diversification

Would You Take Every Drug on the Shelf?

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We have written quite a bit about the conventional investing wisdom recently. This essay puts the focus on what we do here at 228 Main.

One of our principles is to find the best bargains. We cannot be sure where they are, but we will still try to find them. We look for seemingly healthy investments at historically low-seeming valuations.

We recognize this means buying investments which are unpopular. This is fine with us. In fact, we rely on it. One of our core principles is to avoid stampedes. The more of something everyone else is buying, the more expensive it is going to get.

A natural consequence of our approach is that our portfolio construction may not be as diversified as conventional wisdom dictates. But we are not interested in trying to own everything. We want to own the bargains.

We may not always be able to pick them. We may miss out on some high flyers because we thought they were too expensive to buy. Sometimes a “bargain” turns out not to be one. Generally, though, we believe that our odds are better if we at least try to find the bargains.

An alternative to our way is like going to a doctor who prescribes every drug he can think of in case one of them works. “Chances are some of them will make things better and some of them will make things worse, but in theory one of them should cure you.” Wouldn’t you run out the door?

There are many unknowns in both medicine and investing. A doctor may have to try several courses of treatment before finding one that works. Similarly, we frequently implement several promising tactics at the same time. Some don’t work out and need to be replaced.

We think it is reckless, however, to simply give up trying to find successful investments in favor of simply grabbing a little bit of everything. Yet that seems to be a popular, if lazy, strategy with some investment professionals.

Clients, please call or email us if you want to discuss how our investment ideas apply to your situation.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk, including possible loss of principal.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

No strategy assures success or protects against loss.

Two Robbers Lurk in the Shortcut

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The investment methodology promoted by most financial professionals has a costly shortcut at its core. A mathematical trick is used in place of common sense, one that simply equates volatility with risk.

The shortcut enables people to pretend that statistical models can predict the future risk in any portfolio. The model always works perfectly, until it doesn’t. Three Nobel Prize-winners using these kinds of models blew up a hedge fund with billions of dollars in 1998. The failure of Long Term Capital Management caused an international crisis.

Warren Buffett wrote a wonderful analysis of this issue in his 2014 letter to shareholders. He explained that stock prices will always be more volatile than cash holdings in the short term. But he believes that fixed-dollar investments are far riskier than widely diversified stock portfolios over the long term.

One of the robbers that lurks in the shortcut is inflation. A dollar today will only buy 98 cents worth of goods next year, and 96 cents the year after that. Buffett wrote in 2014 that the dollar had lost 87% of its purchasing power over the previous 50 years. So over the long haul, the stable fixed investment becomes quite risky in terms of the potential to melt your wealth away.

While the high risk in currency-denominated investments did its damage, the same 50 year period saw the S&P 500 advance by 11,196%. Another of the robbers lurking in the shortcut is missed opportunity for long term gains.

Fortunately, you can spot the shortcut fairly easily. Every one of the following situations involves costly confusion about volatility and risk:

1. When every market sector supposedly needs to be owned for proper diversification. Our view: Some sectors are overpriced and should not be owned—tech stocks in 2000, real estate in 2007, commodities in 2011, and so forth.

2. When the presence of declining elements in a portfolio is held as proof of proper investment process—the idea that some things always zig when others zag, and keep the whole bucket more stable. Our view: When a crisis hits, many things decline across the board.

3. When a short-term decline is spoken of as ‘a loss.’ Our view: This is a costly misperception, born of a short-sighted approach.

4. When the future returns of a portfolio are described as a range that will be accurate 95% of the time—this is a hallmark of the statistical model. Our view: The model knows the past. The future will be different than the past. The wheels will come off the model when these differences emerge.

No one knows what the future holds. Our approach is to avoid stampedes, seek the best bargains, and strive to own the orchard for the fruit crop. These principles help us pick our spots, so to speak, rather than think we need to own a little bit of everything no matter what. The principles are no guarantee against loss.

The key advantage in our method, we believe, is avoiding the robbers who lurk in the shortcut. No systematic wealth melting from unneeded stagnant fixed investments, no missed opportunities for long term gains. We have no guarantees that our approach will be superior.

Clients, you know that one thing is required of you in order to have a chance to be successful with our methods. The understanding that volatility is NOT risk is key. Please call us or email if you would like to discuss this at greater length.


The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The State of Our Union

© Can Stock Photo / Niyazz

Our union? Yes, you and we are partners in a unique enterprise. As a client, you share our confidence about the long term. Many of you are willing to live with volatility in the short term to get where you want to go. And many of you don’t join stampedes or sell out in panic. This investment behavior puts you in a select group. It is a vital ingredient in the beginning of your success—and ours.

The 21st anniversary of the decision to embark on our ultimate business venture is a natural time to take stock. Where are we now? Where are we going? We’ll assess this in terms of our three key activities.

Communications.

We love to talk—you know this. About two years ago, we began to figure out how to talk to all of you, every day if you would like. The new media has two aspects. Real time commentary and news shows up in the social media venues like Facebook and Twitter. A permanent library of all of our philosophy and strategies and methods can be found 24/7 at 228Main.com.

Paradoxically, the success of our new media has given us more time to talk one on one, by telephone or email or in person. So now we spend more time doing what we love, connecting with you directly. We expect to continue to build both our archives and our skill at real time interaction.

Investment Research.

To a surprising extent, our research capabilities are tied to new media activity. We interact with great minds in economics and market strategy, trading ideas and insights and finding topics we wish to investigate more deeply.

The one-to-one communications with you also contain a research element. We gain perspective on global markets by talking to executives who have traveled the world on business. We have a better understanding of specific industries and companies because we talk to people who are in those businesses. Every one of you is a consumer, and we talk to you about companies and products you deal with every day.

Our conventional sources have never been better, either. LPL Financial continues to build out our back office research staff by adding and developing talent. Bottom line: we are connected to ever-richer sources of ideas and trends as well as the specific data we need to do our work.

Portfolio Management.

Over the past eighteen months we have worked on improving our capability to act more quickly on fleeting opportunities. You saw the results. Our portfolio review process is more robust than it ever has been.

We also have tweaked our strategy. Now, client portfolios see more activity but in smaller pieces. Instead of looking for opportunities where we can invest 5% of a portfolio balance, we will take action if 1 or 2 or 3% position sizes are appropriate. With more holdings comes greater diversification. Theoretically, this may give us a smoother ride to our goals.

The markets are like a thousand piece mosaic whose tiles are constantly changing. So we cannot tell you what changes are coming in the future—only that we will always be trying to figure out how to grow your buckets more effectively.

So the state of our union is grand. We have focused on our systems and processes so we can take care of business no matter what happens in our lives or the economy and markets. We offer no guarantees about the future, except for our intent to get better as we go along. Thank you all for your part in our unique partnership. Clients, if you’d like to talk at greater length about these things or anything else, please email or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

If You Always Do What Everybody Else Does…

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Our clients know we are not like most other financial advisors. We used to be content to let people discover the differences at their own pace, if ever. But changes in the world have made clarity about the distinction a crucial matter—vital for us, vital for you.

The financial industry is responding to regulatory and competitive pressures by adopting standardized approaches for all investors. This ‘safe’ approach based on conventional thinking supposedly reduces risk of fines or litigation.

Consequently, many advisors spend no time reading SEC filings or analyzing financial statements or managing portfolios of stocks and bonds. Instead, they try to find people to stuff into one of three or five pie charts filled with packaged products.

There are more than 300 million people in the country. We do not believe you all fit into one of these pie charts.

Our principles-based approach is based on building custom portfolios for each client. We are contrarian—we do NOT want to do what everybody else does, and get what everybody else gets. We hope this is why you continue to do business with us.

With different methods, we get different outcomes. Client results generally do not match “benchmark” returns such as the S&P 500 Index, or what the pie chart would have gotten you. Sometimes we do better, sometimes we do worse, and over the long term we hope to come out ahead. No guarantees, of course.

Our portfolios also experience volatility. We all understand that this is an integral part of long term investing. We do not sell out just because the price goes down. Warren Buffett loves to buy when the price of a good opportunity declines, and so do we.

Since each client has a custom portfolio, there is a range of returns even among clients with similar objectives. We are constantly improving our portfolio process hoping that all clients receive as much benefit as possible from the opportunities we identify. But with our approach to portfolio-building, there are still nearly infinite variations in holdings. Money comes in at different times, and client preferences are taken into account when investing. Naturally outcomes differ one from the next.

Bottom line: if you want the benchmark return, or to end up with what everybody else gets, or to avoid volatility, you should find an advisor to slot you into a pie chart. Don’t worry, it is easy to find one—they are all over the place.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

A 1-2-3 Approach to Investing

© Can Stock Photo / dexns

At times we feel embarrassed to be learning so much at a mature age. But we are grateful for the energy to attempt to improve what we are doing. Here we discuss developments in our portfolio management theory and practice.

One. Recently we figured out that one of our investment themes may benefit from a 1% position in a more speculative holding than we usually want to own. (By that we mean that 1% of a client portfolio could be invested in this company.) While failure could cost a dollar per dollar invested, success might return multiple dollars back, in our opinion.

We believe this makes sense because success might come at the expense of our other holdings. So one investment may serve to offset losses in another. No guarantees, of course.

We also realized that the 1% idea might help us in another way. Value investors have trouble buying exciting growth companies that have yet to develop large earnings, or dividends, or book value. But taking a smaller position in companies with solid prospects for growth can more easily be justified than buying a more sizable position. Perhaps this will let us participate with more comfort in the ownership of faster-growing companies.

Two. The next portfolio development came from our research into the biotech industry. The biopharmaceuticals each have their own specialties, and new products in various stages of development. Based on current earnings and prospects for growth, we wanted to gain exposure. It was too difficult to choose one over another, even among the larger and established companies. So we decided to buy 2% positions in each of four large players.

Three. We reduced our core position size from 5% to 3% for mainstream holdings. After 2015 we became interested in avoiding excessive portfolio volatility. Owning smaller pieces of more companies lets us be more diversified. We will also have more flexibility to let potential successful companies grow into larger fractions of the portfolio over time.

We are excited about the evolution in our thinking about the best ways to put portfolios together. Combined with the development of our trading protocols, we hope to put money to work faster than ever before—and in new ways. We still research carefully and come to conclusions only after thought and study, of course.

If you have questions or comments about how your portfolio is affected, or any other question we might help you with, please call or write.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing involves risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

The Benefit of Being Picky

© Can Stock Photo Inc. / Farina5000

Suppose you had the opportunity to attend a fancy catered gala. When you get to the dessert table, a dizzying array of delicious looking pies are spread out for you to sample, too many to choose from. Not knowing which ones might be the best, a fellow next to you tells you he’s going to sample a little bit of everything and offers to help load up your plate the same way.

If you happen to be deathly allergic to peanuts, you would ask your helpful friend to skip the peanut butter pie and just get you some of the rest.
“Nonsense,” he tells you. “You never know, the peanut butter pie might be the best of the lot.”

“But if I eat it I’ll go into shock and might die. I can’t even let it touch the rest of the dessert on my plate.”

“You don’t know the future. Just because you’ve had an allergic reaction before doesn’t mean that you’ll have one now,” he says, handing you a plate with a slice of peanut butter pie smack in the middle. Instead of getting to enjoy your dessert you’re left unhappily trying to pick around the edges of the uncontaminated slices of pie.

This situation sounds absurd, and it is. And yet it resembles a commonplace practice within the investment industry. There is a portfolio strategy known as asset allocation that says that since we can’t know for sure which assets are going to go up or down, investors should aim to own a slice of everything. Because different asset classes move in response to different economic pressures, when one goes down it will hopefully be balanced out by a different asset going up. The goal is to try to reduce volatility through diversification.

However, just like our unhappy party-goer in the example above, there are probably some slices you don’t want any of—period. Tech stocks during the dot-com bubble in 2000 and mortgage based securities during the real estate bubble of 2007 were two slices of the investment universe that were very dangerous to your financial health.

Proponents of asset allocation dismiss this notion as market timing, saying that you can’t predict when the bubble will burst and that you miss out on potential gains by staying out of the bubble. But if we’re allergic to the pie, we don’t care how delicious the pie might be—we don’t want a slice.

Our approach may or may not be the right one. Nevertheless, we believe that being picky about the slices we take may bring us better results than blindly grabbing a bit of everything. If you want to talk about how this may apply to your portfolio, please call or email us.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Asset allocation does not ensure a profit or protect against a loss.