but Better than ‘Buy-and-Hope’
March 3, 2009
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If you’ve lost faith in the stock market and your clients have lost faith in you, you’re not alone. According to a recent survey by Russ Alan Prince and Associates, a market research firm, 57 percent of investors plan to fire their advisor and a jaw-dropping 86 percent said they would tell others to avoid investing with their advisor’s firm. Only two percent of investors said they would recommend their advisor’s firm to other investors.
Although media attention has focused on the Wall Street banks and the expense to taxpayers of bailing them out, the retail financial services industry also shares blame for the trillions investors have lost. If you use traditional asset allocation in your portfolio, your losses over the last eighteen months have been stomach-churning. Advisors using passive asset allocation have stood by and watched with their clients as the stock market and the economy have turned from bad to worse. Their only guidance is a Wall Street mantra: “Stay the course.” They charged fees for this advice.
Passive asset allocation works well during bull markets, especially the last one — the greatest bull market in history — which lasted from 1982 until 1999. But buy-and-hold has a fatal flaw.
Modern Portfolio Theory and its supporting corollaries, Efficient Market Hypothesis and Random Walk Theory, are built on incorrect assumptions. As the famous investor George Soros recently said, “The idea that markets tend toward equilibrium, that deviations in return are random, and that markets are self-correcting is true most of the time, but not all of the time.” When a 100-year storm hits, buy-and-hold theories get washed away in the flood — along with the portfolios tied to them.
If traditional buy-and-hold strategies are flawed, then what should be Plan B? The alternative is some form of active asset management.
But we’ve been told active management doesn’t work and that it’s impossible to time the market. Maybe that assumption is wrong, too. We’ve learned a lot since 1952, when Harry Markowitz first introduced Modern Portfolio Theory. It’s about time we set aside the old theory and took a fresh look. Let’s take a quick review of some of the market realities that make active investing necessary, an example of an active strategy, and an explanation of why it works.
Risk and uncertainty
Risk denotes the precise probability of specific eventualities. When you flip a coin, you know the probability of the possible outcomes. Most investors think risk is the only consideration when it comes to investing. They think in terms of heads and tails: I’m either going to make money or lose money. But investing isn’t like flipping a coin; the outcomes aren’t black and white. Investing is rife with uncertainty.
Risk has limits, but uncertainty has no boundaries. Think about the 9/11 attacks, this year’s credit crisis, natural disasters, war, political instability; the possibilities are endless.
The concept of uncertainty is inherently complex because the potential events and outcomes are infinite. It’s not only risk, but more profoundly, uncertainty, that makes passive investing so dangerous. Where there is uncertainty, anything can happen.
The former U.S. Secretary of Defense, Donald Rumsfeld said it best: “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things we know we do not know. But, there are also unknown unknowns. These are things we do not know we do not know.”Display article as PDF for printing.
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