The other side of the coin... investment management.
What is an “investment philosophy?” Our thinking is that an investment philosophy is a set of beliefs that connect outside stimuli with performance in the financial markets. We observe that most investment managers do not have one.
In his book Investment Policy, Charles D. Ellis wrote "In investment management, the real opportunity to achieve superior results is not in scrambling to outperform the market but in establishing and adhering to appropriate investment policies over the long term, policies that position the portfolio to benefit from riding with the main long-term forces in the market." This serves as the core of our investment philosophy. After we have gained a thorough understanding of financial goals, return expectations and risk tolerance, we craft a customized Investment Policy Statement for each client. This document confirms our understanding of client desires and serves as the 'blueprint' for building and maintaining client investment portfolios.
Our overall investment objective for all clients is the maximization of after-tax returns over a complete market cycle with an emphasis on defending capital over the course of that cycle. Central to our approach of maximizing returns while minimizing risk is the concept of asset allocation. Asset allocation is the cornerstone of the investment management process. The distribution of financial assets among various types of stocks and bonds is the primary determinant of the variability of returns to an investment portfolio. Because we believe no one can predict, with any sufficiently consistent level of success, which class of financial assets will generate optimal returns over any period of time, we recommend prudent exposure to multiple asset classes. Each recommended asset class offers what we believe to be an attractive rate of return over time. However, each recommended asset class is expected to generate its returns in a pattern that is different from other recommended asset classes. This is the essence of asset allocation - assets that 'zig' while others 'zag'.
As a result, our investment philosophy consists of the following six principles:
Results are Dependent on Behavior
We believe managing expectations and behavior (ours and our clients’) is as critical – if not more so - as managing the investments. The returns you experience are far more dependent on YOUR behavior than on investment fund or investment manager performance. Two key behaviors in investment management are patience and being a disciplined contrarian. Two classic stories best describe each behavior.
Warren Buffet on the rational (patient) investor’s advantage:
“The wonderful thing about being a rational investor is that you are the batter in a game in which there are no called strikes. Day after day the pitches keep coming, but you don’t have to swing. They throw you XYZ at $60, but you let it go by because it’s not juicy enough or you don’t understand it. As long as you are patient, you can just stand there and wait for the perfect pitch. You may not hit even that one out of the park, but the odds are with you. It may get boring standing there with the bat on your shoulder day after day, and boredom limits the capacity of many investment managers, but it is the intelligent way to invest.”
Benjamin Graham on the stock market:
“Living with the stock market is like having a manic-depressive partner. Although Mr. Market is a pleasant fellow who can have long periods of relatively sane behavior, underneath he is a functioning manic-depressive. When Mr. Market is giddy, euphoric, infatuated with the future, and willing to pay crazy prices for your shares, you sell them to him. On the other hand, when he is tortured by gloom and despair and wants out at any price, you buy.”.
The opening lines of Rudyard Kipling’s “If” should be memorized by all investors:
If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting...
Invest for the Long Term
We are long term investors. By holding assets for a long period, we increase the probability of generating positive absolute returns by reducing transaction costs (commissions, spreads, etc.). Furthermore, in the presence of taxes, it is imperative that an investor benefit from tax-free compounding and the lower long-term capital gains tax rate to generate an acceptable after-tax rate of return.
Pay A Reasonable Price For Assets
It is essential to pay a reasonable price for assets. It is difficult to generate attractive returns on assets for which the investor has overpaid. We prefer a deliberate and disciplined approach that emphasizes preservation. We strive to assure ourselves that assets we own have a substantial margin of indicated present value above the market price. Such margin could be used to absorb unfavorable developments in the future, if necessary.
Diversify Adequately But Not Excessively
An appropriate level of diversification attempts to minimize portfolio volatility for a stated level of portfolio return. However, excessive diversification clearly dilutes returns. Quite often, an individual creates wealth through the concentration of investment, frequently in their own business. However, the diversification of one's investment portfolio through an asset allocation approach can improve the risk/reward tradeoff as well as increase the probability of preserving wealth while generating an acceptable after-tax rate of return.
Define "Risk" As "The Probability That Assets Will Not Meet Long-Term Objectives."
It is common to define risk in terms of "volatility", with the assumption being that assets exhibiting higher volatility of returns, like stocks, are more risky than assets like bonds. This can be shortsighted and stressful. We believe instead, that true risk is longer term and must be defined more broadly. We consider true risk to be the probability that your investment portfolio will not meet your long-term objectives. Our asset allocation approach to portfolio design focuses on the client and their long term objectives. In this manner, the chance of achieving the longer term desired rate of return is balanced with the chance of incurring an unacceptable amount of volatility. This is accomplished by selecting a variety of assets within a variety of asset classes so that some zig when others zag. The result is that the overall portfolio will be less volatile than one invested solely in any one asset class.
Consider Investment Returns On An After-Tax Basis
Finally, taxes can be one of the greatest drags on long term investment returns. To the extent possible, we strive to minimize taxes within the context of a prudent decision-making process. Where practical, we shift realized gains into the lesser-taxed, long term categories. We also put an emphasis on matching losses to gains and selling the highest cost positions first.
In summary, most investment managers and clients perceive the work of the investment manager as active, assertive and offensive. We believe the work of the investment manager is primarily a defensive process.
We divide the universe of investment opportunities into four primary asset classes: 1) Liquidity, 2) Fixed Income, 3) Equities, and 4) Other. In defining our asset classes, we borrow a fact from quantum mechanics and note that we can only observe interactions and not the asset classes themselves. In other words, we ignore labels and focus on the interactions between assets.
In the wake of the recent financial crisis, it has become popular to proclaim that diversification no longer works. Our response is that “diversification”, as practiced by most investors, was never true diversification. The popular process of diversification was to own assets that had low average correlations over time. The problem with “average correlations” is that correlations are not stable over time. In a paper published in the Fall 2009 issue of the Journal of Portfolio Management (“The Myth of Diversification”), David Chua, Mark Kritzman and Sebastien Page showed that, when both the US and the foreign markets were up by more than one standard deviation above their mean, the correlation between them was 35%. When both were down by more than one standard deviation below their mean, their correlation rose to 85%, precisely the opposite of what investors desire. Moreover, this correlation asymmetry was observed across many of the major sectors of the equity and fixed income markets.
It is therefore insufficient to naively own asset classes with low average correlations over time. It is, in fact, critical to own asset classes with lower downside correlation but higher upside correlation. We prefer to ignore the labels and observe the interactions between assets in down markets and separately in up markets, choosing to invest in those with low downside/high upside correlations.
At present, our asset classes consist of the following:
- Liquidity: Cash and cash equivalents
- Fixed Income: Bonds (sovereign, corporate or municipal) and preferred stock
- Equities: Common stock of domestic or foreign issuers
- Other: Any asset not included in the above three classes that is reasonably expected to provide an attractive, non-correlated return