customer expectationsDr. Harry Markowitz won a Nobel Prize for his pioneering quantitative research and economic theories. He is credited with developing much of the intellectual framework for modern finance as well as Modern Portfolio Theory (MPT). MPT allegedly identifies the effects of asset risk, return, correlation and diversification on probable investment portfolio returns. The overriding objective of MPT is to construct an “optimal portfolio,” one that maximizes the expected return for a given level of risk.

Financial journalist Jason Zweig once asked Dr. Markowitz how he manages his own portfolio. “My intention” Dr. Markowitz explained, “was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.” I was astounded when I read this remark. Why would one of the founding fathers of modern finance and MPT presume “future regret,” and why would he choose such a simplistic, if not naïve, approach to allocating capital in his own portfolio?  The first thing that popped into my head when I read Dr. Markowitz’s response was a remark attributed to Sir Isaac Newton after he lost his entire fortune in the South Sea Bubble: “I can calculate the motion of heavenly bodies, but not the madness of people.”

Perhaps Dr. Markowitz’s remark about portfolio construction has something to do with the fact that his theories do not quite reflect reality? Perhaps it is the recognition that while his theoretical model defines an “efficient portfolio” – one that purportedly maximizes return for a given level of risk – in the real world the theory falls apart and delivers suboptimal results. I liken MPT to a seat belt that works all the time, except in a car crash.

If you have been reading my articles long enough you know I categorically reject MPT and its progeny. Over the years my articles have largely been inspired by, and revolved around, the following themes:

  • “Margin of safety” is, singularly, the most important of all investment concepts. Never invest without it!
  • This time is never different.
  • For the intelligent investor, the stock market represents an opportunity to purchase fractional ownership interests in businesses.
  • Always be prepared for bad times and for the bad times to last far longer than anyone anticipates. (The good times have a way of taking care of themselves.)
  • What everyone knows about investing is usually worth little.
  • Broad diversification is a proxy for ignorance and the refuge of amateurs.
  • There has always been, and will remain, an enduring relationship between price and value.
  • There has never been a time when an asset is so good that it was incapable of becoming a bad investment if purchased at too high a price. Similarly, there are few assets so bad that they could not become excellent investments if purchased cheaply enough.
  • It is unreasonable to expect an investment to be cheap and be popular. Popular investments are dear.
  • It is axiomatic that one cannot perform better than average if one’s portfolio contains the same stocks as everyone else.
  • Financial risk has nothing to do with beta, or any other measure. Financial risk is exclusively about a loss of future purchasing power – a permanent impairment of capital.
  • Here is all you need to understand about financial leverage: (a) Leverage will not enhance the underlying merits of an investment. (b) While leverage amplifies prospective gains and losses it does not increase the likelihood of gain, but it does increase the consequence of loss.
  • Patience is a virtue; invest in haste, repent in leisure.
  • In this discipline called investing, winning is largely a function of not losing.
  • A correct process will occasionally yield a poor result. A poor process will occasionally yield a good result. However, an excellent long term result will always be a result of consistently applying a correct process over time.

Today we shall explore a few of the nuances of these last three convictions.

Career Risk vs. Stewardship of Client Resources (or Client Expectations Matter!)

The investment management business is a strange one. What do you suppose matters more, satisfactory performance relative to the risk assumed or superior relative performance irrespective of the risk assumed? If you look at the behavior of investors and their agents, it is clearly the latter.

The sad reality is simply this: the overriding objective for the vast majority of professional investment managers is not to safely shepherd client resources. Their uppermost agenda is to grow Assets Under Management (AUM) by ensuring the investment management firm has contented, approving clients. While on the surface this may sound reasonable, even appropriate – to nurture contented, approving clients – I would suggest that such behavior may be in conflict with a fiduciary obligation to the client.

You see, investment managers understand that investors want immediate results, and client expectations matter. A failure to keep up in an advancing market – irrespective of the risk assumed – will invite client defections and will earn the employee/manager of the firm a pink slip. I have referred to this phenomenon before as “career risk.” “A sound banker” explained John Maynard Keynes, “…is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.”

The conflict of interest between the investment manager and their clients is unambiguous: stewardship vs. salesmanship. There is an “acid test” one can administer to begin to unearth this unacknowledged agenda. By virtue of their portfolio holdings, look to see if the manager is engaged in a predominantly offensive strategy (shooting for high returns); or is the manager obsessed with “tracking error” (closet indexing); or is the manager engaged in a predominantly defensive strategy (that’s me), attempting to mitigate the possibility of loss. The path chosen by the investment manager speaks more about their genuine motivations than all their eloquent narratives.

But the world is a messy place and investment managers are not a stupid lot. Simply asking a question about strategic focus will elicit a highly predictable response. Reaching a correct conclusion about how your money will be, or is currently, managed will require an appreciation of context.


Professional investors have various approaches, biases and analytical frameworks to assess the probable future performance of their portfolio selections. Clearly these biases will heavily influence their security choices. Even a cursory glance at portfolio holdings will, therefore, speak volumes about the predispositions of the manager.

I will now let you in on one of the best kept secrets in the investment management business: irrespective of investment methodology, while the ultimate outcome may turn out as hoped, rarely do the anticipated events unfold as expected, and even more rarely do they manifest in the time expected. I repeat, while the ultimate outcome may turn out as hoped, rarely do the anticipated events unfold as expected, and even more rarely do they manifest in the time expected. Beware of bold postmortem declarations, explanations and accounts. The bolder the explanations and depictions of strategy and results, the greater the likelihood you are listening to marketing hype – not manager aptitude.

Within the intellectual framework we embrace – the Benjamin Graham School of investing – we acknowledge that even grossly overpriced assets can relentlessly and unimaginably continue to advance in price; and deeply discounted assets can continue to decline way beyond reason. In other words, even when one’s assessments are correct, and even if one’s ultimate outcome is superb, one’s timing will rarely be on point. This is particularly true within Graham’s framework. So one’s timing – and here’s my point – can play a pivotal role in the short and even intermediate term assessment of competency… and, by itself, this timing biased assessment of competency is just as likely to be mistaken, as correct.

In Nassim Taleb’s excellent book, Fooled by Randomness, he points out how easily random events can create the illusion that a highly favorable outcome – even from a horrible decision –can bestow the appearance of brilliance. Think about all the folks who were purchasing tech stocks all through the 1990s, right up to the time before the house of cards caved. Timing, the point of entry and departure, can easily, and convincingly, foster the illusion of genius or stupidity. In other words, impostor investors are often (temporarily) “successful” for the wrong reasons; less frequently, superb investors are “unsuccessful” for appropriate reasons.

All this is well understood by professional investment managers; which is to say they recognize that their clients are obsessed with short term success and the fulfillment of these client expectations can mean the difference between a corner office and the unemployment line. Unfortunately, being early (i.e. buying or selling early) and appearing wrong look identical – and appearing wrong is unacceptable. If my remarks make sense to you it leads to a disturbing conclusion: the average investment manager who failed their clients in year 2000, and the 13+ years that have followed, must either be incompetent, duplicitous or both.

It is ironic that the investment managers who chose stewardship over salesmanship were the ones most likely to be fired during the tech madness that climaxed in March of 2000. Those money managers who chose their careers, over stewardship, simply rode the momentum gravy train over the cliff… clients in tow. In the words of John Maynard Keynes, these clients were “…ruined in a conventional and orthodox way… so that no one can really blame [the investment manager].”

But What If…

Some investment strategies produce results – no matter how ephemeral – in a way that is manifestly appealing to investors who demand immediate results. That the earth revolves about the sun every 365 days may be factually accurate, but why should such a natural occurrence be considered an appropriate time constraint to measure investment success? While there is the human predilection for definable and orderly time frames, I believe the primary reason 365 days is deemed suitable is because investors demand immediate results – and one year pushes the limits of their time tolerance.

But what if the financial crisis never materialized and we would have experienced only an average result – perhaps comparable to the S&P 500? Would an average result have been acceptable to you? How about a below average result, would that have been acceptable to you? Without hesitation I would answer both questions in the affirmative. Even a below average experience – reflecting an inability to unearth deeply discounted opportunities resulting in under exposure to equities and over exposure to cash – would have been a highly successful outcome because the consequence, if a disruption would have occurred, would have resulted in too harmful an impact to our financial wellbeing. I repeat: even a below average experience – reflecting an inability to unearth deeply discounted opportunities resulting in under exposure to equities and over exposure to cash – would have been a highly successful outcome because the consequence, if a disruption would have occurred, would have resulted in too harmful an impact to our financial wellbeing.

Potentially placing one’s financial health in harms way is an investment approach that is as irrational as it is common – and way beyond foolish. The precise moment of a financial calamity is as inherently unpredictable as its approach is undetectable. Because Graham’s investment discipline is unrelenting in attempting to protect against a permanent impairment of capital, the followers of Graham’s intellectual investment process typically consider a wide range of possible outcomes, weights to the outcomes that appear to be most probable, and then always seek a deep discount to assessed value – our margin of safety – because things rarely turn out the way one anticipates. While a long term track record is important, the process employed to achieve the track record is far more important. Invest in haste, repent in leisure.

To learn more about Marshall Serwitz view his Paladin Registry profile.