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Friction

January 25, 2007 by  


By Bob Wood

Some may find it strange that I tend to find parallels and lessons on investing in unusual places. Of course, as a somewhat contrarian investor, I’m always looking for new ways to look at things. This past week, I perused a book originally written in the early 1800s, which, I believe, offers information that may prove valuable to those managing their own investments.

An example of my finding useful investment information in odd places, this book has nothing to do with investing. Actually, it is one of the classics on conducting war.

    On War

, by Carl Von Clausewitz, the great theorist on war strategy, offers help to those experiencing the inevitable rough times that we all must learn to manage.

Chapter 7 in Book One, entitled “Friction in War,” begins with insights that help explain why our current leaders seem hopelessly bogged down in Iraq and Afghanistan. And they might apply, as well, to self-taught investors — or those trying to compete with the pros — in their spare time. Clausewitz writes:

‘’If one has never personally experienced war, one cannot understand in what the difficulties constantly mentioned really consist, nor why a commander should need any brilliance and exceptional ability. Everything looks simple; the knowledge required does not look remarkable, the strategic options are so obvious that by comparison the simplest problem of higher mathematics has an impressive scientific dignity.

‘’Once war has actually been seen the difficulties become clear; but it is still extremely hard to describe the unseen, all-pervading element that brings about this change of perspective.’’

I think Clausewitz implies that what seems easy enough in theory becomes much more complicated when applied in a real-world war setting. In terms of investors, this explanation could relate to managing a hypothetical portfolio of stocks on paper, which always seems to perform as expected, as opposed to putting real money behind those allocations. Or consider the investor who is assured that one sector of the markets, maybe energy, makes perfect sense and will continue to do well, until the inevitable “friction” sets in.

Friction in investing can come from unforeseen developments, such as the implosion of a big hedge fund, after it has taken highly leveraged positions in natural gas that suddenly reverses its trend. For example, last year’s implosion of the Amaranth Fund made some well-thought-out plans suddenly look suspect.

‘’Everything in war is very simple, but the simplest thing is difficult,” Clausewitz continues. “The difficulties accumulate and end by producing a kind of friction that is inconceivable unless one has experienced war… Countless minor incidents – the kind you can never really foresee – combine to lower the general level of performance, so that one always falls far short of the intended goal.’’

I see in this point the mindset an investor might have after reading many pages of modern ‘’stocks for the long-run’’ theories, purporting that if you only wait long enough, your portfolio will inevitably grow much larger. But even in the past, when markets trended higher than in preceding decades, various events and interruptions in those bull markets cast investors into situations that their planning had not anticipated. Remember the market crash in 1987, amid one of the strongest secular bull markets in modern times?

How many investors calmly watched as the markets fell — the S&P 500 dropping from the 330 level to 225 in about two weeks? And that event causes me to wonder about investors who recently enjoyed a wonderful bull market in energy but have been spooked out of today’s markets with the price of oil dropping from $78/barrell to just below $50 this past week? Unseasonably warm weather in the northern parts of the country qualify as one of those unforeseen incients cited by Clausewitz.

If you are managing a “paper” portfolio, you haven’t had much worrying to do. In fact, you are probably quite relieved that you weren’t risking real money. But by now, you may be confidently mapping a strategy to load up on oil, using whatever technical chart pattern you have adopted as the best indicator for direction changes in the price of oil. Clausewitz continues:

‘’Friction is the only concept that more or less corresponds to the factors that distinguish real war from war on paper. The military machine – the army and everything related to it – is basically very simple and therefore seems easy to manage. But we should bear in mind that none of its components is of one piece; each part is composed of individuals, every one of whom retains his potential of friction.’’

So let’s consider the investor who thinks he has everything figured out correctly and waits patiently for his profits to begin rolling in. He has little concern for all those other market players, those with different agendas or methods who are also involved in this favorite investment, which could be energy or any other investment option.

Some portfolio managers, like me, prefer to invest in less liquid, less frequently traded shares in more obscure stocks and funds. Yet we have seen on several occasions that it takes only one mutual fund or hedge fund manager with a shorter attention span than mine to send a favorite holding into a price drop that casts doubt on the wisdom of having ever chosen it at all.

‘’This tremendous friction, which cannot, as in mechanics, be reduced to a few points, is everywhere in contact with chance, and brings effects that cannot be measured, just because they are largely due to chance. One, for example, is the weather. Fog can prevent the enemy from being seen in time, a gun from firing when it should, a report from reaching the commanding officer. Rain can prevent a battalion from arriving, make another late by keeping it not three but eight hours on the march, ruin a cavalry charge by bogging horses down in mud, etc.’’

So yes, investing can be like war when an unforeseen military coup in Thailand affects my small holdings in that country, in the closed-end fund, TTF. Or consider the impact of recent calls for nationalizing strategic industries in Venezuela’s red hot market that tumble that market’s shares almost 20% in one day.

‘’We give these examples simply for illustration, to help the reader follow the argument. It would take volumes to cover all difficulties. We could exhaust the reader with illustrations alone if we really tried to deal with the whole range of minor troubles that must be faced in war. The few we have given will be excused by those readers who have long since understood what we are after.’’

And how many investors could have foreseen the Long Term Capital hedge fund debacle, even with the fund managed by Nobel Prize winning experts? Or the Arab Oil embargo of 1973? A savings-and-loan crisis? Or the stock of high-flying Enron suddenly becoming worthless?

Of course, such “friction” can work both ways. Sometimes, great things happen for investors who can see through bad hype coming from politicians or market players in the financial media. Who would have guessed that one of the world’s strongest stock markets in 2006 would be in Venezuela, amid constant criticism of its leader’s Socialist leanings?

Who would have guessed that Brazil’s stock market would be one of the best places to invest in 2002, when that country’s leader, Lula da Silva was derided as bad for business — as well as Socialistic? And how many thought to load up in the Russian stock market in 1998, when the country appeared to be imploding, as news spread of a pending massive bond default?

With the benefit of hindsight, these examples look rather obvious. As in war, we can easily formulate a winning investment plan on paper — where risks are nonexistent. But with real money on the line, how can we possibly plan for the inevitable frictions, caused by the conflicting actions of so many others in the markets — those with methods and agendas much different than our own?

In short, we can’t. Our best strategy may well be paying close attention to the risks inherent in our investing models and planning in advance the level of losses we will accept before selling out. Pay proper attention to the size of each position, allowing no one position to hurt overall performance if adverse events should send its price much lower. Of course, you could also adopt a much more rigorous method for identifying which investments make it into your portolfio in the first place.

But for me, the best strategy of all is following long-term trends. The most powerful trends have a much better chance of shrugging off smaller bits of bad news or temporary adverse price movements based on selling by a small number of players who also hold your favorites.

I still think one of the best secular trends to watch is energy. And while the ride down from $78 to the current $50/barrel for oil might alter the plans of many other investors, it provides me a great time to be looking over solid companies whose shares are selling at big discounts when compared to the overvalued Dow or S&P 500, not to mention “priced for Nirvana” shares in the Nasdaq 100.

None of us may ever be blessed with perfect knowledge or foresight when investing. Just as Clausewitz taught about war almost 200 years ago, situations occur that cannot be predicted or planned for in advance. But the studious investor will anticipate a wider range of possibilities for events in the economy, geo-politics and stock or commodity prices and can react better than most, if only for knowing that we cannot know everything. Yet how we react to the unexpected might make all the difference!

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

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