Thursday, December 08, 2005



The investment strategy that most investment advisors recommend is to buy and hold a diversified portfolio of investments. The diversification strategy is usually determined by the percentages set out in a computer-generated pie chart.

Many readers have seen these pie charts. The prior post contains a simplified, yet more “accurate” example of the pie charts most brokers and financial planners prepare for their clients. I am of course being snarky and sarcastic. But in Secular Bear Markets where investments are flat or lagging, this is not an inaccurate caricature.

The “Buy and Hold” diversification strategy had some financial and investment basis in the last Secular Bull Market, 1982-2000. Time, but not the industry, has passed it buy.

This "Buy and Hold" method combines three disparate strategies:

Modern Portfolio Theory. Modern Portfolio Theory, often abbreviated as MPT, has been around since the 1950s. Henry Markowitz first introduced it. MPT states that there are two types of risk in the market, systemic risk and non-systemic risk. The first risk, systemic risk, is the baseline risk of the investment market itself. So if you invest in the stock market, you are incurring the general risk that the market will rise or fall. You cannot eliminate this risk. It is systemic to the stock market. The second type of risk is non-systemic risk. This is risk above and beyond stock market risk. It is not risk from the stock market itself. It is the risk you take by owning a specific stock or mutual fund. Calculations like Beta, Alpha, and Standard Deviation can help you determine what that non-systemic risk might be.

MPT seeks to minimize non-systemic by investing in diversified portfolios of investment that either minimize risk or reduce non-systemic risk. Index funds, exchange-traded funds, broad baskets of category stocks would ways to achieve this diversification. Under MPT, we do not focus much on balancing risk/reward. We seek to minimize the risks through more sophisticated “buy and hold” pie-chart models. And we stick with this model until one of three things happen:

1. Our model fails and we must reallocate and try something else.

2. Our model succeeds and we “rebalance” the portfolio. This means that we sell our winners while they are still making money with them. We take the profits from our good performing holdings and reinvest this money into investments in our portfolio that are lagging and losing money. “We must,” will say the pie-chart broker, keep 10% of your portfolio in mid-cap value funds, no matter how much they have fallen in value. That is what the home-office pie chart says.”

3. We get older (like reach 35 or 55 or 65 and the portfolio must get more "conservative") and the broker’s home office tells us the pie chart must change, regardless of what was working or not-working the day before the pie-chart changes.

Efficient Market Hypothesis. (EMH). EMH comes in two flavors, flavors that a particle physicist might admire[i]. Strong EMH and Weak EMH. So what is EMH? The Efficient Market Hypothesis believes that the stock market is “informationally efficient”. This means that everything that is out there to be known about a stock is known and that the price of a stock reflects all of that information. And since everyone knows everything about the stocks and markets, it is impossible to “out know” a stock or a market. Let’s try an example:

One of our more maligned stocks, Hogsome-Darlington (HOG), is a manufacturer of obsolete American motorcycles. You are a stock analyst and your research determines that HOG motorcycle sales will fall precipitously when the US government outlaws the use of leather tassels on the end of motorcycle handlebars. Your research has revealed that people do not ride HOGs based upon their performance or reliability. In fact, HOGS grossly under perform other motorcycles and are notoriously unreliable. They are sold with a pre-printed “Lemon Law” complaint that the buyer can fill out ahead of time and send in with the registration documents.

No, your research reveals that people buy HOGs so they can let their leather tassels fly in the wind and look cool in the eyes of other HOG owners. Based upon this research, you sell HOG short and wait for it to fall.

The EMH, however, tells you that the market must already know the leather tassel story and the current price of HOG must reflect this knowledge. Even if HOG continues to rise in the face of certain bankruptcy. So why bother picking stocks? Since the market knows all of the information, like some giant lattice of magic wisdom, you cannot beat the market by speculating on HOG’s demise. Under EMH, all you can do is buy index investments and exchange-traded funds and hold them while the stock market (hopefully) rises. Sound familiar.

Above is the Strong Version of EMH. A newer theory, developed with the recognition that Strong EMH is baseless, is Weak EMH. Weak EMH argues that most everything about the market is known, and the market is generally informationally efficient. Could be. Or it could be the EMGH proponents finanly acknowledged their hypothesis was wrong and had to salvage their theory by diluting it.

Never Be Wrong Alone. Sir John Maynard Keynes once said (paraphrased) “If you are to be wrong, better be wrong with most everyone else”. So most brokers, financial advisors, portfolio advisors, like most other professions, all strive to be wrong together. If you are right and alone, you might get a bonus. Wrong and alone, a pink slip. This tendency among investment advisors to follow the dogma of the day, “Buy and Hold” like the pie-chart says, is safer. And it is a heck a lot of easier than developing investment models that actually help clients prosper in a Secular Bear Market.


Prior posts have discussed Secular Bear Market strategies such as inverse funds, put purchases and lots of cash earning T-Note interest rates. A post of the last week talked about high Alpha mutual funds. In upcoming posts the Author will discuss some ways to value stocks and international investments as modest growth strategies.


[i] Okay, this is an inside joke for the physicists out there. There are two atomic forces, the “Strong” force, and the “Weak” force.


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