Here Is the Really Bad News
Your investment advisor went to the same school as your banker.
Panic is a book about ideas, about the ideas that created the crisis, the ideas that your banker, the people who regulate your banker, your Senator (either party) and your investment adviser all still believe.
So as we have been doing media interviews for Panic we have been searching for a way to explain that theory in seconds or minutes. We have found that it is easiest not to talk about the banking system, but about what your investment advisor probably tells you, because that is an experience most people have had or will have.
Sit down with any one of 95% of American investment advisors and they will do the exact same thing. They will ask about your age, your health, your family situation, your investment goals, and your feelings about risk, and how much risk you are willing to take. They ask all these questions because the first thing they want to do is create a “risk/reward” profile for you.
And that right there is the first big element of “modern portfolio theory”, the theory that blew up the banks. Your investment advisor, like your banker, wants to know how much risk you can accept because he believes that “risk regulates return.” He believes that over time how much money investors earn in the market depends on how much risk they are willing to take. The more risk, the more return.
Yes, they really believe that. They learned it in business school. As we show in Chapter 5 in Panic (The Reign of Risk) virtually every basic finance textbook used in undergraduate and graduate finance programs today states this point as absolute dogma: More risk = More return.
Now of course your investment advisor doesn’t believe that any old crazy risk will make more return. No, Modern Portfolio Theory is understood as the SCIENCE of arranging your portfolio so that you will get paid for all the risks you take and don’t take any “inefficient” (i.e. crazy) risks by accident.
Still, this first belief, “risk drives return”, is absolutely fundamental to your advisor’s world-view. It means that your advisor rejects the investment methods of the old masters, men like Benjamin Graham, author of The Intelligent Investor and also Warren Buffet’s teacher.
Graham and the other old masters taught just the opposite idea. They believed that the way to get rich was to identify every risk in your portfolio and ruthlessly eliminate it.
Graham gave his students 11 basic rules for investment. Every single one was a rule for reducing risk or, as Graham would have put it, “increasing the margin of safety.”
Why doesn’t your investment advisor believe in Graham’s rules?
Simple. In business school he was taught those rules were impossible for any investor to follow in practice. Trying to do so would just get an investor in trouble.
Why? Well that takes us to the second great idea, and tomorrow’s column.
Tags: Andrew Redleaf, finance, Investing, Richard Vigilante, Whitebox
