For years I have participated in competitive motorcycling events. A skill that is absolutely necessary for a rider to obtain is the ability to overcome their natural tendency of “target fixation”. You either acquire this skill quickly or suffer the consequences –“road rash”, or worse (for those interested, road rash is a polite way of describing how you look after having your skin ground off).
A motorcycle tends to go in the direction the rider is looking. If you are riding down the road and see a pothole ahead of you and you don’t take your eyes off of it, you are very likely to hit it. This is not a big deal for a casual rider, but for someone riding in competition, coming off the bike and sliding on the asphalt at 100 mph is not fun!
When it comes to portfolio management, most professionals are forced to practice target fixation with your money. Their target is normally a predefined index of common stocks or bonds and they are rewarded based on their ability to exceed the returns of their target. You may not think this is important to you, yet this target fixation leads to all kinds of problems. Your manager will invariably take on increasing risk knowing that it is one of the few ways he or she can exceed their target. You or your financial advisor tend to use this outperformance as proof of superior management instead of what it really is, just higher risk. Sooner or later, your manager (with you along for the ride) will hit a pothole with so much speed that you will be lucky to walk away with only a rash.
In our own way, we have been telling you to take your eyes off the potholes and manage your portfolio conservatively so that you can maximize your returns with less risk. Of course, this means that you should not play the professional management game based on target fixation, but instead a game designed for you. One that encourages those of you with a large enough portfolio to own the common shares of a limited number of high quality companies and to only lend your money to those borrowers exhibiting a high enough probability that they will repay your principal. This low-volatility strategy may not be as exciting as hands off the bars investment approach, but it is the appropriate way for many of you to invest your hard earned funds.
This approach has not only been frowned on, but also considered naïve by many institutional investment consultants, so it was a great surprise when I recently read an article written by Kevin Olsen of Pensions & Investments titled “McKinsey report predicts return to basics for investors”. McKinsey & Company is considered one of the most prestigious firms in the management consulting industry across the globe. They are advisor to many of the largest businesses in the world. They recently published a report detailing the major shifts that are expected in the way institutional investors will invest funds entrusted to them in the coming decade titled, “The Best of Times and the Worst of Times for Institutional Investors”. In it, Mr. Olsen says, “Investors will be moving away from a focus on beating benchmarks and maximizing alpha regardless of market conditions, to one that emphasizes meeting their fundamental investment objectives.”
It was even a greater surprise when Mercer, the global leader for trusted human resources and related financial advice, products and services, published a report titled, “Winning by not Losing, An introduction to low-volatility equity strategies”. In the article they ask the question, “Why is higher volatility not rewarded?” (In the academic world higher volatility is the equivalent of higher risk.)
Mercer concludes – “Just as the ‘value effect’ is persistent and durable an increasing body of academic evidence indicates that this ‘high volatility not being rewarded’ is a function of the way investors behave; that is, the anomaly can be explained by behavioral finance studies. “
Even more surprising to me was their recognition of the usage of “quality” in constructing a low-volatility portfolio. I like it so much that I want to share with you the entire paragraph:
“Quality,” even if described in broad terms, can represent dependability or predictability – the archetypal quality stock belongs to a strong, stable, well-managed and profitable company that is able to withstand external pressures, such as economic downturns (or financial crises). It is a defensive “steady Eddie” stock that keeps up, or outperforms, in steadily rising markets, gets left behind as markets gather pace and then significantly outperforms as markets come back to earth, and as investors make a “flight to quality.”
We know that the accepted method to allocate equity assets is to group your investments by size, value, growth, or geography. This may be why so little attention is given to quality – it just doesn’t fit. Yet quality can easily fit into your portfolio if you take your eyes off of the target that others have set for you and create a new target of your own.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.