Charles D. Ellis recently wrote a guest editorial for the Financial Analysts Journal entitled Lessons on Grand Strategy.
Grand Strategy is a term used in military and foreign policy.
It represents an approach whereby a nation makes use of all available resources at its disposal, including military, industrial, diplomatic, economic, and cultural, and aligns them toward a common mission.
Generally, the objective of Grand Strategy is to achieve the long-term goals of the nation by leveraging a wide range of resources, in addition to a country’s military power.
In order to be a successful investor, you must understand the broader picture from which an investment portfolio should be constructed.
In his editorial, Ellis draws comparisons between the lessons on leadership from several of history’s wisest Grand Strategists and today’s investment management industry.
Although Mr. Ellis’ article is geared towards investment professionals, there are several valuable takeaways for the individual investor as well.
The following are a few of the key points that investors would be well-served to remember:
“War is the continuation of [political] policy by other means” – Carl von Clausewitz
“Investing is the continuation of an investor’s overall financial strategy by other means.” – Charles D. Ellis
By translating von Clausewitz’s quote to the world of investing, Ellis is making a single, but very important point: In order to be a successful investor, you must understand the broader picture from which an investment portfolio should be constructed.
This means taking into account key factors such as your risk profile (ability, willingness, and need to take risk), your tax situation, and your overall financial plan.
Information and decisions about each of those factors are the very inputs that should be used to build a portfolio.
Without knowledge of those areas, it is very difficult, if not impossible, to make intelligent investment decisions.
“Friction, as we choose to call it, is the force that makes the apparently easy thing difficult.” – Carl von Clausewitz
In the world of investing, there are many sources of friction, or resistance, that can detract from returns. Some of these are more obvious, such as taxes and trading commissions.
Critical decisions around asset allocation, international diversification, asset classes, tax minimization, and costs should not be made on the fly.
Others, such as bid-ask spreads and market impact costs are much less obvious. These would be best characterized as hidden costs, since many investors are not aware of their impact on performance.
All of these frictional costs reduce investment returns, often in very significant ways.
For example, it is very common in the investment world to see a manager promote “market-beating” results for a new fund based on a back-tested strategy (in other words they advertise what would have happened had they invested according to the strategy in the past).
The manager will trot out the results to a bunch of investors and advisors who are excited by the “performance” and decide to invest in the fund.
Unfortunately for the investors the back-tested results didn’t take into account the frictions of the real world. The end result is that the fund fails miserably relative to the so-called “market-beating” performance everyone was expecting.
“…a victorious army wins its victories before the battle.” – Sun Tzu
In much the same way battles are won before the fighting begins, wise investors know that in order to be successful, they must have a clear plan in place before they put their capital at risk.
Haphazardly making investment decisions without first assessing your current financial position, your objectives and goals, your time horizon, and your tolerance for risk can lead to disastrous results.
Likewise, an intelligent portfolio invests with a clear, well-defined purpose that should be articulated in advance of making any investments.
“A navy is by nature an attacking arm, and so is an investment portfolio. There is no hiding place on the open seas or in the stock or bond markets. Thus, a leader in either realm must accept the sea and weather or the market as it is and always be thinking about the offense.”
The vicissitudes and volatility of the stock market can elicit all kinds of negative emotions for investors.
For those who took more investment risk than they could handle in a past bear market, it might be tempting to shun stocks for good after seeing a decline of 30% or more and selling at the bottom.
For others, they’ve simply watched from the sidelines through up and down markets, seeking to avoid any risk at all.
The reality, however, is that in order to achieve our long-term financial goals, most of us need to take some investment risk.
Without the higher expected returns of stocks, the growth in our portfolio is almost certain to fall short of our required return.
Quite simply, the expected returns on cash or short-term bonds are just too low.
In much the same way a captain takes great care to ensure his vessel is sea-worthy before he sets sail, smart investors build low-cost, widely-diversified portfolios to ensure they can weather the storms of markets and still reach their destination successfully.
Sea captains, like wise investors, also know to focus on what they can control.
Although the captain accounts for the weather and bumpy seas in his plans, he knows they are not in his control.
Instead, he “accepts the sea” and focuses on making progress towards his final destination.
Similarly, smart investors know that interest rates, the economy, and the volatility of stocks are out of their control.
However, because stocks offer the opportunity for higher returns that give us a better chance of reaching our goals, they “accept the market” and shift their focus to what they can control.