The Globe and Mail, Report on Business
Published January 24, 2009

Readers are quick to point out when they think I am naive, dismissive, misinformed or just plain wrong. No doubt there has been some loose analysis in this column from time to time (I think there was a paragraph in September, 2006,...), but that doesn't prevent me from pointing out seriously sloppy thinking going on elsewhere in the investment industry.

It's timely to do so because at extreme and emotional times like this, the sloppiness quotient goes up. Here are examples showing up at the top of the list.

My adviser should have got me out of the market.

I'm the first to say that too many Canadians are paying their adviser too much for too little. And too many have portfolios that are inappropriate for their needs. But for clients to expect that their adviser will get them out of the market at the right time is unreasonable; it implies that people knew this crisis was going to happen. They didn't. Timing the market correctly is impossible to do consistently and evidence shows that it does more harm than good.

In light of the current economic turmoil, we should lower our return expectations.

This is almost a throwaway comment these days, like discussing the weather or Mats Sundin. But it's not right.

Stocks now trade at half of what they did 18 months ago. After big negative returns, markets always do well.

As a starting point from which to make money, where we sit today looks attractive: valuations are reasonable again, dividend and corporate bond yields are high, the recession has been declared (good), investor sentiment is rock bottom (perfect) and there is a pile of cash building up on the sidelines.

Two firms I watch closely – Edinburgh Partners, which manages our Global Equity Fund, and Boston-based GMO – have steadily increased their return forecasts. Based on their valuation models, expected real returns (after inflation) over the next five to seven years have moved into double-digit territory in most equity classes.

You can never be too diversified.

Nobody can argue with the benefit of diversification, but the wealth management industry has taken the implementation of this principle too far. By requiring “properly diversified” clients to have numerous asset classes, each with a variety of managers and styles, we have arrived at a very bad place, namely high-fee indexing.

Academic studies show that the diversification benefit of adding stocks to a portfolio disappears after 20 to 25 holdings. In other words, the addition of a 26th stock does nothing to reduce the volatility of the portfolio.

To my way of thinking, the rule of thumb should be the opposite of what's happening today: The higher the fee you pay, the fewer securities you should expect to own. An index-like portfolio with hundreds or thousands of stocks should be priced as such.

Better, more sophisticated risk management systems are needed to prevent another crisis like this.

Following the crash of 1987, risk management grew rapidly in sophistication and profile. We now have tens of thousands of scary-smart people developing models based on historic correlations and volatility, and an expectation of never-ending liquidity.

Unfortunately, the elegant math and technology is only good at preventing past mishaps from happening again, not avoiding new and different ones. The systems haven't stopped the banks, brokers and hedge funds from blowing themselves up. Rather, the false comfort they've given senior executives has led to the development of complex products of questionable investment merit.

Now is not the time to refine and adjust the systems, it's time to blow them up and start again. My recommendation to these institutions: Go simple. Hire a seasoned veteran, preferably a seriously jaded portfolio manager, and let him or her use some common sense.

I suspect the dialogue would go something like this.

“Hmmm. We seem to have a ton of this stuff with the funny name. What exactly is the underlying asset we're holding? I wonder who'll buy it if we need to sell? Oh my, we've given a lot of capital to that 28 year-old from Wharton. Has he been through a cycle yet? Hmmm.”

The asset management business is all about scale.

Upon hearing this, we must remember that the executives are speaking to company shareholders rather than investors in their funds. If we own stock in an asset manager, we want scale in sales, marketing, administration and compliance. Bring it on.

If we own units in the same institution's mutual fund, however, size is an impediment to generating superior returns. From the unitholders' point of view, nothing good comes of billion-dollar funds becoming multibillion-dollar funds.

So in these uncertain times, be wary of statements that sound appropriate, but are misleading or inaccurate. Be especially careful if investment executives promise to prepare you for the coming bear market by using a risk management system that gets you into their large, highly diversified funds at just the right time.