Boiling Frog Syndrome

An investment paradigm?

It is a well-established characteristic of the lovable, tailless amphibian – the frog – that it struggles to detect subtle changes in the temperature of the water in which it resides. If you place a frog into a pot of boiling water  (not something that we would encourage!), it will instinctively jump out to save its own life. However, if you place a frog into a pot of cool water and put the pan on your stove the frog allegedly fails to notice that the water is getting gradually warmer. The frog doesn’t just ignore the steadily warming water, it adapts to its changing environment and will stay in the water until, sadly, it boils to death.

Many commentators have applied this concept to business in that management slowly become a victim of the “Boiling Frog Syndrome”! Some business leaders settle into unproductive routines or let damaging practices that start out small become very significant, eventually allowing inertia and complacency to set in, to the point that they slowly “boil” their companies to death.

Worryingly this phenomenon has also crept its way into the investment arena. So, how does this apply to investment markets and are there solutions that we can apply to prevent the ensuing damage and wealth destruction? There is a cycle behind an under performing asset and the effect this has on the investor is similar to that of the boiling frog. No investor would ever want to invest in a failing investment and, in the event they did, would look to get out of the position very quickly. However, an investment that has all the familiar hallmarks and characteristics of a good investment that gradually worsens lulls the investor into adapting to this new environment and thus maintaining their position in the belief that life will improve – whilst all the time they are boiling their returns to death. Timing is ultimately key in any decision, whether it is to do with the temperature of the water or the entry/exit decision made by investors.

There are many quite persuasive ideas that have been put forward to the investor to help them deal with this conundrum; however, a true solution to the “investment temperature gauge” has proved particularly evasive. Ideas that have been prevalent to date typically rely on the skill of the investor to time their entry and exit points into markets or underlying stocks yet, bar the handful of exceptional people, few investors have an ability to consistently get this complex decision right, and unfortunately access to them is very limited and can prove extremely costly.

An alternative approach spawned the rise of the “Long-term Investor”, one who bought and held through the bad times in the hope that things got better in the long-term. In essence this was an argument to not try and time the market but stay invested because time is your friend.

There is another argument which is the inverse of the above and challenges this thesis. An investor who managed to avoid the worst twenty performing months would very significantly outperform the market, yet the relationship between the under performance of missing the twenty best performing and the twenty worst performing is not correlated. It is therefore of much greater value to protect your asset base during the difficult times than to be fully exposed all the time.

An investment solution that protected you during these damaging periods and shapes your return profile is therefore of huge attraction. Back to the frog… How can we build a level of protection into our investment pot that ensures we don’t boil to death? Structured Equity is an investor’s tool to protect against a gradually worsening environment. As markets fall, investors often feel that markets will revert and losses will be made good; however, often by the time the recovery is established the underlying asset has fallen very significantly and the investment return required to return the asset to par is unrealistic. If there were a fail-safe mechanism that could protect the asset in falling markets the investment return required to recover would be much lower. This is akin to building a cooling system into the boiling pot of water to protect the frog from its environment becoming so hostile that it can no longer survive. Good for frogs and the investor.

 

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