Would an Intelligent Advisor Just Give It Away?
Phil Hammond, CFP®
In order to produce above market averages, one must have some sort of strategy insight or intelligence edge that other investors do not. And if indeed you did have that insight or intelligence relatively unknown to most others, would you just give it away? What if, over years of market experience, you had created an investment edge, developed strategy insight, and designed a market professional decision-making discipline? Would you share it with others? Before you can even address that question, I feel it is important to ask if it is even possible to obtain that kind of investment knowledge and develop that systematic approach, because, after all, the more popular theories of today’s prevalent Conventional Wisdom, like Modern Portfolio Theory, Efficient Market Hypothesis, and others that are taught and popularized in academics and financial advice industry, say, or imply something else.
Markets are not Rational
Some investors are very short term speculative in nature, like day traders, and some are long-term passive buy-and-hold forever. Some might utilize fundamental analysis, while others use technical analysis. Some try to make predictions and forecasts, while others just follow trends. Some might employ asset diversification as a means of controlling risk while others use robust decision-making. Some buy into the studies and research that supposedly conclude that active management is a waste of time and effort, concluding that the only way to maximize returns is to own a diversified portfolio of low-cost index funds focusing on tax and cost efficiencies.
Others take an opposite view as the key to success by concentrating investment capital into fewer assets and even at times using leverage to enhance potential portfolio returns. You cannot say that all market participants view and approach investing, the capital markets, and portfolio management in the same way. It is pretty obvious that investors, traders, speculators, and all other types of market participants around the globe do not all have the same ideas about what strategies to employ, or have parallel timeframes and time horizons, or even have similar goals and objectives. And it is all these differences (of human opinion) that lead to capital markets being highly inefficient and irrational. This is a foundational realization that led me to consider and finally conclude that much of today’s popular academic investment theories, like Modern Portfolio Theory, Efficient Market Hypothesis, and other published works on capital markets, investment strategy, and portfolio construction, is misleading and half-baked at best, or outright false and delusional, at least in the real world of investing.
And like it or not, all investors in the capital markets do not have access to all the same information at all the same times as they go about making buy, hold, and sell decisions. The type of information I am talking about has nothing at all to do with the (public) macro or micro financial or economic news, nor am I talking about the use of (non-public) inside information and insider trading from it.
The kind of information I am talking about here has everything to do with the systems, strategies, and tactics of portfolio management, and the making of buy, hold, sell decisions. For example, many investors and investment advisors limit their knowledge to what an article or what some popular financial expert tells them or encourages them to do, or even to the conclusions and conventional wisdom of the collective and published popular academia research and theories. Others may test an unimaginable number of parameters, strategies, and variations of strategies in an effort to find some approach that gives them an investment edge in the markets and with their competition.
My point is that most academic investment theories assume that all (with “all” meaning – theories, investments, advisors, or investors) act rationally and are all-knowing, but the reality is something different. We do not have the same information. And there are various opinions that lead to different philosophies, different tactics, and different points of reference.
Am I Making a Difference? Moment
Now suppose for a minute that you are an investment professional who is enjoying a reputable, above average career with earnings that put you in the top 5% or even in that “evil” top 1%. You have a decent life with a great family and a nice house in a good neighborhood. You try to be a good steward of time and money by choosing to regularly give to the less fortunate and volunteer to the less fortunate who need more of a hand up than a handout. You are not motivated by greed for the most part (but nonetheless recognize your limitations as a fallible human being). You despise the amount of taxes you pay but nonetheless feel the greatest thing you can do with your money is help others that are in need and deserving. You try hard to treat everyone fairly. And you demand the best in all.
One day you wake up and ask that proverbial question that many do at some point in their lives, “Am I making a difference?” Are you actually improving the lives of those around you? Is your advice truly changing people’s financial lives for the better? Or are you just going through the motions and doing the expected, but not what might be exceptional? You have apprehension, and maybe start questioning your worth as an advisor. It is the Fall of 2007, and the stock market starts yet another steep decline, and seemingly all investors, including your clients, start to see huge losses that can leave permanent scars on people’s future financial and retirement plans and portfolios.
You have seen this before: (1) Black Monday, October 19, 1987, while working for EF Hutton, experiencing the single worst day in investing history with the -22.6% collapse that crushed U.S. and worldwide investors; (2) late summer/early fall 1990, during the buildup to the first Gulf War when equities markets declined more than 20% in less than three months; and (3) in March 2000, the NASDAQ-100 index reached its peak and started a long deep 2½ year -81% decline when a lot of the dot-coms became dot-bombs going completely bust by the time it bottomed out. And now, it’s 2007, we are at the beginning of what became known as the Great Financial Crisis, heading into another steep, excruciating decline, and you think, here we go again. Will it be any different this time? How long will it take until markets hit bottom? How long will investors be underwater having to hold their breath until the markets recover and get back above the surface of even? Can investors hold on long enough to recover? (As it turned out, the markets declined for 16 months, bottoming out in March 2009 with losses exceeding 50% across the board and it was many years later until they got back to even and recovered all the losses.)
Exploring what Might be Possible
But this time, you just cannot take it anymore. Like Howard Beale in the 1976 movie classic, Network, said, “I'm mad as Hell and I'm not going to take this anymore!” You set out on an odyssey to study, read, and research all the popular and not so popular investment ideas and theories for yourself. For your own understanding, you employ Ronald Reagan’s trust-but-verify necessity by challenging all the conventional financial wisdom to see (for yourself) just how valid it may or may not be. You test everything you can, first by means of backtesting, then paper trading in a practice account, and then with your own dollars. In the process of all that testing of various strategies, you personally lose north of $100,000 of value in your retirement account. The losses are frustrating as much as they are painful. You’re embarrassed, yet you persist with trial-and-error, continue to see losses, but then at some point those losses are starting to be smaller in size and fewer in number. You start to experience more and larger successes which are now outnumbering failures both in size and volume. Then, in October 2010, you feel confident enough that you start publishing your thoughts in weekly emails to one of your dear friends and clients, let’s call him Jerry, laying out your exact recommendations and commentary on investing and the investment markets, the financial advice industry, and many of your conclusions about the popular financial theories and conventional wisdom.
Suppose that through all that research, study, testing, and live trading, you discover an investment edge that allows you to see a variety of things in the capital markets that others don’t as quickly as you. In addition, you develop systems for embracing (managing without eliminating) risk that allows you to focus on the probability for profit in any situation with a methodical, disciplined, decision-making process that avoids the personal emotional influences that will ruin even the best of plans or strategies.
Investment Edge, Profit Margin, and Crowds
Now, knowing that as more investors and advisors start to use the same or similar strategy and tactics, your unique investment edge(s) and margins of profit will shrink, if not get outright eliminated, would you share or publish a paper describing in detail how it works? Or would you instead keep the details of that system private and set out to earn great returns from that investment edge, strategy insight, and market professional decision-making discipline that you apply for both your clients and for yourself?
Now contrast that approach with advice that does not provide much investment insight, other than to say, “markets are efficient,” “no one can beat the market,’’ or that 80% of “active” managed mutual funds underperform passive benchmark averages (which is both true and not true at the same time!), so you better just buy-and-hold index funds. These markets-are-efficient, you-can’t-beat-the-market, buy-and-hold general conclusions are not going to create any extraordinary profits and wealth, so it is not like you are giving much up if you choose to share or publish your results. As a matter of fact, since that work was unsuccessful in producing extraordinary profits and wealth, it might make sense to just go ahead and publish it, and soak up some fame and adoration of others as you are praised for your insight and contribution to the academic understanding of financial markets.
But here’s the result of sharing: too many investors using the same strategy will spoil an investment edge and its potential for profitability. The probability for success will be diminished, if not outright eliminated. As more and more attempt to utilize the same or similar strategy, the investment edge and profit margin will be arbitraged away by its very popularity. Those with a successful investment strategy realize this. And this why you rarely see the details of very successful strategies ever published (until long after those who developed it have been handsomely rewarded).
A Famous, Well-Respected Investor Who Screwed Himself and Never Even Knew It
During the Great Depression of the 1930s, Benjamin Graham, (often referred to as the Father of Fundamental Analysis), developed a stock picking system by looking at the fundamental characteristics (earning, sales, assets, liabilities, etc.) of publicly traded companies. He was typically looking for low-priced common stocks that were selling in the open market for significantly less than what he considered to be their liquidation value. If a company’s market stock price was trading significantly less than what all its various factories, equipment, security holdings, and other assets could be sold for if the company was just closed and sold off piece by piece, Graham considered it a bargain and a great buy. During the depression, he often referred to these companies as “cigar butts.” At that time, he made a killing buying these much-undervalued “cigar butt” stocks.
Graham then started sharing his fundamental analysis to others through classes he taught at Columbia Business School. Finally, in 1949, he, with the help of David Dodd, published one of the all-time most famous investment books on fundamental analysis, The Intelligent Investor. In that book he basically was telling the whole world what his successful strategy was and laid out exactly how he did it.
People obviously saw his success. People learned his techniques from taking his business class at Columbia and reading his book, The Intelligent Investor. Many went on to apply the very techniques and investment analysis looking for those much-undervalued companies. And as more and more were doing the very same fundamental analysis, it got harder and harder to find those much-undervalued bargains. Eventually that very profitable investment edge shrank and at times completely disappeared.
Just before he died in 1976, Graham, finally gave in and concluded that the stock markets are efficient and that no one could consistently beat them long term. I find this very sad because Graham never realized that he ultimately screwed himself and his own ability for extraordinary profits by telling others exactly how he picked stocks. He gave away his proprietary investment edge and its profits with the classes he taught and that damn book.
Today fundamental analysis and buy-and-hold both remain very popular and are widely taught, used, and marketed by more academics and Wall Street professionals that any other. From what I have seen, I find that most fundamental analysis and conventional wisdom’s passive buy-and-hold do not provide much of any discernible long-term investment edge or extraordinary profits. It is just a less than efficient exercise in average-averaging.
So What is The Rational Choice?
So, you have a unique profitable investment edge, do you show everyone your cards and tell them exactly what you are going to do? What is the rational choice, yes or no? I know my choice.
Here’s my point: This is not about personal greed. This is about making a difference. This is about truly taking care of clients who remained faithful in you as you would to them through all this. This is about returning the favor to those clients and investors who put their faith and trust in you, by positioning and exposing them for opportunity to life-changing extraordinary success, by applying that unique investment edge, strategy insight, and market professional decision-making discipline.
I remember a meeting regarding compliance many, many years ago, when I was asked to disclose all the details of the proprietary investment strategies before they would allow me to recommend them to clients. I laughed and very respectfully said, no way!
(This was originally written ~10 years ago in 2012 but remains as valid and valuable today.)
This material is not a recommendation to buy, sell, hold, or roll over any asset, adopt an investment strategy, retain a specific investment manager, or use a particular account type. It does not take into account the specific investment objectives, tax and financial condition or particular needs of any specific person. Investors should discuss their specific situation with their financial professional.
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