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Constructive paranoia [ClearOnMoney]
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Commentary

Constructive paranoia

19 Feb 2011 by Jim Fickett.

A conservative portfolio is not one with a certain fraction of bonds, but rather one in which risk control is paramount.

I saved the following clipping from the Economist months ago, and just ran across it again. The fund management perspective expressed is one I admire:

PIMCO’s power also stems from its ultra-rigorous approach to investing. It has a big team of managers, any number of whom would be stars around which other firms could be built, says Eric Jacobson of Morningstar, a fund-research company. They are called together no less than four days a week, for three hours at a time, to debate the issues of the moment. In each discussion, one group is given the task of offering ideas, a “shadow” group that of shooting them down. It is, says Mohamed El-Erian, Pimco’s chief executive, all part of “a culture of constructive paranoia.”

The main reason I write commentary on this site is that as I write things up, all the objections that someone might make come to the fore, helping me do, on a very limited scale, what Pimco apparently does. (I wouldn't mind, though, to be shot down more often in the comments :-))

This approach reminds me of a related topic, namely how different my idea of a conservative portfolio is from what the big fund managers provide. If you look at, for example, target date retirement funds, the ultra-conservative funds, intended for those near retirement age, are mostly, or even all, bonds, while the aggressive funds, intended for the young, are all, or mostly, stocks.

This is downright silly. Are the bonds of Greece (or the US ten years from now) safer than bank stocks? Are US junk bonds safer than utility stocks paying a similar interest rate? If we have entered a long period of rising rates, will long bonds even provide a positive real return?

I have a very conservative portfolio, as defined not by fraction of bonds, but by risk. I own a fair number of bonds that I bought when interest rates were higher, and shares in a few bond funds (all of the latter with fairly short duration). On each of them there was convincing evidence, when I bought, that the rate offered was more than enough to compensate for both inflation and the risk of default. I own a number of individual stocks. All were bought when the evidence was strong that they were fairly- or under-valued, so that the volatility of the stock market presents little risk of long-term principal loss. When things become overvalued I usually sell, both to keep risk low and to avoid the very dangerous psychology of becoming attached to gains not yet realized. The money I might need soon, and money waiting to be invested, is mostly in money market funds, where I am getting a small negative real return, but little risk of principal loss.

And low risk does not mean low returns. When I bought Cameco it was clearly undervalued. It is now up 58% and probably fairly valued. That money was made by understanding the uranium market better than the average investor, not by taking risk.

The bottom line is to look, either in yourself, if you have time, or in a good manager, for real knowledge and skill. Neither risk management nor money making can be reduced to simple rules.