Sadly, I have never been to culinary school.
It is something
I have secretly always wanted to do but have just never had the time. I have
watched lots of videos on cooking and can hold my own with a grilled cheese
sandwich and even occasionally branch out into some simple recipes. Someday, I
may become a real chef, but until then I can lean on ideas like the one I learned
last week. Specifically, the lesson I learned is that there are five mother sauces:
béchamel, velouté, espagnole, hollandaise, and tomato. From these mother sauces, you can literally
make thousands of derivatives.
Apparently, culinary students learn these sauces at the very
beginning of their curriculum, because they are so important in creating dishes.
They can be described as the five heads of all the cooking genres. Think of them as a baseline of knowledge for
cooking. If you don't have these five mastered, or at least have a strong
familiarity with them, then you can never be a great chef. A good cook, perhaps,
but not a chef. I'm obviously not an expert on this topic, but I'll take that assertion
at face value!
So, how does this idea connect to investing and portfolio
management? I think it is an almost perfect analogy. I can't say there are only
five mother rules of investing, but I came up with five rules that I think you
must learn to help you become a great investor (there may be more!).
1. You Can Make a Correct Decision and Still Lose
Anyone who has been involved in the capital markets for longer than a few months will recognize this truth. We can conduct a thorough analysis and study on any given asset. We can make math and logic-based decisions from that study, and yet we will still not win every single time. No investor has ever done that, and none ever will. There could have been investors in the past who made the demonstrably "best" decision every single time based on the then-current fact sets, but they still did not win every time. The way that I try to bring this point home when I teach is to use a very simple example. I write down (and hide) a random number between zero and ten.
I then choose two students to pick a number. The winner of
the game is the person that chooses the number closest to what I wrote down.
The first decision is whether to pick first or second. The first choice should
be obvious. Let's focus on the second chooser. The logical choice for the first
chooser is five, because it is right in the middle, but believe it or not, I
get all sorts of guesses in these situations. Let's say the first player
chooses three. The analytically best choice for the second player is then four,
taking control of all numbers between four and ten. Choosing two is the analytically
wrong or worse answer because it only wins in the less likely case that the
hidden number is zero, one, or two.
But the second player can still lose. Perhaps the hidden
number is three, in which case there was no possibility of winning. Or it could
in fact be zero, one, or two, so the second player could have won, but didn't
due to the choice of four. But given the rules of this game, four was still the
best choice.
The key takeaway from this sauce is that even the best
investors with the most in-depth analytics, tools, and resources will still
sometimes lose. No one is perfect
because the game (or market) doesn't logically allow for perfect. So, no one
should be expected to be perfect. What is important is to cultivate the ability
to describe, explain, and yes, accept, that we can lose even when we do the
"best" thing.
2. Break-Even
The co-founder of Performance Trust, Rich Berg, always lists
this as one of the most important and simple lessons he learned early in his
career. Most brokers and investors focus on many different types of statistics,
such as yield, spread, duration, prepayment speeds, option-adjusted spread, and
other parameters. But the mother sauce of all these derivative statistics is
simple break-even.
Let's break it down to a very simple example that your Uncle
Joe may face when he goes down to the local bank to buy a CD. As he walks in
the lobby, he sees the current CD rates on the board, and is faced with the
following choices:
1 Year CD = 1.00%
2 Year CD = 2.00%
Which one should he buy? Is there a correct choice, as
described above (in rule #1), or is this a different situation? I would argue
that there may not be a correct choice in this situation, but we can use
break-even to help us determine what must occur for a particular choice to lead
to Uncle Joe winning.
If Uncle Joe chooses the 2-year option, we know that he will
earn a total of 4% over the two-year period.
If he decides to buy the 1-year CD at 1.00%, we can immediately know
what must occur for him to at least end up in a tie with the alternative, the 2-year
option. In one year, when the 1-year CD matures, the new 1-year CD must be
paying 3.00% or more, for this choice to end up earning Uncle Joe at least as
much as he can lock in on day one by choosing the 2-year CD. Those are the
facts that are knowable at the moment of decision. Believe it or not, these
decisions are made every single day in the capital markets. The idea of
"compared to what?" that I often reference stems directly from this mother sauce. We can almost always lay out a future
earnings stream and we can measure how long an investment may be. There will
always be a tradeoff between the duration of an investment and its income, and
alternate choices offer a different tradeoff. There may be additional risk
tradeoffs besides prevailing interest rates, but in any case, we should always
know what must occur over the period in question to cause us to win, or lose,
compared to available alternative choices
3. Proper Time Horizons
Very few, if any, great investors have a one-day or even one-quarter
investment horizon. Yet, many of the structures we are forced to bow to tend to
push us into worrying about shorter and shorter horizons. Most public companies
must report their earnings on a quarterly basis. Our boards and committee often
reflect on and react to, results every month, and the broker-dealer community presses
us to react in minutes, hours, or if we are lucky, days. This is really messed
up. If you happen to be a portfolio manager for some sort of financial
institution, your time horizon must be extended if you want to make great
decisions; you need to give yourself time to be right. This is especially true with
fixed-income portfolios.
One of the most difficult questions I get is "How long
should my time horizons be?" and the simple answer is that there is no correct
answer. In our approach, we happen to use a combination of one-year and three-year
horizons for day-to-day decisions, because we think it is important to measure short-term
risk along with longer-term reward. However, even longer horizons are
appropriate for evaluating manager performance, to capture the value of a
longer sequence of decisions. Warren Buffet apparently believes the same,
famously saying:
"If you aren't willing to own
a stock for ten years, don't even think about owning it for ten minutes."
I would say the contractual nature of fixed income
investments may allow for a shorter "willing to own" standard, but the idea
still applies. Longer horizons give us a chance to earn income and offset short-term
price fluctuations. At the very least, we need to have this discussion with our
reporting bodies. We happen to be at this moment in a very good demonstration
of why. Rates have risen dramatically over the last three to six months, and
this is causing investors to react to price dislocations without considering longer-term
implications. The longer the time frame we give ourselves for decision-making context,
the higher our chances to make wiser choices. Always fight the inclination to
focus on short horizons.
4. Portfolio Management is Not About One Security
We all get caught up in this one. I do not know a person who
only owns only one position. Most of the portfolio managers I know have several
hundred-line items and yet, they could still fall into the trap of immediacy
when a broker calls with a hot idea, and they react to a single security in
isolation. This is almost never a good idea. While I agree that the markets are
not perfectly efficient, and occasionally there are exceptionally "great" deals,
this is the exception and not the rule. Brokers rely upon the idea of urgency
and stress your need to act quickly. Really great strategists focus on the
portfolio—and hopefully the entire balance sheet when making individual decisions.
This concept is so important that it should be a focus for
all portfolio managers.
We may take on positions that don't seem to make logical
sense—by themselves—but in the context of the entire portfolio we are managing
they not only make sense but are very wise. However, to prepare this sauce
well, we do need to have a very detailed understanding of our portfolio and
balance sheet. Selecting sauce
ingredients one by one, without regard to all the ingredients, is a recipe
for... well, probably something awful.
5. Cheap Does Not Mean Better
If you had a teenager with a brand-new license, would you try to buy the cheapest possible used car you can lay your hands for them to drive? Would your only focus be on the spread between the car for your teenager and the next cheapest vehicle currently available in the marketplace?
Seriously: would you buy them a car if the tires were bald,
the engine was sputtering, and the windows were broken? Of course not.
Unfortunately, I can't tell you how many times I have heard a portfolio manager
tell me they bought a security because the broker showed how cheap it was to
the market.
This makes no sense.
Why is it so cheap? Usually because it involves selling a
ton of optionality or accepting poor quality in some underlying
characteristics. If you really think about it, this is what pushed us into the
sub-prime mortgage catastrophe of 2007. Investors chased yield without regard
to structure or creditworthiness. They
just went for cheap. The vast majority of the CDO market in 2005-2007 was
focused on the supposed high yield available from reconstituted garbage. None
of this still felt cheap when it started to fail and headed towards $0.
There is almost no sphere of decision making in which people focus solely on cheapness, except when it comes to securities, and especially fixed income securities. It is the sales pitch of choice for most fixed income brokers: "This bond is cheap!" You have probably heard that siren song many times. Sometimes, of course, options become overpriced, and it makes sense to purchase securities that can create more income for a known level of risk, but we always need to measure this over a proper time horizon and across a variety of scenarios.
Conclusion
I would sincerely
love to hear about any mother sauce that you use when making investment
decisions. I tried to choose these
sauces based on their applicability to every investor, large or small, and I am
also pretty sure I didn't identify them all!
Final, final thought: Speaking of mother sauces makes me
hungry. As always, I am looking for good recipes! I'm an alright cook, but not
a chef. Any ideas on how to use some of these sauces in dishes I can manage would
be greatly appreciated!
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The information,
analysis, guidance, and opinions expressed herein are for general and
educational purposes only and are not intended to constitute legal, tax, securities,
or investment advice or a recommended course of action in any given situation.
Information obtained from third-party resources are believed to be reliable but
not guaranteed. All opinions and views constitute our judgments as of the date
of writing and are subject to change at any time without notice. Past
performance does not guarantee future results.
