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Breaking the Rules

February 1, 2007 by  


By Bob Wood

Investing is much like other pursuits where complexity is a given. So over time, “financial experts” have exerted substantial effort to try to identify a workable set of guidelines or rules to follow. And, for the most part, I am convinced that investors observing these rules encounter disappointing performance over time.

Take, for example, the investing guidelines suggested by noted academics William Sharpe, Harry Markowitz and Jack Treynor. Their work, called Modern Portfolio Theory (MPT), was once so widely acclaimed for its guidance to investors that the founders won the Nobel Prize for Economics. At the time, in the absence of any other accepted theories on diversification and portfolio construction, it was indeed something special. But, basically, what I am suggesting to you now is this: ignore it!

Well, let’s be realistic for a minute. Yes, I can hear the jeers from some professional investors stopping by to read this article on page 6 (if for no other reason than the amusement provided!). After all, the vast majority of professionals would never suggest what I just said about Modern Portfolio Theory. What I have been told, pointedly, when previously venturing into such financial heresy is that most institutional fund managers also play by such established rules.

“OK,” I respond. “So what?” The fact that most money managers play by using the same playbook strikes me as rather weak in terms of rationale. And how many actively managed mutual funds, pension funds or other large pools of money beat their passively managed benchmarks such as one of the S&P indices tracking some portion of the markets?

Think about it: how many investors do you know who credit Modern Portfolio Theory or diversification strategies with having generated their wealth? Why is it with this wonderful, scientific theory, we have an absence of proof that they work, proven by those few people, if any, you know personally who made their money in stocks. It seems suspicious, doesn’t it?

I agree that it may be hard for some readers to accept my case against all those noted academics who won major awards for their work on investing. So what if I told you that the greatest investor of our time agrees with me? And that several others who really did make fortunes in stocks also agree with me? Would that help?

Surely many investors took notice when Warren Buffett said that his considerable success in investing has been helped by others who invested – differently! He refers to those who invested according to theory rather than with proper respect for valuation and common sense.

So many investors took notice and changed their ways, right? No, that has not happened. Actually, Buffett has been quoted as saying that not much has changed in finding what works in the years he’s been investing, and he sees few who use methods that look like his own. And when commenting about the Modern Portfolio Theory and Efficient Market Theory, Buffett has said that ‘’the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us.’’ He adds that ‘’Modern Portfolio Theory tells you how to be average. But I think almost anybody can figure out how to do average in fifth grade.’’

Sir John Templeton, who agrees with Buffett, also amassed an incredible performance record as founder of The Templeton Funds. His basic premise was to invest where the crowds were not, and we know that, historically, the crowd follows those same basic strategies of diversification and asset allocation.

Templeton made his fortune by investing in places around the world that were, for the most part, ignored by the crowd. While using MPT and diversification strategies led most managers to allocate the bulk of their investment funds to domestic markets, as they still do today, they either missed entirely far better opportunities to profit in markets around the world or added such small portions to their portfolios as to make little difference.

Another of the all time great investors, George Soros, also agrees with my premise. (Well, as I think about it now, maybe I agree with him!) Soros and his partner at the time, Jim Rogers, managed the Quantum Fund, which from 1970 to 1980 earned a total return of nearly 3,400%! (No, that’s not a typo.) He is a multi-billionaire from his work as an investor.

Soros readily dismisses arguments for Random Walk, Efficient Markets and MPT, saying, ‘’I have disproved it by consistently outperforming the averages over a period of twelve years. Institutions may well be advised to invest in index funds rather than making specific investment decisions, but the reason is to be found in their substandard performance, not in the impossibility of outperforming the averages.’’

Oh, and while Soros and Rogers were building that phenomenal performance record during the 1970s, the S&P 500 rose from the 92 level to 135, a total return of 46% with an average annual gain of about 4%. So while the crowd and their money managers were doubtlessly trailing the S&P 500 due to added costs, Soros, Buffett and Templeton simply chose to invest where the crowd was not.

Buffett was sitting on cash from 1969 until the nasty bear markets of 1972 and 1973, when he loaded up on what he considered bargains in stocks. Templeton found better values in places like Australia and Canada. And Soros found other asset classes altogether, those like commodities and currencies. The more traditional investors who followed MPT and other aspects of what academia called “the best way to go” endured a bear market that lasted throughout the 1970s and finally ended in 1982.

However, English Economist John Maynard Keynes, weighing in on the MPT concept, said in his highly regarded book, The General Theory of Employment, Interest and Money, that investing professionals would find it safest to run with the crowd. His comment: ‘’It is better to fail conventionally than it is to succeed unconventionally.’’

In essence, he believed it was safer to buy well known, blue chip stocks and diversify using large cap, small and mid-caps for the bulk of stock allocations, just as the academics argue. But, should the market, as shown by the S&P 500 index, suffer another drop like the one in the 2000-2002 bear market cycle, I suppose we can blame other outside forces like the market, irrational investors, or anything but a manager’s ability to invest wisely.

Safe, Buffett argues, is a recipe for mediocrity. None of the great investors became successful at investing by being safe or running with the herd. So while allocating the bulk of your assets into a few asset classes and excluding the more popular places favored by the crowd (like the domestic markets) may seem risky or unwise, recent performance proves this strategy worth considering.

I will agree that asset allocation and Modern Portfolio Theory are probably fine methods for those who lack any another method. They will work as a starting point and suffice in the absence of any other solid plan. But, once again, let me quote Carl Von Clausewitz from his book, On War (an unlikely source), where he talks about planning for military engagements.

“Theory exists so that one need not start afresh each time sorting out the material (of study) and plowing through it, but will find it ready to hand and in good order. It is meant to educate the mind of the future commander, or, more accurately, to guide him in his self education, not to accompany him to the battlefield; just as a wise teacher guides and stimulates a young man’s intellectual development, but is careful not to lead him by the hand for the rest of his life…

Even these principles and rules are intended to provide a thinking man with a frame of reference for the movements he has been trained to carry out, rather than to serve as a guide which at the moment of action lays down precisely the path he must take.’’

To apply his advice to investing: study what the academics teach about efficient markets, Modern Portfolio Theory and Random Walk principles. Know them, and know how they work and why so many others use them. Just don’t expect to play by the same rules as everyone else and outperform them or the underlying market indices.

Clausewitz also wrote, ‘’Talent and genius operate outside the rules, and theory conflicts with practice.’’ So, again, understand the rules and theories, and let them take you only so far. Either accept them and use a basket of index funds, or let your inner genius create a portfolio of real value.

Break the rules of investing in the way the truly great investors have, looking at valuation and opportunity where the crowd fails to find them. Only then will you enjoy uncommon performance in your investing activities.

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

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