MARKET ANALYSIS AND PORTFOLIO MANAGEMENT: A MARRIAGE MADE IN HELL
In yesterday's posting of the February Monthly Performance Report, I touched on a subject that I believe deserves further exploration. There are two key tenets that create the foundation of the investment process, yet they are contradictory in nature when stripped down to their essence. Market analysis and portfolio management drive the investment process through analytic examination and management of risk that comes with attempting to extract extraordinary returns on capital. These two key tenets of the investment process are like water and oil, however. To the detriment of both the professional and retail investor, these two functions of the investment process are thought of as a singular entity. This pattern of thought in relation to analysis and management create a foundation for investors that is doomed to mediocrity and eventually complete ruin.
In order to understand this concept, first we must look at what market participants deem as analysis. Analysis can fall into many categories: Technical, fundamental, macro, micro. And then there are the various sub-categories of each discipline. The methods used within these sub-categories is more or less endless. It is true that analysis of the markets can be tailored to the investors choosing. Much like religious beliefs, in the mind of believer, their method is superior to all others as it has been reinforced through study, examination and proof in the marketplace. The conflict between analysis and management of a portfolio is not rooted in the method of analysis, but rather the process.
When the average or in fact, above average market participant begins their process of analytical study of a particular investment, a series of emotional triggers begins to take shape:
1. Value of time: We want to be compensated for our time put into any endeavor, whether through emotional gratification or monetary success. Attachment to a successful outcome as a result of this desire is the first result of the analytical process.
2. The desire to be proven right: The analytical process is nothing if not a stadium for ego to shine through perceived brilliance of analysis. That brilliance is proven through monetary success as a result of time, effort and methodology. Avoiding the pain of your time, effort and methodology being proven completely fruitless is the second result of the analytical process.
3. A sense of community: We naturally seek others who share our view. Whether with respect to politics, sports, hate, love or misery. We want to be connected through shared beliefs. An attachment to a community of those who share your analytical view further reinforces the process.
4. Mental illustrations: Prior to losing my virginity at the age of 16, I had mental images of what the process would entail. Much to my devastation, the process took a completely different route than expected and was generally disappointing, if not comedic in nature. Anytime you begin the process of analyzing a situation, illustrations of the outcome begin taking shape. These mental illustrations create a desire to be proven correct in order to avoid disappointment.
All of these emotional triggers work together to create desire, which then leads to risking capital in order to achieve validation. But wait. What is the common thread shared by all of these emotional triggers? ATTACHMENT. It is through attachment that we expect to achieve these results. Market analysis can therefore be classified as nothing more than an emotional process to create the attachment necessary to take on risk. A process that is inherently flawed from the very start.
It gets more complicated. Then comes the issue of portfolio management. Portfolio management comes down to properly allocating investments, controlling risk and being responsible in the face of uncertain conditions. Let's look at what portfolio management demands of the investor:
1. Discipline: To be able to look at a situation and judge it squarely on the basis of risk.
2. Lack of emotion: To be able to look at a situation without emotional attachment to gain or loss.
3. Consistency: The ability to create a process and execute on it without question.
Portfolio management is robotic and unemotional. It is a process that only functions correctly when rooted in consistency. If there is no consistency, then it is no less emotionally based than anything having to do with the analytical process. Logically, in order to create inconsistency in a situation it must be analyzed before making the decision to deviate from the proper path. Analysis is an emotional process. Therefore, a lack of consistency in portfolio management falls under the market analysis umbrella. It ceases to be an unattached process and becomes one that has attachments to decisions that led to the inconsistency.
You see the conflict. These two processes - market analysis and portfolio management - have no place in the same sphere influence. Yet they are basically cross-pollinated on an ongoing, consistent basis within the traditional precepts of traditional portfolio management.
In order to be effective in the markets, there needs to be a separation of the two. Not a vague or obscure separation that is easily confused during periods of extreme market stress. But rather a robust, process driven separation that is clearly identifiable.
I will follow up in the coming weeks with a post on achieving that separation properly.
