From the May 01, 2010 issue of Futures Magazine • Subscribe!

The naked portfolio manager: Why rules trump reason on Wall Street

The Naked Portfolio Manager: Why Rules Trump Reason on Wall Street

By Robert J. Fischer, CFP
Abbalucci Press
155 pages, $21.95

In Wall Street, one of the most important concepts to understand is that the decision-making process matters a great deal. That means that the first step investors need to take is to select a winning investment strategy and the method to implement that strategy rather than deciding which investments to make based on their broker’s or their own decision.

The author, a senior portfolio manager and senior vice president at a Richmond, Va.–based brokerage firm, puts forth the premise that better investment decisions and outcomes are achieved by using transparent Statistical Prediction Methods (SPMs) instead of human decision-making. He believes that a rules-based decision-making process works better than the standard advice-giving approach provided by most investment professionals. He points out that many studies have found that human experts (e.g., portfolio managers) can obtain better results using their knowledge to construct rule-based models for making predictions instead of making predictions themselves. In medicine, evidence-based SPMs are routine.

An SPM is a statistical model or algorithm that establishes a set of rules to select a winning portfolio based on input of the portfolio manager. This rule-based approach produces far superior results compared to portfolio managers who just use their own judgment without using specific rules. Even though their own judgment is used to select rules to construct models, the results are better than using the standard investing approach of counseling clients based verbally and with a general investing philosophy.

To support his views the author uses empirical, logical and anecdotal evidence, together with case studies and drawings instead of boring statistical data. Based on his extensive research into human behavior, he argues that most Wall Street professionals fail to understand that humans and more specifically, the vast majority of portfolio managers, do not make better decisions themselves than their own rule-based systems, no matter what their level of experience or intelligence. The author points out there have been nearly 200 studies in human decision-making under uncertainty. In almost every instance, SPMs were superior to traditional human judgment. That is why it is important to apply SPMs to stock market decision-making. Smart portfolio managers focus on defining their investing rules, placing them in a model and then creating their client portfolios. The model rules determine the approach for stock selection and come up with a numerical score for the portfolio.

Fischer believes that investors can gain an edge by consistently applying SPMs that should provide better investment performance with reduced risk compared to relying on human judgment with black boxes. He indicates that clearly defined, replicatable portfolio selection rules produce consistent results over the long-term. Fischer emphasizes that in addition to having practical SPMs, that specific behavioral strategies are needed to ensure that individuals remain with their investment strategies during difficult market conditions. Thus, he recommends that investors work with another trusted person who will help them stay the course.

Interestingly, one of the inputs to the author’s investing approach was obtained by studying the way world-class chess masters made their decisions that led to victory. In addition, he studied classical military decision-making at the U.S. Military Academy. Fischer advocates use of SPMs to select a diversified, equally weighted, unleveraged equity portfolio, which is basically completely transparent. SPM should be considered successful if it beats an appropriate benchmark six or seven years out of ten. That shows its consistency. Short-term periods of underperformance should be expected as the norm.

Questions that investors need to ask their current or prospective advisors are: How will you make money for me? What evidence do you have that your investing approach works over the long-term? Avoid advisors who cannot answer these and other questions directly and succinctly. Moreover, the author simply states his conclusion about investing, as follows: “….if you invest the way everyone else does, you have no reason to expect better returns than everyone else gets.”

Fischer has written an excellent book on a topic that can help investors get a handle on the right way to go about their portfolio decision-making. The book is easy to read with interesting stories, clearly written prose, and many examples in related fields to investing. Before handing your money over to a financial advisor, hedge fund manager, or money manager, the smart investor should now have a better understanding of exactly what to look for and what questions to ask, before making a big and possibly costly mistake. On the other hand, if the investor can develop his own investing rules based on back-tested strategies, and follow these rules, then he/she can save the fees that advisors charge and be in charge of their own investment program.

Leslie N. Masonson is the author of “Buy—DON’T Hold: Investing With ETFs to Increase Returns With Less Risk.” Reach him at lesmasonson@yahoo.com.

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