The Equity Conundrum Part III: When Analysts Become Analists

“If you do what you’ve always done, you’ll get what you’ve always got”

Context is king.

Studies show that in well-diversified portfolios the asset allocation decision constitutes 85 to 90% of investment performance. Yet, it has been my experience that 85 to 90% of most investors’ time is spent on the 10 – 15% of individual issue analysis and not on the more significant larger context that is the asset allocation decision domain. Why do most investors, professional and non, spend the vast majority of their time digging into the details of individual companies and not on larger, more significant portfolio-wide decision process?

Studies also show that the vast majority of investors do not beat the market. This is true for traditional portfolio management types (mutual fund managers, for example) and the unregulated money types, specifically hedge funds. Call it the “losers game” if you wish, but it is a fact.

Why is this? Why do so many smart people spend so much of their time with such little results? Perhaps, they were trained to do so. Trained in a methodology of a bygone era. Consider the following:

It’s a market of stocks and not a stock market. Or so the saying goes. However, if the asset allocation trumps the individual stock selection process, then doesn’t it behoove investors to spend more time on identifying and understand the macro than dwelling on the details of individual issues? Moreover, isn’t it fair to say that far too many resources are expended in the area of the specific and too few resources are spent on the more significant macro environment?

For investment strategy purposes, the value in focusing on individual issues rests in the insights they can provide to the larger context. To be sure, there is value in getting down in the trenches. But when trench warfare is the dominant focus of investors, then getting lost in the forest for the trees is the more apt phrase. And that, unfortunately, is where many investors find themselves.

Investment Strategy Implications

The impacts from mega trends and themes such as those exemplified in the sub prime mortgage problem, the consequences of globalization and market fundamentalism, the opaqueness of unregulated money (just how deep does the credit derivatives rabbit hole go?), the effects of electronic traders, systems, and exchanges, the hard to quantify aspects of geo political risks, McVey’s “Misalignment Triangle”, and innovation (both technological and financial), among others, need to appreciated at worst and understood at best.

In a globalized world, an opportunity exists for those who can widen the lens and understand the larger context. This is a world where context is king and analysts are not analists.

Note: Tomorrow's fourth and final installment touches on one such mega trend and a key driver in today's equity markets - liquidity and leverage.