2018 Second Quarter Commentary

Tom Wolfe, the acclaimed journalist and novelist of the Wall Street tale The Bonfire of the Vanities, passed away several weeks ago.  If you’ve read Wolfe, he might prefer we use the present tense to write about his life.  He wrote in that form, as the reporter he was (is).

Modern finance works along similar lines as Wolfe’s description of modern art.  Those who advocate Modern Portfolio Theory say that the model is more important than the qualities of individual investments within a portfolio.  If a stock or group of stocks in the past has moved in price according to certain patterns of return and volatility (risk), then buy if favorable, regardless of the companies the stocks represent.  An intellectually consistent theory, I believe, just rather incomplete.

In one of Wolfe’s critical masterworks, The Painted Word, he tells how modern art begins with a Truth, a theory of the art.  Wolfe also calls it the Word — modern art avoids reproduction of real scenes.

Wolfe ridicules those who champion theory even as they minimize an artwork’s technical or realist qualities.  He writes that they believe as “like Plato’s cave dwellers watching the shadows, without knowing what had projected them.”

In modern art, Wolfe says, what the viewer sees, the reality of what is painted or sculpted, is thought unimportant.  It’s theory that tells you what you see!

Let’s not forget (as many financial advisors do) that in the real world a stock represents an ownership stake in a business.  Over the long term, the underlying prospects of the business are arguably what drives its stock price up or down.  In the historical record, we see how stocks moved as they did.

When a company’s return on investment falls below its financial costs, that’s bad.  If a company can’t pay the interest on its borrowings over an extended period, that’s even worse, i.e. Tesla automobiles.

As much as the Modern Portfolio Theory can tell you how a portfolio’s risk can be reduced through holding investments in combination, reducing the risk that any single investment would drag down the portfolio’s returns, it doesn’t tell you a whit about how to identify an undervalued investment.

So many investment managers value theory more than what you can see.  Don’t allow theory to overrule.

I believe that a composite picture of real world observations builds what we’re looking to create — a balanced portfolio where each individual investment stands on its own merits.
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Sources:
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Tom Wolfe (1975).  The Painted Word.  New York: Farrar, Straus and Giroux.

Steven D. Bleiberg (2018 April).  “The Limits of Theory."  Epoch Investment Partners, Inc.  Retrieved http://www.eipny.com/white-papers/the-limits-of-theory/