Breaking With Tradition

A new way of looking at diversification.

Conductor and composer Gustav Mahler (1860-1911), while classically schooled, was an enormously innovative musician. Composers of classical music, by definition, are expected to adhere to traditional orchestral disciplines. But Mahler, a demanding conductor, was notorious among musicians for his motto, "Tradition is slovenly."

His openness to creative inspiration eventually brought him fame for the emotional range and clarity of his works. For example, in his Second Symphony, "Resurrection," perhaps his most famous work, we experience the power of big horns and the beauty of choral arrangements in the middle of the symphony... both of which were radical breaks from classical tradition.

Most of us who earn our living by navigating the capital markets eventually come to appreciate that successful investing, like successful symphonic composition, requires both discipline and creativity. The fundamentals must be understood and incorporated in our daily work, yet there is a role for vision, for insight, even sometimes for departing from the herd in search of value. But for most of us, it seems, innovation is uncomfortable.

Thousands of professional musicians have mastered the fundamentals. It is the openness to inspiration and the courage to innovate that separate the Mahlers, Mozarts and Bernsteins from the merely skillful.

A daunting list of variables confronts the personal financial advisor. Investment issues are so complex and the inputs change so rapidly that the portfolio management task cries out for a reliable, simple framework for managing the decision process. Over the last quarter century, personal advisors have embraced just such a framework, loosely formalized under the rubric "modern portfolio theory." The average advisor is now quite familiar with beta, duration, efficient frontier modeling, indexing, benchmarking, style boxes, Monte Carlo theory, and Ibbotson data on the history of interest rates, inflation and stock and bond returns. These have become our fundamentals, our tools, our "tradition," if you will.

Challenging his orchestras to stretch their skills, Mahler constantly reminded them that, "Tradition is slovenly." In investing, as in music, I believe there is a way in which an unexamined adherence to tradition tends to dull the mind, prevent insight and suppress inspiration. A comfortable professional routine can make us insensitive to changes in the investment environment and less prepared to adapt.

Free capital markets are dynamic, with every participant vying for advantage. In open markets with significant participation by non-professionals, securities prices tend to reflect cyclical waves of emotional buying and selling as well as traditional economic influences. Long-term success in this semi-rational competitive environment, it seems to me, requires alertness to change, an eagerness to realistically appraise both rational and emotional variables, and a willingness to re-examine the adequacy of our traditional tools.

Traditional Diversification

Modern Portfolio Theory, or MPT (I use the term generically, not referring to the work of any particular theoretician), is established upon the principle that a large market with free access to relevant data will efficiently incorporate that data into the prices of all securities. "The market" is so efficient that it is a waste of time to seek an advantage from one's interpretation of available data.

A corollary to this principle maintains that the more risk (meaning volatility of return) that one takes, the greater the long-term return one should expect. Stocks, being inherently more volatile than bonds, will provide superior returns over time; hence, to the extent that an investor can ignore price volatility in the short run, stocks are always the preferred asset class.

A second principle is that risk can be separated into business risk (an investment in a particular company's securities can be negatively impacted by poor management, competitive developments and the like) and market risk (the volatility of securities prices in general). MPT maintains that business risk can be virtually eliminated (a very attractive idea, to be sure) by including in a portfolio such a wide variety of securities that an implosion of any one or even several issues would have negligible impact on the whole.

First « 1 2 3 4 » Next