Starting a Financial OODA Loop

I want to explore a different and structured way of thinking about investments. I have been involved in investing for the better part of the last three decades so I have seen my fair share of new ways to think about investments and I realise that most of them are of limited utility or are just restatements of the old truths.

Finding ideas in unusual places

I encountered this particular idea about 10 years ago and it really spoke to the way I try to look at investing. I have tried to implement elements of the theory on an institutional level but it didn’t work. Part of the reason is that the theory is designed for use by an individual, not a committee (the latter being the key mechanism most institutions employ to reduce risk). The other part of the reason is that it was always more important to “sell the product” and/or make sure the product performed within the given parameters rather than try to introduce new thinking amongst colleagues in the office or headquarters. If you are Bill Gross, John Hussman or the guys at Oaktree, you can indulge in some philosophical thoughts…the rest of us need to focus on the bottom line.

I came upon General John Boyd’s OODA Loop at the suggestion of an old friend. As usual, he was trying to demonstrate that he was smarter than me (which he is, by the way). There was also an element of my friend hoping to show that he knew a thing or two about F-16 fighter strategy. Why? Because frankly, the thought of flying a fighter jet is much sexier than the desks, telephones and Bloomberg screens that we usually piloted. That said, either one of us would probably get a nose-bleed just standing within 30 feet of one of these machines.

John Boyd’s theory appealed to me because it described what I would call my ideal operating conditions. Not my everyday conditions because believe it or not, there have been some blah days over the last 30 years in my career. Nor am I talking about bull market conditions. Full throated bull runs are great fun but investing in one of them requires all the skill one might employ in falling out of bed. When the markets are running, just showing up is often the most important ingredient to landing a big bonus.

No, I am talking about the markets at turning points and during choppy performance when keeping one’s head on straight, ignoring the specious nonsense, not over trading and maintaining good investment discipline will determine whether you finish the year in the top or bottom quartile. Fund manager votes, hedge fund trades and asset flows all depended upon and flowed towards the best performance. A few bad decisions could quickly wipe out a lot of good will, assets, revenues and profits.

General Boyd developed his OODA Loop to quantify how a good jet fighter pilot makes decisions in a combat situation. The acronym stands for Observe, Orient, Decision, Action and it is meant to run as a continuous loop with feedback from each stage going back into the beginning Observation Stage. As the fighter pilot makes decisions and takes actions, his position in the battlespace changes and his opponents will respond. While much less dramatic and dangerous than dogfighting, we can draw some parallels when we apply the same framework to investing. Once you have decided to overweight a particular asset class or sector in your portfolio, your risk/return profile has shifted. Going forward, you need to take your new position and the different perspective that the new position gives you into your evaluation process. Clinging to the original paradigm or thought processes can lead to many of the cognitive biases which plague all investors to a greater or lesser extent and cause us to lose money.

General Boyd’s thought a lot about how we as humans process information. He observed that in order to make our way and thrive in the world, we are compelled to make a steady stream of decisions. Our ability to make good decisions hinged on our ability to create and manipulate mental concepts to represent observed reality.

His hypothesis was that a pilot who could process observations through to decisions and actions faster than his opponent would be able to win on the battlefield. Perhaps his most significant intellectual contribution comes with the definition of the Orientation part of the process. General Boyd recognised that several different, personalised filters go to work on data. Understanding how each of these filters were build and operate helps the OODA Loop user to optimise the process. As many observers have noted as they have tried to apply the lessons to business organisations, the OODA Loop is optimised for a single user and depends on that user’s ability to cycle through the steps quickly and recycle information, observations, decisions and impressions that such cycling generates back into the start of the cycle. Therefore, it is not terribly well suited to a large organisation where developing consensus and buy-in are important end points for the decision process. As organisations become larger, the consensus building process naturally develops its own inertia. That is why one time innovators like Yahoo, Apple and Google are often seen in the market place buying up nimble startups to ensure that they do not lose their ability to innovate. In a military setting, the aircraft carrier needs to operate on a different tempo to the fighters it launches from its deck.

It is important when using the OODA Loop to have an overarching view of your circumstances. The new information, analysis and decisions and actions need to take place against a specific background. In John Boyd’s model, this is called the Implicit guidance and Control. Fighter pilots do not just take their planes out for joy rides looking for enemy planes to engage when they are in the mood. They have command structures, missions, strategies and parameters. A typical parameter is the type of plane they are flying. If it is an unarmed electronics warfare plane, the pilot is going to react to situations very differently that if he is flying a fully armed top of the line jet. And the mission is important. In a hot war where the opponent is an immediate and deadly threat, the decision to attack is arrived at much more quickly than it might if the two sides were just experiencing tense relations along a shared border.

The same concepts should apply to us as investors. We need to use the information and our own circumstances to decide how to change the composition of our portfolio to return it to the correct orientation to achieve the long term goal or strategy that we have set. That is why “hot tips” are rarely useful. Unless the person delivering the “hot tip” actually knows what your situation is, it is unlikely that the great opportunity he is pushing will suit your situation. It is great to hear that a friend has implemented a fast trading, complex options strategy which is a “sure thing” but unless we are able to watch the markets as closely as our friend, it is probably a non-starter.

And let’s be honest, most of us are not fully armed F-18 pilots with our hair on fire when it comes to investing. There may be fledgling Facebook, Google, Amazon or Federal Express ideas out there and we may even stumble across one from time to time. But sadly, for most of us, we do not have the wherewithal to pursue these ideas to their multi-billion dollar conclusion. It is great to say that we will copy Warren Buffett but unless you have an insurance company’s cash-flow to back you up, decades of high profile experience and a couple extra billion in the bank, many of the opportunities to pick up sweet convertible bond deals will not come your way. For most of us, our near term obligations (mortgage, food, tuition for the kids) are too great to roll the dice on a fantastic but highly speculative idea. That is just the way things are. As in the Air Force, someone needs to drive the refueling plane.

With investing, however, just because we are conservative, perhaps less sophisticated investors today does not mean we cannot train ourselves and get up the learning curve with new methods and new markets. The trick is to make sure than you realise when you are moving out of your comfort zone and keep new ventures small while you are learning the ropes.

Where does one start? How does one take the first step? The beauty of the OODA Loop is that it is designed out of the box to give you that answer.

You do not need to worry about what the right first step is because you have already taken it. Right now, you have an investment portfolio. It may not be a terribly complex portfolio (all in cash at a bank) or it may look like a teenager’s room after a sleepover party (or in my house, almost any morning). It doesn’t really matter because one has to start where one is, not where one might hope to be. The hoping part is for later. That is for where we want to end up. And where might that be? Well, there are generalities that one can assume (enough money for retirement, money for college fees, a second house, whatever). Your goals can be quite personalised. In fact, the more specific, the better. But that is part of the process which will come into play as we take our observations into the second O or Orientation Phase. For now, let’s gather up some observations to see where we stand today.

Observation – the first O in OODA

So how does the world look today? Let’s start by focussing in on observable reality as much as possible. It is very easy to be swayed by the financial media, newsletters, online chat groups, friends and family. We will get to all of that in the Orientation Phase.

Putting all of the noisy bits off to one side, let’s look at the financial markets in terms of what we can measure with hard numbers (Index levels, interest rates, inflation gauges, and other sundry prices).

Starting with the largest and most liquid markets, we look to the US bond and equity markets. Let’s start with that bellwether of risk free return, the US Treasury markets. Even though Standard and Poor’s foolishly chose to downgrade US sovereign debt from Triple-A (an act which had repercussions a few years later), most investors still use US Treasuries as a starting point for pricing investments. LIBOR is another place to look for a short term indication of pricing levels but despite the best efforts of London traders, LIBOR still largely tracks the comings and goings of the larger US Government debt market.

So how do things look in Treasury land? On the face of it, not bad at all. Interest rates are much lower than most of us remember for quite a while. According to the gurus at the Federal Reserve, inflation is not a problem for the near term and the cost of acquiring and holding assets (like a house on a 30 year mortgage) is low and should encourage more business activity. A quick check of the housing markets suggest that quite a few people have taken advantage of relatively low rates which has pushed housing values up to and beyond pre-crisis levels (2006-2007) in some markets. Since housing construction and consumption related to housing makes up a significant portion of America’s GDP (almost a fifth, broadly defined), this is positive.

How about over on the equity side of things? The markets have rebounded smartly from the lows in 2009, setting a string of new records for the broad indices lately. Corporate profitability is at an historically high share of GDP and most of the representative large corporations are in strong financial positions.

The US financial markets are broadcasting a fairly positive scenario for the foreseeable future.

In fact, from the US domestic economy’s point of view, there are only two dark spots on the horizon. Healthcare and overall employment. Healthcare is undergoing a massive reorganisation on the back of the implementation of Obamacare. Love it or loathe it, one-sixth of the US economy is being reorganised and that will mean a period of consolidation as some portions are encouraged while others are cut back. But the larger question mark is the observable (as far as the figures allow) lack of employment growth. The labor participation rate has fallen as the economy has failed to produce enough new full time jobs to re-employ those laid off in the Great Recession as well as absorb the new workers who have entered the market place since 2008. Some of this is due to the start of the great Baby Boom Retirement Wave which may have been front-loaded by the Great Recession (older workers laid off and deciding to retire rather than attempt to reenter the workforce).

Just because we start with the big markets doesn’t mean we can stop there. Often trouble does not show up on the big indices but in smaller or less transparent markets. A quick search of recent history will turn up an avalanche of comforting comments back in 2007 about how a small problem in the US subprime mortgage market was miniscule relative to the overall financial markets, fully hedged and well within the handling capacity of banks. The Asian Crisis of 1997 started in small to middling Thailand and the tiny Russian Government bond market nearly brought the global financial markets to its knees just over a year later when Long Term Capital Management sank beneath the waves.

Europe is the next stop because it also boasts large, liquid markets and, via London in particular, controls a large chunk of the world’s trade finance, derivatives and foreign exchange trading. The Eurozone is actually a larger economy than the United States so it makes sense that the wobbles of its periphery – Ireland, Greece, Portugal and Spain – were enough to throw the world markets into panic on several occasions over the last three or four years. Closer to the core, Italy and France have struggled and continue to labor while Germany, which undertook reforms well before the Global Financial Crisis, powers ahead. Like the US, Europe’s stock markets are dominated by Global Companies which rely on global markets for revenues and earnings. And, with the global economy in a moderate growth pattern, the corporate outlook has been reasonably good for most of the name brand companies listed in London and Frankfurt, the two major markets.

Moving over to Asia, we have a fast growing economy, China, which may be succumbing to the “law of large numbers” at best or perhaps getting ready to pop a major bubble at worst, a former giant, Japan, appears to be emerging from two decades of stagnation and India which has experienced some good growth on the back of economic reforms in recent times but has stalled of late. The rest of Asia has become dependent to a greater or lesser extent on the Great China Supply Chain. Most countries in the Asian Region (including Australia and New Zealand) have seen China become the number one trading partner in the last 10 years. So, until Japan pulls another economic miracle, we can focus on China for now as the leading indicator for the economy and financial markets in this region.

Africa and South America can be overlooked for the moment. Good things are happening in Africa while Latin America appears to be offering a mixed bag of tricks after some solid improvement in the last two decades. For now, we will note that there is nothing surprisingly positive or negative that might impinge on our observations taken elsewhere.

The observations, from this quick spin around the globe, are of reasonable optimism. The bull markets which have raged since the depths of 2009 may be a bit long in the tooth, the commodities Super Cycle appears to have taken extended leave and China may be building empty cities in the desert but the numbers point to growth and profitability for now.

We will refine these observations as we run through the OODA Loop. The important thing here is not to pass judgements but to gather observations and baselines that can serve to help us build the mental constructs that will help us make sense of the observable reality. The judgments and decisions come in the Orientation and Decision phases.

Also note that we have left out most of the political rumblings both domestic and international. We will add them in during later cycles through the loop to spice up the picture. But for now, we will start with the large bits that are easily observable.

Orientation – The Second O in the OODA Loop

Next, we will look at the Orientation part of the cycle. This will allow us to start to make judgments about the facts that we have observed. So, rather than coming to a judgement and finding facts to support our opinion, we are looking at the broad world with neutral eyes first and drawing conclusions later. Hopefully, this will allow us to see the investment landscape as clearly and as close to reality as it is, rather than as we would wish it to be.