Inadequacies in Fundamentalist Approach to Investment Risk Management

Dear Friends,

John Authers' "Short View on the of UK Financial Times website has always been excellent, and I never miss his ideas and opinions. Like any market participant, I may not agree with all his views, but I have always found his ideas to be interesting, and worthy of consideration and deeper critical reflection.

In this regard, I would highlight his Special Video Presentation entitled "Escaping the Damage" for your viewing and more importantly, to challenge your current basic assumptions about investing and risk management strategies, especially so, if you are a Fundamentalist.

Portfolio Diversification is considered the main approach to Risk Management in the Investment World adopting the Fundamentalist Approach. The Fundamentalist Approach invests a disproportionate amount of time, effort and money, in identifying "good" investments, i.e. WHAT to Buy, and they usually acknowledge that they cannot manage the timing of their market entries and exits very well.

In fact, most Fundamentalists believe that it is not possible to manage market timing, i.e. WHEN to buy or sell, with any reasonably reliable degree of accuracy and reliability. Thus, Investment Risk Management is a function of

• identifying good stocks and buying them at a discount to their Intrinsic Value;
  
• holding them for the long term, based on the assumption that in the long term, stocks will outperform other assets, and
• Portfolio Diversification, i.e. buying a variety of types of stocks (Large Capital vs Small Capital, Growth Stocks, also called Green Chips vs Value, normally the Blue Chips) in different markets.
  

The Fundamentalist Approach presumes, rightfully or wrongfully, that if you adopt this strategy to Risk Diversification, you would do well in the long term.

John Authers' presentation above shows that whichever Portfolio Diversification Approach you adopted, i.e. Growth vs Value, Large Cap vs Small Cap, or Markets of US, Japan or Europe, the performances of the funds are about the same. This means that you would have lost a lot of money; but more importantly, the losses are about the same, whichever Portfolio Diversification Risk Management Strategy you adopted.

This blog, together with Chuck Jaffe's video clip discussion on the performance of the 2010 Target Life Funds and Legg Mason Fund in my earlier blog entitled The World has Changed, So Must Your Basic Assumptions demonstrates the importance of managing key assumptions in a changed world.

Today's blog is not a proposal that the Fundamentalist Approach is wrong, or that the Fundamentalist Approach is dead. No, today's blog's objective is to encourage you, my friend, to think carefully, as to what approach works under what conditions, and why, so that the right winning approach is adopted at the right time.

Never fall in love with any one theory on investment. Just as a carpenter requires more than just a hammer, so does a market participant.

As already highlighted in my blog entitled The Three Strategies for Investment / Trading Success,we need to consider the

• Economic Cycle and World Economic Situation, which is the Global Macro Strategy,
• Fundamentals of a Particular Industry and Stock, AND
• Technical Analysis
  

Failure to understand any one of the 3 strategies may lead to disastrous performance results in the financial markets, especially in abnormally, troubled economic times like today.

There will come a time, when Buying & Holding Good Stocks for the Long Term, will make sense once more, especially with a Dollar Averaging Strategy to help manage the ups and downs in market conditions. However, I urge you to reconsider this approach today, in view of the high level of uncertainties plaguing not only the economy, but industries and individual stocks.

The only time when you can be really successful on a consistent basis, in adopting the Fundamental Approach is when two key conditions are fulfilled: -

• The World Economy is Growing, i.e. a Positive Sum Economy, and
• High Probability of Reliability in Profit & Business Performance Forecasts.
  

Obviously, today, we are still in a Negative Sum Economy, i.e. in an Asset Deflation Environment, and most enterprises can't even forecast their own business performance, let alone normal investors with less information.

Old habits die hard. Long entrenched values and beliefs will always be cherished and held on to. To challenge such values, beliefs and assumptions, is to provoke havoc in a person. However, it is necessary, if we are to perform well under extraordinarily abnormal conditions.

I hope that I have provoked such uncomfortable thoughts in you; not because it is fun for me, but because it may save you some losses, or better still, it may make you some money. Of course, the final decision is always yours, and you will live with the decision, or the omission of a decision.

Best wishes,

Ooi
© Copyright 2008 of Praesciens.Blogspot.Com.