Investment process
It is not shooting for the stars
In this post I propose to discuss the pros and cons of two quite different approaches to managing an investment portfolio. One emphasizes offense and the other emphasizes defense.
There is a sports analogy. In soccer, some teams are known for aggressive play, scoring lots of goals and hoping to keep their opponents from scoring as many. Other teams focus on solid defense. They plan to score a limited number of goals and expect their strong defense to keep their opponents off the score board. The first is thought of as ‘The best defense is a good offense’. The second, ‘The best offense is a good defense.’
Emphasizing defense
The case for emphasizing defense in investing is best put by Howard Marks. In his 2013 book The most important thing illuminated: uncommon sense for the thoughtful investor, Marks has a chapter titled ‘Investing Defensively’.
Howard Marks is an American investor and writer. He is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide.
He writes: “Oaktree’s preference for defense is clear.” “Oaktree’s portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below average volatility, and our clients will enjoy outperformance when others are suffering.” (Marks, 2013) pp174-5
Marks explains how he came by emphasizing defense. He writes: “In fixed income, where I got my start as a portfolio manager, returns are limited and the manager’s greatest contribution comes through the avoidance of loss. Because the upside is truly “fixed,” the only variability is on the downside, and avoiding it holds the key.”
He describes playing offense as “trying for winners through risk bearing – a high-octane activity”. The chapter clearly describes the pitfalls of what he describes as investing aggressively.
It is clear that he feels almost all investors should go the defensive route. And that is probably sound advice. Most investors wishing to take advantage of the superior returns from common stocks should invest in ETFs that track the broad indexes like the S&P 500. They should avoid trying to time entrances and exits from the ETF based on the pundits’ outlook for either the economy or the stock market. They should avoid thematic ETFs like the plague. There is nothing wrong with a standard 60/40 asset allocation as between stocks and a bond ETF. This approach will produce satisfactory returns.
Emphasizing offense
For myself, I believe the best defense is a good offense. Many readers will know that my default asset allocation is 100% stocks in a concentrated portfolio of superb companies bought at very attractive prices. In the last fifty plus years I have been 100% stocks for about 40 years, in 90-day treasury bills for about 5 years and in 2-year bonds for about five years.
I would rather have our family’s investments in fifteen profitable well financed and well managed companies than in distressed debt or any kind of debt. With debt, when you reach for yield, your quality goes down. With equities, when you reach for better returns (better companies), the quality of the investment goes up.
In the 1970s, bond investors were brutalized by inflation. For about 30 years, starting in 1980, there was a golden age for bond investors as yields were in a secular decline. Bonds enjoyed capital gains. In the 2000s, bond investors received skimpy yields through Fed action. In 2023, bond investors were hurt again by the war on inflation. In truth, I’m more comfortable with a small diversified and balanced portfolio of common stocks than an investment in government bonds sold by profligate over-indebted governments.
You can be too conservative
Investors do not have to engage in high-risk, high-octane activity to invest successfully in common stocks.
I had a conversation with a legal friend many years ago. He was about 15 years older than I. He was thinking about retirement in about 5 years. We talked about investing. He told me that the biggest mistake he had made was to be too conservative in his investing. He had almost all of his savings in bonds, certificates of deposit and other fixed income. By being risk averse he had risked his retirement.
The risk level in investing in common stocks is more akin to the business risks business people take every day. It is not gambling. It is not trading. It is not shooting for the stars. Here are some posts I have written about the risks of investing in common stocks that are self-explanatory.
What it means to not lose money
How much riskier are stocks than bonds?
Let’s clear up misunderstandings about risk and volatility
Best defense is a good offense
In the context of investing what does a good offense mean? And why would that protect you against losses?
The most critical strategic decision in investing is asset allocation. This is the amount to allocate to stocks vs bonds or other investable assets. The simple fact is that over the long haul, stocks outperform all other asset classes. There is a simple reason for this as explained in this post: Why stocks outperform all other asset classes
A good offense is a high allocation to stocks to take advantage of common stocks’ performance. Bonds are thought of as a defense against volatility and risk. But over the long haul, any amount allocated to bonds will underperform stocks.
Another critical strategic decision is portfolio diversification. There is no need to repeat what I have written earlier. These posts explain why a concentrated stock portfolio makes perfect common sense and is not a risky approach. It will, over time, lead to superior performance.
Asset allocation out of step with modern investment management
Conventional diversification makes no sense
The last critical strategic decision revolves around value investing. This is the approach of buying only superb companies with highly competent management and then only if they can be bought at very attractive prices. One buys with what Ben Graham describes as a Margin of Safety.
Benjamin Graham wrote: “To obtain better than average investment results over a long pull requires a policy of selection or operation possessing a twofold merit: (1) It must meet objective or rational tests of underlying soundness; and (2) it must be different from the policy followed by most investors or speculators.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p78
There is only one way to achieve this. Benjamin Graham says: “Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may be viewed, in the first instance, as an ownership interest in, or claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success.” (Graham, 1973) p286
Here’s how it works for investors. See my post: The joy of higher return with no more risk
Conventional vs conservative
My last thought is that a concentrated portfolio of superb companies bought at very attractive prices is actually a conservative way to invest. Some investors have a penchant to invest in household name companies on the theory that they can’t be criticized for investing in Walmart or Exxon nor will they feel regret if those investments don’t work out because everybody knows they are good companies.
Conservative investors win – conventional investors lose
Conclusion
Some people would say that investing almost exclusively in common stocks, in a concentrated portfolio, is a high-risk approach. I don’t think so. It takes a lot of book learning to understand what you are doing. It takes many years to develop experience and skill. Overconfidence is the hobgoblin that can wreck your portfolio. Successful investing is harder than it looks. For those willing to learn and put in the time, the rewards of a ‘best defense is a good offense’ are substantial. This is because, through the magic of compounding, even a two percent outperformance can make a huge difference over time.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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