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Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
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Next year I will be celebrating my 30th year in the investment management profession. When I got into this business my daughter was three years old and my son was less than one. I am now a grandfather. Yikes! Getting older in many occupations turns from being an asset to being a liability because of our society’s obsession with youth, and it usually happens in our fifties. Fortunately for me, age and experience are valuable assets in my profession way beyond the age of 50, especially when you are an “old dog” like me who likes to learn new tricks.
When I first got into this business in 1982, I quickly realized that much of what I had learned about investment management in books did not provide a lot of insight into the real world practice of the profession. Most of the accepted principles and methods of investment management are based on mathematical models that make sense on paper but are not always as effective in achieving the desired investment objectives.
One would expect to see those accepted principles and methods evolve and improve over time as lessons are learned from actual experiences and as technological advancements provide better analytical tools. While the tools are better and make analysis of the economy, the financial markets, individual securities and portfolios easier and less time consuming, I have not seen a similar progression in the accepted standards of practice within the investment management industry.
Since the 1950s when Harry Markowitz, a University of Chicago economist, brought Modern Portfolio Theory (MPT) to the investment management industry, investment managers have been managing portfolios and the risk within those portfolios in a very similar fashion. MPT is a mathematical formulation of the concept of diversification in investing. Its objective is to minimize risk in a portfolio for a given level of expected return by choosing the proportions of various investment assets whose returns are not perfectly and positively correlated.
Over the next few decades, the industry standard for risk management consisted of asset allocation decisions and determining the number of securities within each asset class to control the variability of annual investment returns for a portfolio. Over time, as the number of asset classes expanded with the help of very creative Wall Street investment bankers, diversification has grown beyond just the three main investment staples of stocks, bonds and cash.
At the same time that the number of investment alternatives has dramatically increased, the old tired investment maxim of “don’t time the market” is still alive and well. This has caused the believers of that adage to permanently increase the number of asset classes and individual securities within their clients’ portfolios.
The result of this evolutionary expansion of asset class representation and number of individual securities is the investment professionals’ belief that they have actually decreased risk for their clients by having greater diversification within the portfolio. This is what I call the “passive strategy” portion of the standard risk management process in that there will be few changes in that strategy over time.
The active part of this risk management strategy consists of rebalancing the various asset classes within the portfolio to the desired target allocation on a regularly scheduled basis. Risk is reduced as money is shifted out of the asset classes that have higher valuations and is put into those assets that have not performed and, therefore, are considered to be cheap.
While this risk management strategy has merit when analyzed on a statistical basis, I found over my 30 years in the business that it comes up short for real people in the real world when the financial markets are suffering through the inevitable bear market part of the cycle. Most of my clients expected me to use my “professional expertise” to protect their portfolios when stock and/or bond prices are generally heading down.
That is why the more progressive firms in the industry have moved far beyond Modern Portfolio Theory and other accepted industry standards of practice to focus our efforts on developing more effective risk management tools and strategies that better protect clients’ portfolios when the circumstances call for them. This has included expanding our analysis to determine the current investment merits of the different asset classes in order to determine what exposure if any our clients should have.
In my opinion, there are too many “dogs” in the investment management business who have not learned new tricks to better manage their clients’ retirement savings. They cling to the accepted industry principles of risk management even though those strategies are responsible for many baby boomers postponing retirement because of the damage to their portfolios from the last two bear markets. In the end they will lose out as people search for investment managers that utilize more contemporary and sophisticated risk management strategies that actually protect their portfolios when conditions call for such action.
John W. Gudritz CFA is a principal at Front Street Investment Management LLC, a fee-only investment management firm in Traverse City. Reach him at 866-933-7668 or visit www.frontstreet.com.