Like most armchair generals, I enjoy reading about military history, particularly about strategy and tactics. One thing I’ve learned, however, is that reading classics such as Carl von Clausewitz’s On War and Sun Tzu’s The Art of War doesn’t just satisfy a curiosity or historical interest. These types of books cover many basic principles that can easily be applied to most endeavors in life. It’s one of many reasons why The Art of War is often listed as among the best business books to read. The lessons learned aren’t merely theoretical; in my many years in financial services and portfolio management, I’ve learned that some military maxims such as “concentration of force at the decisive point” and “no battle plan survives contact with the enemy” apply very much in a practical sense to investing.
For example, when creating a financial plan most investors have several professionals who help them with it: accountants, lawyers, and financial advisers. Successful investors will seek to bring these professionals into agreement in forming a cohesive plan that is fiscally prudent and tax-efficient, much like successful commanders utilize the various branches of the military, – Air Force, Navy, and Army/Marines, – in what are called “combined arms operations.” These “combined arms operations” involve, for instance, air power supporting ground forces to overcome and occupy enemy territory. However, during wartime, because of inter-service rivalries, building consensus on an objective and how to achieve it can be difficult. The same is true in financial planning; natural conflicts may arise between, say, your accountant who advocates one strategy, and your lawyer who counsels in favor of another. Successful investors will first of all recognize and evaluate the professionals they trust most to counsel them, and then work to coordinate their efforts to succeed in the common goal: the financial success of their mutual client, you the investor.
Regarding the overall financial plan the words of Prussian Field Marshal Helmuth von Moltke come to mind: “No battle plan survives contact with the enemy.” This obviously applies to financial planning; how often have we as advisers created financial plans predicated on X being contributed to Y accounts, or A being distributed to fund B goal in retirement, only to have something like a serious illness or loss of a job seriously disrupt the financial plan? The point, then, that I try to reinforce with clients is that you can expect almost nothing to work out as you had planned or hoped. The market might crash the day after you retire, or it could soar for years. The way to survive these potential financial disruptions is to be nimble, have realistic expectations, and live to fight another day.
Just how does one live to fight another day? Well, the maxim of Napoleon, – “Victory goes to him who has the last reserve,” – is true for investors in the sense that one way to ride out the inevitable turmoil in our financial lives is to maintain a reserve of liquidity, whether it’s in short-term high-quality bonds, FDIC-insured deposits or whatever low-risk type assets you choose, all with the purpose of having liquidity available when it’s needed most. There will be temptations if the market runs to go all in when it’s least opportune, but a prudent financial commander resists this temptation, knowing that the decisive point at which the reserves may be needed will eventually come.
When it comes to asset allocation, another maxim of Napoleon’s, – that “He who defends everything defends nothing,” – applies to investors who over-diversify their portfolio as they attempt to hedge against every conceivable headwind, many of which are very low-probability outcomes. For example, today investors might have too much capital allocated to long-term bonds even with historically low yields, simply because inflation has recently been low, and because they’ve been spooked by recent headlines about deflation, even though historically higher inflation has been the far likelier risk. Instead of “defending everything,” successful investors should “First reckon, then risk,” in the words of Von Moltke. It should be obvious that we cannot successfully counter every possible headwind to our investments’ performance, so the logical thing to do is to assign probabilities to the possible outcomes, and try to diversify against the most probable ones. So-called “black swans” will likely happen, but by definition they will catch most people off-guard, and deploying precious capital against these low-probability outcomes is likely to drag on your long-term returns.
Before I make my next point, I should say that for most investors who seek only average returns, owning broad-based, low-cost equity portfolios such as index funds is probably a default choice. If you seek only market returns, it makes sense simply to duplicate the market. However, if your goal is to achieve “alpha,” then you should attempt to build more focused equity positions within your portfolio. Another way to look at this is through the words of von Clausewitz: “To achieve victory we must amass our forces at the hub of all power…the enemy’s center of gravity.” In investment terms, this means that you should attempt to identify and invest in concentrated positions, and, by definition, avoid parts of the market that you view as unattractive on a risk-reward standpoint. Patrick O’Shaughnessy put this best in his brilliant post “Alpha or Assets:”
“To achieve what we call factor alpha, we believe that investors should use multiple, unique factors to build a more concentrated portfolio of stocks (as few as 50) with the best possible factor profiles. That means not owning wide swaths of the market.”
Consider that when the Germans invaded France in May 1940, the French actually had better tanks, but they dispersed them so widely throughout their defensive front that their qualitative superiority was negated by the Germans’ mass of armor. The same happens to investors who scatter their equity capital far and wide; even the best performing stocks will have limited impact on a portfolio’s performance if the relative size of their positions is too small.
In addition, just as stratagems or coups de main will most likely have their greatest success when they are first used, – the fabled ‘element of surprise,’ – many investment strategies that seek to generate alpha will lead to diminishing results the more market participants become aware of them and their usefulness in generating excess returns. Wise investors will recognize that piling into investments made by high-profile investors or chasing returns of “hot” funds will likely lead to the opposite of the desired outcome, just as any commander would know that his enemy will learn his tendencies and counter them.
Also, when considering any investment, a prudent investor starts with the end in mind. Just as von Clausewitz wrote that no commander or leader should ‘take the first step without considering what may be the last,’ investors should train themselves not just to look at the potential upside of an investment, but also the potential downside. It follows, then, that prudent investors should prize liquidity above almost all else. I’ve often remarked that my favorite thing about any investment is the ability to rid myself