Sunday, July 28, 2013

The Real Investment Risk is not Changing Your Thinking

In the US Marine Corps and in the long-term investment portfolios that I manage we never lose sight of our final goals of accomplishing the mission and survival. In the Corps, investment portfolios, school lesson plans, and certain other activities it is desirable to move orderly in one direction and with a single set of instructions. Unfortunately that approach is often called the ‘school’ solution, a theoretical plan that does not represent the reality on the ground or in portfolios that must perform. In the real world more often than not we are confronted with challenges and therefore opportunities that take us off the narrow principles-based trajectory we have been schooled to follow. At every given moment, those of us that invest for others must negotiate the differing challenges of:

·       Selecting among tactical vs. strategic considerations
·       Diversification against a laundry lists of risks
·       Incorporating multiple and changing definitions of risks
·       Managing operational considerations both for the client and our own shop

The future starts with the present

While a long journey begins with the first step, our near-term vision can dictate how we approach our long-term goals. One of the traditional problems in using long-term performance is that the jumping off point may be radically different than the first step that built the enviable record. In almost all cases it is better to start when the market prices reflect past poor performance rather than counting on momentum to continue. Intellectually this may be easy, but emotionally tough to do. Luckily peaks and bottoms are relatively rare in terms of frequency. Most of the time we are zigging and zagging within an unclear trend.

One of the advantages of my practice is that I get the great opportunity to have meaningful discussions with smart managers, (there are very few, if any, dumb portfolio managers in the fund business). I am often struck that in this world of supposedly fair disclosure, that the better managers receive very productive insights from conversations with people not directly connected to the corporate or financials worlds. In addition, the better managers have good powers of detailed observations.

I try to learn from the good and great ones and apply their different approaches when I can.

A breakfast at Caltech

Some time ago I spoke to a group of incredibly intelligent students from the California Institute of Technology about financial community opportunities. I must have made some sense because a few weeks ago one student asked whether we could continue the discussion with a few of his fellow grad students. My time on the Caltech campus is always quite limited, so I challenged him to come to an eight o'clock breakfast. (For many students, 8 AM is the middle of their sleep period!)  Four of them attended as did a fellow trustee with three degrees from Caltech, who is also a successful company founder. We were joined by a professor and research project leader in neuroeconomics.  He is developing an understanding as to how the brain makes investment decisions.

The students appear to want to focus their efforts in biotechnology. While still on campus one of the students has already founded his first company.

I don't know what they received out of our discussion, I got an understanding of what their science (and others) can do for mankind. This discussion was followed by another about the development of a potential home machine that could transmit the nature of ailments through sampling body fluids that could be delivered to doctors before the patient arrives.

What does this mean to me?

One of my antecedents was an Elector for Abraham Lincoln, and even though my brother received an appointment as a page from a Democratic senator, I am a believer in much of Republican philosophy.

I had firmly believed that the so-called Obamacare was a mistake for the country economically and socially. While philosophically I am still opposed to government sponsored healthcare, the discussions on the campus of Caltech and reviewing a fund that has been a successful investor in biotech companies of high promise, I am now contemplating that the government's projections are extremely misleading, not because of their socialistic policies, but because of technology. Relatively low cost and widely spread new families of healthcare instruments or appliances as well as new drug therapies could materially lower the costs of healthcare. My purpose of bringing this subject up is to show that as long-term investors, we need to constantly examine our thought patterns. This is just like the Marine Corps had to develop tactics of moving off of ridge lines and moving down into the valleys or cross-compartments to take the "critical terrain" and accomplish its mission.

Our mission is to invest successfully long-term

The first rule of successful investing is to avoid permanent loss of capital. In this weekend's Wall Street Journal 
the inestimable Jason Zweig discusses a book that focuses on risk. To me risk is the penalty for being wrong to the degree that critical terrain is lost in accomplishing long-term investment goals. Jason makes the distinction between shallow risk which he harks back to Ben Graham as "quotational risk" or somewhat temporary price declines. "Deep Risk" is what we should be focusing on, he believes.  Deep risk is created by four elements; according to the column they are:
·       Inflation
·       Deflation
·       Confiscation
·       Devastation

Though bad for our future capital, the four conditions above could be survivable if expected and anticipated in our portfolios.  If we don’t recognize the potential for each of the listed ‘four horseman’ then we are truly in deep .... risk.

Recognition time

I could be wrong about the overall costs of healthcare; certainly I will consider more evidence that may alter my view. However we could change direction on national inflation and the continued confiscation of private bond holders' rights versus the government’s prerogatives.

The truly successful long-term investors don't lock themselves into a strategy. Each day if not each hour represents an opportunity to change.

An effective time horizon strategy

Rarely market prices, yields, and other investment ratios reach long-term peaks or bottoms. Most of the time we are zigging or zagging from a past major top or bottom. We just don't know which is the terminal point of a trend. Therefore a mechanical process of adding to or subtracting cash to an investment portfolio makes sense. The trick to do this effectively is to keep the time horizon in mind for each portion of the portfolio. 

Current needs

For the portion of the portfolio that needs to provide current levels of money to meet operating needs, US law has changed. Under modern law the distinction between income and capital has been removed. Thus the general level of acceptable current yield is augmented by trading results. In today's markets, I suggest that trading of stocks and bonds will be a greater source of cash needs than yields. The ability to convert principal to meet needs suggests that current requirements will be met by what we used to call "wasting assets" similar to investing in a mine with a known life. Eventually the funds will be needed to support current cash needs.


The next time horizon bucket is the intermediate bucket or perhaps buckets. The purpose of this intermediate portfolio is to regenerate enough cash in a timely fashion to provide for current needs when the first portfolio is exhausted. This portfolio requires less trading skills and in today's environment more equity type risk taking which can include some so-called high yield product.


The four "horsemen" of deep risk should be the main focus of the long-term portfolio with sufficient upside potential to offset the pains delivered by the deep risk elements. Based on my own recognition from this last week, I will look as to what makes sense in biotech investing either in the public market or through intelligent and not too greedy private equity vehicles.

Questions for today

1. Share with me privately what were the "aha moments" in your portfolios.

2. How are you positioning your portfolio responsibilities for this dynamic world?
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