May 3, 2011: The Art of Investing

I have been reading Sun Tzu’s classic, The Art of War, and I couldn’t ignore some of the striking similarities between his strategies for war and my own investment portfolio construction. Both war and investing involve careful planning, the balance of risk and reward, imperfect information, and uncertainty. Thus, Sun Tzu’s principles intended for a military context have great relevance to investors.

Of course, some of his principles are more applicable to investments than others and I would like to explore two that I find quite relevant.

“One who knows when he can fight, and when he cannot fight, will be victorious.”

This is a principle that I have found consistently violated by many investors, to their own peril. This negligence is unfortunate because with investing we have the valuable luxury of choosing our battles.

One battle not worth fighting is the fight for alpha. No one is pointing a gun to my head asking me if General Electric is going to outperform, and so I take a pass. I don’t want to fight that battle because the odds are against me. After all, alpha is a zero-sum game so why would I take on extra variability and risk in pursuit of it? Fighting a battle with no expected reward is a fruitless endeavor and I don’t care about being a hero, I just want to win the war. I have learned to ignore the hard won prize of alpha. Besides, capturing beta is like shooting fish in a barrel because I can do so with a diversified index fund at practically no cost.

“One who, fully prepared, awaits the unprepared will be victorious”

When I read this principle, the risk manager voice in my head is screaming “diversification!” Through diversification, I am prepared for all economic seasons. When I see investors with +80% equity exposure, I am reminded of a general who has no regard for his flanks. This strategy can work at times, but it leaves you open to suffer heavy losses. For instance, many investors have discounted Treasury bonds, booting them from their portfolios. This move is risky, because their portfolios' flank could swiftly be devastated through a deflationary panic.

It is prudent to never ignore any flank, even if an attack seems unlikely, because markets are notoriously deceptive.

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