February 3, 2009
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This introductory article is intended for the educated layman. It was written originally to introduce a continuing series of essays on a variety of investment topics.
Benjamin Graham (1894-1976), the father of modern securities analysis and portfolio selection, wrote, “To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions…” Graham was a wiser investor than I, but I should add to his statement that intelligent investing also requires that one think about the process in a structural way (as he did), as if you were a scientist. Investing requires both knowledge and an intellectual framework.
Many people mistakenly think that investing, like life, is one damn thing after another. This limited outlook can manifest itself in either of two ways. On the one hand, it leads some to believe intensely that the proper way to invest is to pick stocks or other investments that parade as winners—and lest I seem disparaging, let me add that picking investments that subsequently win is wonderful—and often to believe that these stocks can be identified in advance through intuition or cursory attention, which is a dubious proposition. On the other hand, it leads some into a sort of financial existential despair, and the belief that all investing is a gamble—once again, there is an element of truth here—with the consequence that they fail to take proper care of their financial assets.
When I say that an investor should think about the investment process in a structural way, I do not mean merely that she should have a “system.” To me, a “system” is the sort of gimmicky set of rules, founded more on blind faith than on analysis, that one might find in a paperback sold at airport newsstands to new arrivals in Las Vegas or Reno. Rather, one should have an explanatory model of why investments behaved as they have done historically or as you think they ought. This is the way economists think. Having evidence that the model can explain investment performance that occurred in the past also helps.
Graham wrote the first edition of his second famous book, The Intelligent Investor, in 1949, moments before the beginning of a revolution in finance, when economists began concertedly to wrestle with financial markets and financial instruments. (Graham’s first book, well known to all investment managers at least in name, was Securities Analysis (1934).) This revolution, one of whose principal products was what is often called Modern Portfolio Theory (MPT), has had profound implications for how professionals today manage gargantuan amounts of money. Modern financial theory, partly in recognition of its established status, but more because of its relationship to neoclassical economics, has become known (at least among economists, but not the public or even the investment profession) as “neoclassical finance.” After more than fifty years, Modern Portfolio Theory is far from modern, and we have also completed a circuit, but not a closed one, during which academically trained investment practitioners have rediscovered all the caveats with which the economists originally hedged the assumptions that underlay MPT and the rest of modern finance.Display article as PDF for printing.
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