Investment Policy and the Competent Stranger

Ronald Goodall

The word "strategy" was derived from the ancient Greek word strategos which meant a general, a military leader. "Strategy' is the term applied to the science of planning and directing military operations as distinguished from the term "tactics" which is applied to the use made of troops within those operations.

There are two types of actions which can be taken within the military strategy, actions of offence and actions of defence. Strategic offensive actions include envelopment which is the procedure of gaining the enemy rear, cutting communications and then destroying the enemy position; double envelopment; the turning movement; penetration and pursuit. Strategic defensive actions include position defence which is the procedure of securing a specific battle position; mobile defence and flanking positions.

The terms strategy and strategic planning appear to have been introduced into the business vocabulary in the 1920s. Peter Drucker defines strategic planning as "the continuous process of making present entrepreneurial decisions systematically and with the greatest knowledge of their futurity." Many ideas have been advanced and many texts written on the application of strategic planning to business. However, it seems to me that business today is turning again to military concepts to use in conducting business. In the current spate of takeovers, one hears and reads of military concepts such as the poison pill, the white knight and the golden parachute.

This return to military concepts may lead to new business strategies. One of my favourite business authors, C. Northcote Parkinson, apparently has discovered that in certain fields of warfare, the number of enemy killed varies inversely with the number of generals on one's side!

Charles Ellis earned a BA. at Yale, an M.BA. (with distinction) at Harvard Business School, and a Ph.D. at New York University. He has taught at the Yale School of Management and at the Harvard Business School.

Before joining Greenwich Associates, an international business strategy, consulting, and research firm, Mr. Ellis was vice-president of Donaldson, Lufkin & Jenrette and an associate of Rockefeller Brothers Inc.

He is the author of four books (Investment Policy, The Second Crash, Institutional Investing, and The Repurchase of Common Stock) and more than 50 articles on business, finance, and investment management. He is a chartered financial analyst and an editor of the Financial Analysts Journal. He has served two terms as a trustee of the Institute of Chartered Financial Analysts and one term as president.

Mr. Ellis serves as a trustee of Phillips Exeter Academy and of Eagle Hill School. He is an overseer of the schools of business at New York University, and serves on the visiting committee of the Harvard Business School.

Mr. Ellis and his wife, Susan, live with their sons, Harold and Chad, in Greenwich, Connecticut.

Ladies and gentlemen, please welcome Charles D. Ellis, managing partner of Greenwich Associates, who will address us today on "Investment Policy and the Competent Stranger."

Charles Ellis

Investment policy does not enjoy much popularity. Almost everyone agrees that it is a "good" thing, but almost no one does anything about it.

An extraordinary paradox prevails in the field of investment, particularly professional investment. The paradox is that 99 per cent of all the efforts and energy and skill of investment professionals is devoted to a difficult, even disagreeable task in which they're very unlikely to be successful. And if successful, the success will be small and not long-lasting. Meanwhile, they spend less than 1 per cent of their time and effort on a task that takes very little time, is not very difficult, yet is nearly sure of success and brings good rewards.

The very hard, seldom-rewarded task is to "beat the market" by outsmarting and outworking the competition. The relatively easy and rewarding task is to determine each client's real needs and then set reasonable goals and structure portfolios that can and will meet them.

I plead with those who are not in the investment management field to have a greater degree of respectful distrust for those who are. They are wonderful people. They are brilliant. They are articulate and they have charm. They work very, very hard. And they have the best intentions. They truly want to win.

However, they have misplaced their bets and you-as their client-own the bets. I urge you to be cautious and skeptical. Moreover, I advocate that you do something about it.

First, let me tell you a little bit about investment management. There are three ways in which you might try to achieve superior results: one is physically difficult; one is intellectually difficult; and one is emotionally difficult.

Warren Buffet, John Templeton, Dean LeBaron and Warren Goldring and a very few others have staked out the intellectually difficult way of beating the market.

Intellectually difficult investing is pursued by those who have a deep and profound understanding of the true nature of investing, see the future more clearly and take long-term positions that turn out to be remarkably successful. We admire them, but only in retrospect. At the time of their doing their best work, we see them as misguided. We do not want to do what they are doing because it looks so unpromising.

Most of the crowd is deeply involved in the physically difficult way of beating the market. See if you don't recognize the physically difficult right away. They come to the office earlier; they stay later. They read a larger number of reports more rapidly. They go to more breakfast meetings and more luncheon meetings and more dinner meetings. They are on the telephone, making more calls and receiving more calls than all the rest. They carry huge briefcases home at night, determined to get ahead by reading more reports before the morrow. In every way they possibly can, they put enormous physical energy into trying to beat the market by outworking the competition. What they don't seem to recognize is that so is almost everyone else.

Being incapable of doing the intellectually difficult, and reluctant about the physically difficult, I have set about the emotionally difficult approach to investing. This straightforward, untiring approach is simply to work out the long-term investment policy that's truly right for you and your particular circumstances and is realistic given the history of the capital markets, commit to it and-here is the emotionally difficult part-hold on.

When your friends turn to you and say, "Wow! have I got an opportunity for you! This is a great time to buy!" be absolutely uninterested. And when they turn to you and say, "Oh, Lord, this is it. It's going to be one hell of a crash. Get out now while you can!" you must simply be not interested, absolutely sound asleep. No intellectual effort; no physical effort; but for most, emotionally far too difficult. It suits me just fine. It requires no great genius and no great brawn, but it works.

Now, what is investment policy and whose responsibility is it? First of all, just as war is too important to leave to generals, investment policy is too important to leave to investment professionals. And the reason is simple. Investment managers know a great deal about a great many things in investing-the economic outlook for every major nation, the earnings expected for dozens and dozens of companies, the prices of hundreds of stocks, etc. But their expert knowledge has nothing to do with the specific client. Yet setting sound investment policy depends primarily on knowing the whole story of the specific client's financial situation, expectations and needs and the client's fears, constraints and goals.

Managers will be preoccupied by the demanding daily details of investing while clients' goals and needs are longterm. There's only one way to establish the right investment policy: it must be done by the client.

How can you be a superior client? First, know your own financial situation. Know your long-term goals. Know what your limits are. But be careful. Most people approach investments as if the right "solution" were mathematical, and their investment objectives rational. The objective factors are usually not the most important parts of the "best" investment policy. Experience teaches that the subjective and emotional factors are usually more important because the emotional errors-buying too high because of excessive confidence or selling too low because of excessive anxiety-do more harm than rational errors. So you need to know as well what is your emotional situation and what are your emotional constraints. What riskiness can you live with and live through? Can you hang on when the pressure is most intense and the data most compelling that you are clearly wrong? If not, recognize your own emotional realities-and learn to live well within them.

To become a superior client, you will want to study and understand the capital markets, how they behave over the short and long run, so you will never be surprised or shaken by their future behaviour. Benign neglect is vital to superior clienting.

Select the managers you admire, respect and trust as human beings. Here's the test: if their investment performance is poor for two or three straight years, would you gladly give them more money to manage? If your answer is not clearly in the affirmative, you should not choose that manager-you don't trust him enough. Encourage the managers when their recent results look poor, for they will desperately need it. And then be "reserved" when the current results look great-they don't need praise and applause when they've been lucky and the market's been with them.

Be sure that each manager understands your specific goals and your specific limits. To do this you really must put it in writing. Insist on regular and formal meetings. At these meetings, which need only take 15 minutes' time, restate your goals and constraints and ask, "is there any reason to change our specified goals or our defined constraints?"

Also insist on a careful restatement of the investment philosophy and decision-making process of the investment manager and ask, "Have you made any changes in your philosophy or your process?" If there are no changes, you then review the operation of the portfolio since the last meeting to be sure it matches agreed-upon policy. After this, the real meeting is completed. It shouldn't take more than 15 minutes to do all of the serious work because there really should be nothing "new" and nothing that's "interesting."

Commit yourself absolutely to the discipline of setting and adhering to sound policy. Avoid the many fascinating, enticing distractions that are so prevalent in investing and you will avoid a lot of trouble. In this way, you can assure the achievement of truly good performance: performance that really does meet the real goals of your specific fund.

Now, I'd like to offer you a short test: You are called by Mr. Mulroney to the Hill. He takes you aside and says, "if you will accept the mandate, your nation is going to send you on a secret mission. Your name will go down in history as one of Canada's great national heroes. You will be very safe while on your mission. But you will be gone for 10 long years, and for the entire 10 years you will be incommunicado.

"I have some good news for you," he goes on. "First, your family is being brought here in an hour to say goodbye and to wish you well. They will have been briefed about this mission and will be thrilled that you have been chosen.

"Second, I have retained the services of a highly competent investment professional. You do not know this professional. I regret to say she cannot come to Ottawa today, but we do have about an hour before your family will arrive and I have put pencil and paper in the next room. If you would just go into that room and take the available hour to write down for the Competent Stranger your complete investment policy, the Competent Stranger will implement your policy exactly as you state it. And when you return, the portfolio for which you have been responsible will be returned to you-having been managed faithfully by the Competent Stranger in accordance with your instructions."

Some test! Could you pass it to your own satisfaction? Of course, it's only a story. It's just to catch your attention. But if you are not able to sit down and write out in an hour's time what you are trying to do with your portfolio and how you intend to do it-in such a way that a competent and able professional could take those instructions and fulfil them-you should at least consider making a serious study of your objectives, your risk aversion, the nature of the capital markets, your cash inflow and outflows, and the design of an investment policy that is truly right for the long term, for you. Being a superior client is not easy. It means taking an important responsibility and doing the work. But this is one investment that is guaranteed to pay off. I urge you to make the investment.

The appreciation of the audience was expressed by Douglas L. Derry, a Past President of The Club.