Adaptive Value Investing

Adapt or Perish. There is no single strategy, investment or asset allocation that will serve you well in all economic situations. That is the most important lesson our Chief Strategist has learned in 50 years as an investment professional. It may sound extremely harsh, but those who choose to stick with a single-minded approach to investing often get blown away by the winds of change. For example, for many years simply buying and holding good blue-chip stocks was considered the road to success. Now, as we see what has a happened to the domestic automobile industry and several others, we realize the folly of inaction. Unfortunately many investors who had most of their money in a relatively few such stocks have been nearly wiped out.

While nearly all investment professionals agree that asset allocation is important, we have seen that merely following a computer-generated asset allocation may be ineffective under extreme circumstances. As an increasing number of investment managers converged on the same allocation strategy, the benefits of such a strategy were severely diminished. The herd mentality simply ruined its effectiveness.

Because we are now in a global economy, there are now more investment opportunities than there have ever been. There are also a greater number of sophisticated participants in the markets with different motivations and time horizons. This suggests that we may continue to see opportunities appear and disappear quickly as these professionals react to them.

The old adage of "buy low and sell high" is as valid today it has ever been. Most investors, however, practically ignore the sell side and simply watch investments go up and then back down. Where's the profit?

The bottom line is that you can't expect to make a significant profit
in a highly competitive market by doing nothing.

The Missing Detail - Strategy. The difference between success and failure is often the absence of one detail. Most professional investors and many individuals have a process. Some even have an Investment Policy Statement. Very few, however, have a clear understanding of strategy. The key to strategy is recognizing the fact that in financial markets change is inevitable. While there have been many theories and programs developed to mechanically adjust portfolios to changing markets, I know of none that have avoided eventual catastrophe.

Strategic thinking involves consideration of many potential events and outcomes along with possible tactics to optimize results. This is a much broader and more subjective perspective than most investment plans utilize. At any point in time the economy or a single investment can do one of three things. It can go up, it can go down or it can stay the same. As simple as this sounds, when we add in magnitude and timing, it becomes quite complex.

Suppose the global economy skyrockets for an extended period of time. Do we just sit back and smile and wait for it to go back down? Or do we take advantage of the excess and take some profits? Likewise if the economy spirals into total collapse, do we simply call under the covers and hope for better days, or do we have a strategy to capitalize on the weakness? Do we rely on preparation or whimsy?

The essential difference between strategy and program is in not only anticipating change, but also in evaluating magnitude and probability. For example the higher and more extended the climb, the greater the probability of a fall and the greater the potential magnitude of that fall. With investing we are seldom talking about certainties. We are nearly always talking about probabilities and payoffs.

A competent strategist will take into account as many potential happenings as practical even considering rare but potentially catastrophic events. He will then assign probabilities of occurrence to each along with likely payoffs. It's important to note that payoffs are two-sided. That means most occurrences could have both positive and negative consequences. The strategist will then take action in measured steps relative to the probability/payoff potential. Finally, the strategist will regularly update the probability grid and adjust tactics accordingly.

Opportunity Out of Chaos

While we do not know anything for certain about the future, we do have history as a guideline. We never know until after the fact what the highest or lowest value of a given item is. But, we do have massive amounts of historical data that help us to understand relative valuation.

Economists and investment strategists frequently talk about the concept of "reversion to the mean". Most people would call that the "law of averages". Over very long periods of time a given economic series tends to fluctuate around the long-term average for that period.

While relative valuations are not particularly helpful in the short term, they can be very useful over longer periods of time. When a given series gets to the outer extremes of its historical range, either high or low, there is an increasing probability that it will revert to the mean. That is, it will tend to move back toward its average valuation and perhaps move toward the other extreme.

This pendulum swing tendency brings us back to the concept of buy low, sell high. When we buy well below the historic average valuation or sell well above it, we tilt the probability/payoff potential in our favor. This is more applicable to broad-based investments than to single issues due to solvency concerns with the latter. Moving against the herd in this fashion takes patience, discipline and courage, but it can pay off handsomely.

When the financial markets are under severe stress as they are now, any numbers of investments are likely to move to extremes compared with their historical relationships. At these times it may be appropriate to make substantial adjustments to your asset allocation to defend against loss or to improve profit potential. This is where a proactive strategy is of special benefit. By previewing possibilities and developing tactics in advance, you are in a position to move swiftly at the appropriate time. We refer to this approach as an Adaptive Value Investing.