January has been a hectic month for many investors. The market opened the year with a dreadful selloff. After two weeks, it was the worst performance we had seen for the broad market. However, the results were materially different for some investors. I lost some money in January, but my results were better than the S&P 500 (NYSEARCA:SPY). That was despite being 99% invested, holding a company that fell by 35% and having some international allocations that were down double digits. Contrary to what you might guess, my portfolio had no direct bond exposure and my indirect bond exposure (through an mREIT) was down by over 8%. Given those factors, beating the market was unlikely.
Despite being ahead of the S&P 500, losing quite a bit of money left me looking for ways to reduce the risk. I've been spending more and more of my time thinking about the lessons of Benjamin Graham and David Dodd. I've taken some time off from writing to spend more time reading through "Security Analysis". Even though the first edition was published in 1934 and updated in 1940, the lessons remain relevant today.
Modern Portfolio Theory
When I was learning finance, the latest economic theories were all the rage. Theories like Modern Portfolio Theory were drilled into each analyst. There is certainly some value in being aware of these schools of thought, but I don't believe Benjamin Graham would have looked favorably on them.
Most economic theory today relies on the premise of an efficient market. The biggest problem with the premise of an efficient market is that it is often taken to suggest that it is only through look that an investor can hope to beat the market. Under that theory, all investors should be buying low fee total market indexes and dollar cost averaging into the position. In my opinion, that isn't a bad idea and it will certainly beat the returns many individuals create for themselves after extensive work.
Despite the benefits of such a strategy, there is a fundamental flaw. Economic theories generally assume that every investor has access to all of the information. There is essentially no cost involved in analysis because all of the information is already available and all investors know it. I believe that premise is fundamentally wrong. As an analyst my primary area of coverage is REITs (real estate investment trusts) and even more specifically mREITs (mortgage real estate investment trusts). To have access to good (but still incomplete) data, I have to pay monthly fees. If all investors had access to all information, there would be no market for this data. Further, I can assure readers that there is a substantial time cost that goes into performing solid analysis.
The fallback position for investors focused on this economic line of thinking would be to suggest that any excess returns are really payment for the time invested in researching the security. Under economic theory this could be considered the "normal profits" for doing the work of analyzing the security and making the right investment call. If that were the case, we can suggest that absent luck all investors would have the same return as those that did the most research earning a higher probability of above-average returns. That is better, but far from great. If you're relying on your portfolio to provide for you in retirement, you want substantially more than an expectation of having "better than average luck."
If you are willing to buy into the economic theories to the fullest extent, then you would have to define risk precisely as the volatility of an investment. That's not quite precise enough though because it does not state how the volatility is to be measured. Is it daily returns, weekly, monthly, or perhaps measured down to the minute?
If we are measuring volatility on such a short time frame, then we are looking at the returns from speculation rather than the returns from investing.
When investors are really focused on investing, rather than speculating, the level of volatility is not critical. The critical factor would be the amount of downside protection. Returns are not a perfectly normal distribution. Since equities can't go below 0, it would be impossible for them to be a perfectly normal distribution.
The words that keep coming up are terms like "margin of safety" and "discount to value". The premise relied upon the idea that information available for analysis would be imperfect and the security should be worth the purchase price even if the real values were towards the bottom end of the estimates.
Because Modern Portfolio Theory was pounded into my brain, my analysis often focused simply on beating the sector. In the latest strategies for evaluating portfolios managers, there is evaluation of a manager's ability to beat the sector through superior stock selection and to pick the right sectors.
My focus in research has primarily been to beat the sector. I leave it up to other analysts or portfolio managers to determine the right sector allocations. Instead of worrying about those things, I drill deeply into the individual securities and analyze their prices to determine which ones have better chances than others. As a result, I was able to build a great track record of calling out pair trades. In a pair trade, there is no need to determine which direction the sector will move. I simply need to know which stock within the sector should beat a different stock within the sector. This remains a very effective investment technique, but it suffers from the necessity of being able to implement both sides of the trade.
The Short Challenge
Ben's thinking relied upon a strong aversion to risk. An opportunity to earn $10,000 or lose $10,000 on a coin flip should be avoided. Economic theories still include an aversion to risk, but not to the same extent. In finance, there is generally a distaste for ratings such as: "Sell, don't short". The current perspectives would suggest that if a stock is being sold then it might as well be shorted because it is going down.
Imagine you were contemplating putting your life savings on a coin flip. You've selected heads and the thrower lowers the coin and asks if you're sure. You see three people giving you advice. One is an analyst yelling "buy heads." The second is an analyst yelling, "short heads, buy tails." Benjamin Graham is the third yelling: "What are you doing? Walk away from the volatility. This is speculation, not investing."
Which person is giving you the best advice? It doesn't matter whether the coin lands on heads or tails. The result is only known after the throw. The best advice was to walk away.
Retirement and Downside Risk
I believe that in retirement the emphasis on avoiding downside risk is even more important. Volatility of positive returns is less important than the exclusion of significantly negative returns.
Risk and Returns
According to current theories, high levels of returns can only be the reward for high levels of risk. That theory makes perfect sense in the classroom, but it doesn't translate so well into the world of value investing. The new theories start with the premise of an efficient market, but Benjamin Graham and David Dodd started with precisely the opposite premise. They assumed that the market was inefficient. However, they also demonstrated a substantial aversion to risk so that even in an inefficient market there would be a limited number of attractive investments.
The popular theories of investing today begin with the premise of an efficient market and the idea that volatility is precisely the same as risk. This idea runs contrary to the ideas of value investing. When an investor wants to establish a safer portfolio and prevent the downside risk, they need to be willing to put in quite a bit of due diligence. While reducing volatility can be a positive aspect, it should only be one method of measuring performance.
Since I've been working in a sector that keeps falling, I've placed a premium on finding attractive pair trades. This strategy helped to reduce the volatility of my ideas, but shorting stocks can still be risky. Sometimes the best advice to investors is simply to sit it out on the sidelines because the volatility is so high that neither buying nor shorting makes sense for a risk-averse investor.
I believe it would be wise for more investors to focus on a higher level of risk aversion and treating the agony of defeat as being significantly worse than the joy of victory. Over the next couple of years, I intend to transition my portfolio to provide a better representation of value investing. That will mean more cash and short-to-medium duration bonds.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.