1497 to ward off the disease, but scurvy continued to be the leading killer of sailors on long ocean voyages, with some ships losing as many as 90% of their men. Even after Lind’s discovery, it took an additional forty years of experiments and political lobbying for the cure to be institutionalized within the British Royal Navy. In 1799, all Royal Navy ships in foreign service were ordered to serve 1 oz. of lemon (often called ‘lime’) juice with 1 oz. of sugar daily after two weeks at sea. The result was startling. In 1780, there were 1,457 cases of scurvy admitted to the Naval Hospital at Haslar. From 1806 – 1810, there were two.
At this point, there was a cure for the disease, but the cause was yet unknown. Some thought that the acidity of the fruit fought the disease. Some believed it was a deficiency of vegetable matter. A prominent naval doctor lectured that “scurvy was due to an acid intoxication of the blood caused by bacteria” and that “darkness, cold, and hard work are also important causes of scurvy.”
Many physicians believed that the disease was caused by a kind of chronic food poisoning from a bacterial infection of meat – this was known as the “ptomaine theory.” It was believed that the acidity of citrus juice denatured ptomaines, or killed the bacteria that caused them. In the early 1900’s, this belief became so entrenched that the casks of lime juice mandated by law were now looked at as merely outdated medical superstition.
One of the main proponents of the “ptomaine theory” was Dr. Reginald Koettlitz. Dr. Koettlitz was the Senior Surgeon to the British National Antartic Expedition and had served in several polar expeditions. He had witnessed sailors that had spent several years mired in pack ice survive on a diet of nothing more than seal and polar bear meat. He made note of Eskimo that ate nothing but meat and fish – entire generations that had never consumed a vegetable or piece of fruit. He had noted the complete absence of scurvy in these cases. Having no concept of vitamin C, which is abundant in fresh meat, his assumption was that this was not a disease of deficiency, but something caused by poor preservation techniques. As a result of this belief, arctic expeditions in the early 20th century were outfitted by meticulously prepared and preserved foods. Unfortunately, vitamin C breaks down in the presence of heat, light and air, so the work was for naught. A century after scurvy was all but wiped out, it struck again with a vengeance.
Arctic expeditions in 1894, 1902, 1903 & 1911 suffered massive outbreaks of the disease. Theories based on incomplete knowledge and poorly crafted experiments had undone what hundreds of years of sailing experience had already taught. How could an entire navy just forget a cure like lemon juice? They knew it worked. At one point the island of Sicily had been transformed into a lemon orchard for the British fleet. And it wasn’t just sailors that suffered. In the late 19th century there was an outbreak of infantile scurvy that afflicted primarily upper class families – families that could afford milk made safer by the newly discovered process of pasteurization. Poorer children who were breast fed and quickly weaned onto adult foods received an abundance of vitamin C. It wouldn’t be until 1932 and a stroke of blind luck that the actual cause of scurvy would be discovered and vitamin C finally identified.
This is a classic case of the perfect being the enemy of the good. The intention to constantly improve is admirable, but the cost of that intention cannot be ignored. In this case, the cost of squandered expeditions and unnecessary food preparation pales in comparison to the death and misery suffered by hundreds. In the case of modern investors, the cost of forgetting perfectly good solutions has been in the trillions of dollars.
Things We Forget
- Investors are not rational, they are human.
This idea of the rational investor is pervasive and has lead to widespread adoption of concepts like Modern Portfolio Theory (MPT), where we pretend to be able to calculate the optimal asset allocation plan and then trust that simply by being optimally diversified, we will maximize our risk adjusted return.If investors were rational, during a downturn in the market maybe they would make measured decisions between their foreign mid-cap growth stocks and real estate investment trusts and high yield bonds, etc. However, since investors are human, they do no such thing. Where at one point they may have looked at their holdings as consisting of 8 or 10 different asset classes, during times of stress they see only two: risky and non-risky. Cash, CD’s & treasury bills in one category and everything else in the other. So what was once a diverse portfolio now behaves as something completely different.The asset allocation driven, buy & hold approach that is the standard model for investors from the smallest 401k contributor to the largest public pension plan is vulnerable to massive losses. Because investors are human and are driven by impulses beyond logic, investment returns cannot be reliably optimized through forecasting. Past history of returns and volatility and correlation are all subject to wild swings and do not fit neatly into the statistical formulas that drive the MPT calculations. Even if they did, they would still ultimately be doomed to catastrophic damage because this approach demands that the buy & hold investor surrender responsibility for risk management to the market.
- Markets are tools.
We invest to make money. To that end, we are fortunate to have such a wide array of investment vehicles available at such low cost. But these vehicles are simply a means to that end. They are tools. Like any tool, while they have potential to provide benefit, they also possess potential to do grievous harm. In recent decades, practitioners of the buy & hold, MPT mindset have pushed this reality aside. They insist that you cannot beat nor can you time the market, so you must always maintain your exposure to it. This line of belief forgets that beating the market doesn’t matter. Being down 25% when the market is down 35% is not reason for celebration. Being up 15% when the market is up 20% is not a failure. We invest to make money, not to measure ourselves against some abstract market index.This line of belief also forgets history. Historical observation tells us that every single developed economy on the planet has seen their stock market suffer a peak-to-trough decline of 80% or more on at least one occasion. We’ve seen drawdowns of more than 50% here twice in the last decade. The Japanese stock market (Nikkei 225) peaked a little over twenty years ago at 40,000. As I write this today, the N225 is at 10,949. In the pursuit of making money, sometimes there are very good reasons to step away from stocks or bonds or any other tool at our disposal.
- Defiance of reality has an expiration date.
This seems obvious, but how many boom-bust cycles must we put ourselves through before the lesson is remembered? You would think extending no-money-down mortgage loans to buy obscenely overpriced fixer-uppers could have disastrous consequences. But the competition to lend to these buyers was fiercely competitive until the very end.You’d think the lessons of repeated Latin American debt defaults over the last 190 years would cause lenders to more carefully consider the risk of doing business with sovereign borrowers that are unwilling to adhere to the conditions of their loans. But lenders are always there, ready to write a check, somehow forgetting that the terms of the loan don’t really matter if the borrower can unilaterally declare the debt illegal at some future date.Here at home, states, cities, school districts and every kind of municipality in between are on the hook for well over a trillion dollars in underfunded pension liabilities. The pension fund managers know this. Political leaders charged with responsibility for these plans know it. Public employee and teachers unions know it. Municipal bond buyers know it. Yet it all seems to keep going on as if things will just somehow work themselves out before it’s too late.
Inflating and bursting bubbles have always and will always be with us. They are caused by human nature. They are always obvious in hindsight, but they are also often obvious while the bubble is still expanding. Everyone knew the dot com mania would come crashing down at some point. Everyone knew that real estate prices were growing at a ridiculous pace. I’m sure that many 17th century Dutch tulip bulb buyers knew that paying a years salary for a single bulb was nutty. The truth is, you can make a lot of money from an inflating bubble, but you have to have a plan to deal with the inescapable aftermath. Ultimately, the laws of economics are as intractable as the law of gravity. That is a lesson worth remembering.