A Very Brief Guide To Portfolio Management: 'Watch Everything... Always'

by: CFA Institute Contributors

By Jason Voss, CFA

I read something absolutely crazy earlier this year, clearly written by someone very ignorant. In fact, that the story made it past its editor is evidence of the shoddy state of reporting. Here is a quote from the piece:

". . . quadruplex DNA is found fairly consistently throughout the genome of human cells . . ."

Ha! Can you imagine? Four stranded DNA?! DNA only has two strands wound around each other in a double helix form! That's obvious!

Since its 1953 discovery by Watson and Crick, knowledge of DNA's two strand structure has spread throughout the world, and it ranks as one of science's great achievements, ranking right up there with Newton's F = ma formula for its descriptive powers and consistently accurate predictions.

But you see that's just it. It does rank up there with F = ma in that the two-strand, double-helical DNA model is actually incomplete, just as force = mass × acceleration is an incomplete description of reality and gave way to Einstein's E =mc2, or energy = mass × the square of the speed of light.

You see it turns out there really are four strands of DNA for certain spans along the length of DNA. But it turns out that most researchers stopped looking for more strands because the double-stranded model long ago stopped being questioned.

"It's been sixty years since its structure was solved, but work like this shows us that the story of DNA continues to twist and turn," Julie Sharp, senior science information manager at Cancer Research UK, said.

Paradoxically, it may be that scientific knowledge is the most vulnerable to behavioral finance's admonishments of anchoring and inattentional blindness. Why? Because scientific knowledge has the imprimatur of being fully vetted and complete, and much of it has a long history of acceptance.

How Science is Vulnerable

Anchoring is the tendency of people to fixate on one piece of information, usually owing to nothing more than familiarity or acceptance, to the exclusion of all other information. Researchers long ago accepted the double-stranded DNA model as the right one and they have anchored to that model, as has the general public.

Inattentional blindness is failing to notice the unexpected when we are preoccupied with something else. Most scientists have likely not even noticed anomalies in the DNA model, not because the evidence wasn't there, but because they found the DNA model descriptive enough, and they were focused on solving some other problem, such as finding a cure for a dread disease.

Particularly vulnerable to these snafus of conscious evaluation are models and theories that have the highest explanatory power and that make the most accurate and consistent predictions, such as the double-stranded DNA model. After all, "If it ain't broke, don't fix it."

How Does This Relate to Finance?

What ideas about the world are you currently accepting as real that are actually incomplete? That Sir Isaac Newtown's F = ma has been supplanted by Einstein'sE = mc2, and that Watson and Crick's double helix is coming unraveled means that your portfolio may be most vulnerable to your most cherished assumptions.

How about these as examples?

  • "The world is under a crush of debt and will implode at any time."
  • "The European sovereign debt crisis is a clustercuss that cannot be resolved."
  • "My hedge ratio has worked perfectly for the past year."
  • "I have backtested everything and this strategy works with a 95% confidence."

In graduate school an accounting professor of mine challenged our class to come up with the perfect definition of management. He cautioned us that his definition - volunteered decades prior by a brilliant student - was only two words long and summarized the idea of "management" perfectly.

Our class struggled to define management as succinctly, and we begged for the management version of DNA's double helix - that is, the simple model that explains everything. What does it mean to be a manager, as answered long ago by the brilliant student?

"Watch everything!"

Pretty good, huh? But now that I am 20 years into my investment career, I can state that this management version of the double helix has a newer, more complete, four-strands-for-a-part-of-its-length version:

"Watch everything always!"

As analysts and portfolio managers, I could not impart better advice to you. This is because I know from my many failures that stopping looking for the right answer results in unintentionally creating your greatest risks.

In the movie Excalibur, King Arthur asks his sagacious adviser Merlin, "Where hides evil in my kingdom, then?" Merlin replies, "Always . . . where you never expect it. Always."

Where is the F = ma or two-stranded DNA helix in your portfolio kingdom? Watch everything . . . always!