The Follies of Academic Finance

Includes: AAL, SWY
by: Inglefox Investing

I was recently looking for an inspiring topic to write my next article about when I turned to a collegiate textbook from the first finance class that I ever took. I turned to the chapter about bear markets and recessions and tried to find a topic that I thought would be applicable to current market conditions.

As I read, I was shocked about how many times I found myself in absolute disagreement with the author of the textbook. There were two topics in particular that I, with now actual market experience behind me, take issue with. These topics are the textbook's notions of consumer behavior and diversification.

After further study of these topics, I am prepared to assert that academia as a whole, not just my first finance textbook, believe generally the same thing about both consumer behavior and diversification. This not only makes me question "real world" value of collegiate finance teachings (I have always questioned that), but it also makes me wonder if the finance world is full of professionals who, due to college teachings, wholeheartedly believe what I believe are some of the "follies of finance (teachings)".

My first issue is with the thought that actual consumer behavior can be as broadly generalized as it is in finance textbooks. In several collegiate level finance textbooks, I reviewed the idea of consumer behavior in times of recession and economic weakness and all of them stated approximately the same thing. These textbooks all made the generalization that in times of economic weakness, consumers drastically change their spending patterns and cut off virtually all discretionary spending, which allows for investing opportunities in the consumer staples sectors.

I then looked to the one of the consumer staples industries, the food retail industry, and found that, contrary to what the textbooks may say, this industry as a whole is in the red year to date. This measure even includes several foreign food retailers; it would undoubtedly be much further in the red if only the American grocers were factored in.

Take for example Safeway Foods (NYSE:SWY), a company that, according to conventional "textbook" thinking, would be considered a safe haven in such periods of economic weakness. Safeway, for the year 2008, is down nearly 20% as of August 8, 2008. This is certainly not what I would call a safe haven.

Furthermore I think that this generalization ignores the various classes of wealth that exist as those with more wealth likely will not cut discretionary spending in times of economic weakness. I also believe this generalization ignores the possibilities that people may resist change in their spending patterns by using savings accounts or by use of other means.

I think that this represents an instance where academia actually may not have known what to write about. The inherent problem with textbooks is that they rely on generalizations and I believe that writing about where to invest in times of economic weakness requires precise specification. This is a type of specification which simply cannot be captured in textbooks. As a result, this type of "inside the box" thinking is prevalent in the finance world even though it is not necessarily true.

The topic of diversification is another topic that I take issue with. Diversification is something that goes much further than the scope of academia and has founds its way into the thought process of virtually everyone involved in the financial markets.

I will go out on a limb here and say something that few others would ever dare to say; diversification is a folly.

I am fully aware that in a diversified portfolio the risk of the portfolio can be reduced to approach the market rate of risk. Reducing risk is a great thing; however, in reducing this risk down to the market rate of risk, the return is also reduced to the market rate of return.

I question the hassle of even investing in the financial markets if diversification only allows a market rate of return. You might as well invest in mutual funds or money market funds if all you can achieve is a dismal market rate of return.

While I am sure that many people out there will point to such prominent investors as Warren Buffett, who is actually fairly well diversified, as an example of why diversification works. My response to that is that Mr. Buffett's portfolio and many other multi-million dollar portfolios are diversified because of the excess of capital that they contain. With a large amount of capital it is natural that an investor, such as Mr. Buffett, would pursue many different opportunities. This leads to a portfolio which may look as if it is intentionally diversified; however, I believe that it is simply a result of an excess of capital, of which only a limited amount can be put into a particular investment.

Large portfolios like Mr. Buffett's also have such large investments in any given stock that they can see gigantic profits at minimal stock price movement. I think that the success of such portfolios is proof of the old mantra that "it takes money to make money". I do not believe that "diversified" success like this can be replicated by individuals with smaller portfolios.

It is the inarguable truth that smaller portfolios can only see monumental success by taking on higher levels of risk. This risk does not have to risk the entire value of the portfolio; in fact, I find that option trading is by far the best method to recognize levels of returns greatly in excess of the market rate of return while only risking the minimal cost of the option itself.

I will say that the only positive that diversification brings is a minimized risk and I question any type of participation in the financial markets if someone is so risk averse that they feel as though diversification is necessary. In the financial markets both risk and reward abound. Reward will rarely ever be realized in smaller value portfolios if risk is not first taken. It takes multimillion dollar portfolios to achieve success in such a manner as someone like Warren Buffett. And if one does not have a multimillion dollar portfolio risk is the only method to gain reward.

I will give a quick example of the type of rewards that can be achieved when risk is taken. When US Airways (LCC) was trading at below $2 per share near mid July, the August $2.50 option calls were trading for about $1.50 per contract. If one were to invest just $3,000 dollars into these options to buy 20 contracts, those 20 contracts would be worth $10,800 as of August 8 (a return of 260%). One could also have recognized a great return by trading the low share prices of US Airways, but I provided this example as an example of how options can give great reward with fairly minimal risk (in this case the maximum risk was only $3,000).

As someone who tries to make profits by understanding the market psychology, I am very interested in understanding any type of prevailing market thinking (be it regarding diversification or consumer behavior). Even though I disagree with both of these principles as they are generally taught, I understand that because they are taught as the unquestionable truths of finance they are the prevailing thoughts for most finance professionals. In knowing this, I think that those of us who use market psychology to gain an edge can better understand the prevailing market forces.

I suppose that sometimes the answers for those of us who believe that profits come from understanding the market psychology can sometimes come from such an unlikely source as an old college textbook. So, whether you agree or disagree with me about the topics from the textbooks, you cannot disagree that these topics are the prevailing market methods and in understanding them one can gain a greater understanding of the overall market's movements.

(Disclosure: author is long LCC)